**U.S.SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-K**

** **

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the Year Ended December 31, 2006**

**Commission File No. 000-31267**

** **

**IWTTESORO CORPORATION**

(Exact name ofregistrant as specified in its charter)

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

 

**191 Post Road West, Suite 10, Westport,Connecticut 06880**

(Address of principal executive offices)(zipcode)

**(203) 221-2770**

(Registrant’s telephone number, including areacode)

Securities registered underSection 12(b) of the Exchange Act: ** None**
| Title of Each Class | ** ** | **Name of Each Exchange on Which Registered** |
|------------------------------------|------------|-----------------------------------------------------------------------------|
| NONE                               |       | NONE                                                                        |

 

Securities registered under Section 12(g) of the Exchange Act:

**Common Stock, $.001 par value**

(Title of Class)

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes  x No

Indicate by check mark if the registrant isnot required to file reports pursuant to Section 13 or Section 15(d) of theAct. o Yes  x No

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports, and (2) has been subject to such filing requirements for thepast 90 days.  Yes  x   No  o

Indicate by check mark if disclosure ofdelinquent filers in response to Item 405 of Regulation S-K is not containedherein will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference inPart III of this Form 10-K or any amendment to thisForm 10-K. o

Indicate by a check mark whether theregistrant is a large accelerated filer, an accelerated filer, ornon-accelerated filer.
| Large accelerated  filer   o | Accelerated filer   o | Non-accelerated filer   x |
|---------------------------------------------|--------------------------------------|------------------------------------------|

 

Indicated by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Act). o Yes  x No

State the aggregate market value of the votingand non-voting common equity held by non-affiliates computed by reference tothe price at which the common equity was last sold, or the average bid andasked prices of such common equity, as of the last business day of theregistrants most recently completed second fiscal quarter:  $2,004,891.

**APPLICABLEONLY TO CORPORATE REGISTRANTS**

Indicate the number of shares outstanding ofeach of the registrant’s classes of common equity, as of the latest practicabledate:  12,103,067 shares as of March 21,2007

**DOCUMENTSINCORPORATED BY REFERENCE**

The Registrant has incorporated by reference theinformation required by Part III of this Annual Report on Form 10-Kfrom its proxy statement relating to the 2007 Annual Meeting of Stockholders ofthe Registrant, to be filed within 120 days after the end of its fiscalyear ended December 31, 2006.

 

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**Tableof Contents**
| **Part I**   | ** **                                                                                      | ** ** |
|-------------------|-------------------------------------------------------------------------------------------------|------------|
| Item  1.          | Business                                                                                        |       |
| Item 1A.          | Risk Factors                                                                                    |       |
| Item 2.           | Properties                                                                                      |       |
| Item 3.           | Legal Proceedings                                                                               |       |
| Item 4.           | Submission of Matters to a Vote of Security Holders                                             |       |
|              |                                                                                            |       |
| **Part II**  |                                                                                            |       |
| Item 5.           | Market for Registrant’s Common Equity and Related  Stockholder Matters                     |       |
| Item  6.          | Selected  Financial Data                                                                        |       |
| Item 7.           | Management’s Discussion and Analysis of Financial  Condition and Results of Operations     |       |
| Item 7A           | Quantitative and Qualitative Disclosures About Market  Risk                                     |       |
| Item 8.           | Consolidated Financial Statements and Supplementary  Data                                       |       |
| Item 9.           | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure           |       |
| Item 9A           | Controls and Procedures                                                                         |       |
| Item  9B          | Other  Information                                                                              |       |
|              |                                                                                            |       |
| **Part III** |                                                                                            |       |
| Item 10.          | Directors and Executive Officers and Corporate  Governance                                      |       |
| Item 11.          | Executive Compensation                                                                          |       |
| Item 12.          | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters |       |
| Item 13.          | Certain Relationships and Related Transactions, and  Director Independence                      |       |
| Item 14.          | Principal Accountant Fees and Services                                                          |       |
|              |                                                                                            |       |
| **Part IV**  |                                                                                            |       |
| Item 15.          | Exhibits and Financial Statements Schedules.                                                    |       |

 

 

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**PART I**

**FORWARD LOOKING STATEMENTS**

Statements made in this Annual Report are “forward-lookingstatements” and are not historical facts. For example, statements regarding ourfinancial position, business strategy and other plans and objectives for futureoperations, and assumptions and predictions about future demand for ourservices and products, supply, costs, marketing and pricing factors are allforward-looking statements. When we use words like “intend,” “would”, “anticipate,”“believe,” “estimate,” “plan” or “expect” or the negative of these terms andsimilar expressions we are making forward- looking statements. You should beaware that these forward-looking statements are subject to risks anduncertainties. Additionally, our forward-looking statements speak only as ofthe date of this report. Other than as required by law, we undertake noobligation to update or revise these statements, whether because of newinformation, future events or otherwise. New factors emerge from time to timethat may cause our business not to develop as we expect, and it is not possiblefor us to predict all of them. Factors that may cause our actual results,performance or achievements to be materially different from the results,performance or achievements expressed or implied by the forward-lookingstatements include, among other things:

·                  Ourability to successfully implement our business plan, including expanding ourmarkets, increasing our product lines, and maintaining high quality customerservice;

·                  Continuingand cultivating our relationships with current and new vendors;

·                  Fundingour growth in a manner that is beneficial to our stockholders;

·                  Trendsaffecting our financial condition or results of operations, the impact ofcompetition, the start-up of certain operations, roll out of products andservices and acquisition opportunities;

·                  Restraintson pricing flexibility due to competitive conditions in the flooring industry,while taking into consideration factors beyond our control such as increases infreight and tariff charges, and  currencyrisks;

·                  Dependingon third party suppliers outside the United States;

·                  Theimpact of adverse weather conditions, both in our targeted markets, as well aswith respect to our foreign suppliers; and

·                  Otherrisks referenced from time to time in our SEC filings.

**ITEM1.****                        DESCRIPTIONOF BUSINESS**

### Executive Summary

IWTTesoro Corporation’s (Tesoro) primary business is as a wholesale distributor ofbuilding materials, specifically hard floor and wall coverings. We do not selldirectly to any end user. Our products consist of ceramic, porcelain andnatural stone floor, wall and decorative tile. We import a majority of theseproducts from suppliers and manufacturers in Europe, South America, and theNear and Far East.

Ourmarkets currently include the United States and Canada. We distribute to ourcustomers from four regional warehouses located in Florida, Ohio, Texas andCalifornia. Tesoro provides value added services for our customers ranging frommaintaining significant inventories to fulfill daily orders for smallercustomers to shipping full truckloads of mixed manufacturers’ product to largerdistributors to containers of product shipped directly to our customers fromthe manufacturer. We also offer private label programs for branded retail salescustomers, buying groups, large homebuilders and home center store chains.

Ourcompetition comes from the major full line flooring companies such as Mohawkand Shaw Industries. On a regional basis, there are a number of distributorsthat import competing products and distribute them to smaller dealers. Many ofthese regional distributors maintain retail operations as well. These largerdistributors are becoming Tesoro’s customers for products that are manufacturedfor us on an exclusive basis, which can be shipped directly from the factory.

Tesoro’sfocus is on bringing value to its customers in the form of broad productassortment, current design and competitive pricing. Some of the key componentsof this focus are:

·                  Maintaining strong relationships withsuppliers that allow us to influence design, buy in large quantity and selectthe best manufacturers

·                  Locating product close to ourcustomers to control freight costs, including shipping in our own truckswhenever possible

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·                  Shipping smaller customer orders thesame day they are received

·                  Meeting larger customers’ needs forvolume by shipping full truck loads domestically or container volume directfrom the foreign factory

·                  Supporting our products withaggressive marketing and merchandising programs

Todate, we have financed our growth with revolving debt facilities currentlyprovided by The Bank of America and Laurus Master Funds, Ltd. We have also usedpublic and private offerings of our common stock. If adequate financing is notavailable, we will most likely be forced to slow down our growth.

### **Background**

IWTTesoro Corporation was organized in Nevada on May 3rd, 2000.  Effective October 1, 2002, Tesoroacquired all of the outstanding common stock of International Wholesale Tile,Inc. (IWT) from its three stockholders. IWT was organized in Florida and hasbeen in continuous operations since 1994. In exchange for the IWT stock, theIWT stockholders each received 3.0 million Tesoro shares, representing 83%of Tesoro’s then outstanding common stock

Tesorois the parent company and currently has five wholly-owned subsidiaries and oneof its subsidiaries has a wholly-owned subsidiary as follows:

Ourprincipal executive office is located at 191 Post Road West, Suite 10,Westport, CT 06880. Our telephone number is (203) 221-2770. Our web site can befound at**http://www.iwttesoro.com. Our marketing web sites can be foundat http://www.internationalwholesaletile.com andhttp://www.tesorocolletion.com. Information contained on our web site is notpart of this report.

**Tesoro’sBusiness Strategy**

Webelieve that our corporate strategy to grow through augmenting our  product lines, adding to the types of goodsand services we provide to our customers, and expanding into new territories,while maintaining our strong commitment to customer service will continue tohelp us maintain a competitive advantage. We have been doing this through subsidiaries, each of which are focusedon different aspect of the business.  Through our subsidiaries, we can offer a wide range of product atattractive price points, whether our customers want to buy a small amount ofproduct for a specific project or large amount, for inventory and resale. Whilefocused on the same strategy, each subsidiary has slightly different objectives.

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**InternationalWholesale Tile, Inc.’s (IWT) Business Objectives**

IWT iscurrently our largest and primary operating subsidiary.  As part of our business model, we haveestablished what we consider is a close relationship with flooring dealersthroughout the Sunbelt area of the United States. We feel that we currentlyprovide a purchasing and delivery experience for our customers that meets theirbusiness needs and capacities.

Thefollowing have been the factors that have been critical to our success withrespect to our strategy and philosophy:

·                  We supply quality products;

·                  We are known for our outstanding andpersonalized customer service;

·                  Our pricing is competitive;

·                  We continually introduce new productsto the marketplace; and

·                  We only distribute on a wholesalelevel and not directly to the consumer.

Whilewe ship product in quantities that can range from small cut orders to fullpallets to complete truckloads of mixed products, the current core of ourbusiness is the cut order. Cut order sales include less than a pallet of mixedfloor, wall and decorative tiles specific to a project.  This special handling defines us as avalue-added reseller, rather than merely a distributor and allows us tomaintain higher margins.  We do notoperate any retail outlets. This non-competitive relationship is unique in theceramic floor and wall tile distribution industry, has been a key factor in ourgrowth.

Otherkeys success factors include:

·                  Active merchandising programs throughregional advertising,

·                  Assisting our dealers to meet theircustomers’ demand, with products presented in attractive easy to visualizeenvironments, and

·                  Acting as the extension of our dealernetworks’ stock availability by warehousing levels consistent with the dealers’delivery requirements.

### Other Tesoro Subsidiaries’ Business Strategies

·                  The Tile Club (TTC) intends toacquire licensing, manufacturing and distribution rights for high-end designerand artistic based decorative tiles and to act as an agent for foreignmanufacturers from whom IWT has acquired exclusive distribution rights.  TesoroDirect, Inc. f/k/a Import Flooring Group, Inc. a subsidiary of TheTile Club, Inc., distributes lower quality “seconds”, discontinued series  and slower moving floor and wall coveringmaterials.

·                  American Gres, Inc. (AGI) wasrecently formed to explore the possibility of constructing a state-of-the-arttile manufacturing facility in the Southeast United States.  Our intent is to produce ceramic andporcelain tiles domestically to compete with certain imported goods.  Manufacturing these products locally willalso reduce freight and tariff costs associated with imported tiles.  We have targeted a site location, but no finaldetermination has been made.  In November2006, we  entered into a developmentagreement with an Italian group to design, develop and manage the manufacturingfacility, so long as certain contingencies are met  including obtaining $15 million in financing.

IWTTesoro Transport, a federally licensed freight broker (USDOT), could expandfrom a regional to a national distribution system following the recent effortsto generate sales nationwide.  Until thisexpansion takes place, Transport will remain inactive.  Additionally, IWT Tesoro International, ourBermuda subsidiary, is also inactive.

### Pricing Strategy

Wemaintain a wide distribution of price points for the products we import. Ourpricing strategy provides flexibility to customers allowing them to purchaseproducts in quantities that best fit their sales inventory capacities. Thelowest volume

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product package isthe cut order or project specific unit. For the cut order unit, we act as acustomer fulfillment center. We pick product from full pallets of differentmaterial, reassemble and repackage it for the customer. The next level of unitincludes single pallets of uniform material shipped individually to thecustomers’ location. Above the pallet unit is the full truckload of mixedpallets. We land these to our warehouses and reship to the customer. We carrysignificant levels of inventory to meet the demand for these units and shipmost orders within three days of the customers’ order. Our customers can alsobuy product units directly from the factory. These factory shipping units arefull container volumes. The customer can land the product, i.e. pay the freightand duties or purchase the product landed to their location in which case wehandle the shipping.

### Distribution Centers

Ourwarehousing and distribution centers currently contain over 483,000 square feetof storage space, in which we maintain over 38.8 million square feet of productready for immediate shipment to our customers. In 2006, our warehouseconfiguration included 314,000 square feet in Palm City, FL, 120,000 squarefeet in Dallas, Texas, 9,000 square feet in Canton, Ohio, and 40,000 squarefeet in Pomona, CA at a public warehouse facility. As we expand, we will likelyneed additional satellite warehouse locations. In 2006 a new automated warehouse tracking system was installed in theFlorida warehouse.

### Branded Products

IWThas created Tesoro The Collection®, a branded collection of high qualityporcelain floor and wall tiles complemented by coordinated decorative bordersand listellos. This collection is supported with an extensive merchandisingprogram including grouted display boards and racks, and institutional marketingand advertising. We prominently display the Tesoro line at all of the nationaland regional flooring exhibitions in which we participate

**Factorsfor Tesoro’s Success**

Inorder to meet our corporate goal of building a national building materialsdistribution company that is a value added reseller, Tesoro must be successfulat accomplishing most, if not all the following objectives:
| · | Augment our client base and market penetration by  expanding nationally                                                                           |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                              |
| · | Establishing sub-distribution centers in the West,  Midwest and Northeast regions,                                                                |
|   |                                                                                                                                              |
| · | Creating dealer networks in new territories, and                                                                                                  |
|   |                                                                                                                                              |
| · | Expanding value added services;                                                                                                                   |
|   |                                                                                                                                              |
| · | Deepen our current customer base penetration by  increasing our market share with current dealer customers;                                       |
|   |                                                                                                                                              |
| · | Maintain our high level of customer service and  satisfaction;                                                                                    |
|   |                                                                                                                                              |
| · | Obtain adequate capital to support the necessary  inventory levels required by our customers;                                                     |
|   |                                                                                                                                              |
| · | Continue strengthening our relationships with  suppliers to ensure a continuous flow of high quality, competitively priced  contemporary designs; |
|   |                                                                                                                                              |
| · | Ensure a continuous flow of high quality, current  design and competitively priced products;                                                      |
|   |                                                                                                                                              |
| · | Increase the number and breadth of products we  carry, and                                                                                        |
|   |                                                                                                                                              |
| · | Strengthen our consolidated balance sheet by  reducing our debt to equity ratio.                                                                  |

 

Giventhe right opportunity we intend to look to acquire assets of businesses withproducts and services that complement ours. We further intend to grow byacquiring or merging with existing regional distributors.

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**TheFloor and Wall Tile Covering Industry**

TheJuly 18/25, 2006 edition of Floor Covering Weekly (FCW) reported that U.S.floor covering sales for 2005, the last full year for which data is available,reached $24.2 billion, in wholesale dollars, up 5.9% from 2004. The market forceramic floor and wall tile products in the United States, Tesoro’s majorproduct line, reached $3.1 billion in 2005 up 7.3% from 2004. Sales of ceramicfloor and wall products reached approximately 3.3 billion square feet in 2005.By 2010, the consumption of ceramic floor and wall tile in the US is expectedto reach 4.3 billion square feet (source; Tile Magazine (www.tilemagazine.com),with an estimated increase of 6% per year (source: www.ceramicworldweb.it). For2005 Ceramic tile is the second most widely used floor covering material in theU.S., with a market share, according to FCW, of 12.7% behind carpet and arearugs (62.2%) and ahead of hardwood (10.7%). Carpet and area rugs continue to lose market share to hard flooringproducts, with a 3.9% growth from 2004 to 2005 compared to overall growth ratefor the category of 5.9% for the same period.

The per square foot wholesale price for the products inthe floor covering market varies widely. The average price per square foot in2005, according to FCW, was $0.86. The price ranges from $2.36 for hardwood to$0.48 for vinyl. Ceramic floor and wall tile’s average price in 2005 was $0.94down from an average of $1.02 in 1997. By contrast, the price of hardwoodflooring has increased to $2.36 from $1.83 in 1997. Other types of flooringmaterials, including carpet have remained relatively stable.

The U.S. floor and wall covering market is impacted byseveral economic activities. The U.S. population continues to grow and requiresadditional new and renovated housing. Average house sizes are growing, upapproximately 12% since 1994.

Long acknowledged for its durability andfunctionality, ceramic tile now means fashion. Consumers can chose from softhues or primary colors, finishes that resemble stone, wood or fabric, and canincorporate metal and glass accents for flexible design. The high growth rateof ceramic tile relative to other flooring options has led to more full servicedistributorships, manufacturers, and retailers adding ceramic tile to theirlines. With more floor space being devoted to ceramic tile at retail, effortsat product differentiation have intensified. Licensing, a relatively newstrategy in the ceramic tile marketplace, is heating up, including thefollowing partnerships: Shaw Industries with Martha Stewart and Kathy Ireland;Witex with Laura Ashley, Armstrong’s Liz Claiborne line in partnership withCarpet One, and Marrazzi Group with Benetton.

Sales in the floor covering industry are alsoinfluenced by economic and market factors including:

·                  consumerconfidence;

·                  spendingfor durable goods;

·                  interestrates;

·                  turnoverin housing, the condition of the residential and commercial constructionindustries; and

·                  theoverall strength of the economy.

**Products**

Wepurchase our products on the world market. We import approximately 47% of ourproducts from Italy, 12% from Spain, 21% from Brazil and the balance fromVenezuela, Turkey and China. Each foreign manufacturer has registered agents inthe United States that work with us, as well as with other distributors. Webelieve that we maintain close personal contact with our suppliers, visitingthe plants regularly and working with suppliers to influence design, qualityand reliability. We do not currently purchase any raw materials, but onlyfinished goods.  No one supplier accountsfor 10% or more of products.  Our principalsuppliers and the countries in which each is located include:

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| Italy             | ** ** | **Spain**   | ** ** | **Brazil**     | ** ** | **Turkey**        | ** ** | **China**    | ** ** | **United States** |
|-------------------|------------|-------------|------------|----------------|------------|-------------------|------------|--------------|------------|------------------------|
|              |       |        |       |           |       |              |       |         |       |                   |
| Acif              |       | Alfa        |       | Delta Ceramica |       | Vitra-Eczacibasis |       | MegaCera USA |       | America Marazzi        |
| Ceramicasa        |       | Porcelanico |       | Incepa         |       | Ege Seramik       |       |         |       |                   |
| Ceramiche         |       | Cermaica    |       | Ceramicos      |       | American          |       |         |       |                   |
| Castelvetro       |       |        |       | Lume Cermica   |       |              |       |         |       |                   |
| Ricchetti Ceramic |       |        |       |           |       |              |       |         |       |                   |
| Uda Ceramica      |       |        |       |           |       |              |       |         |       |                   |
| Isla Tiles        |       |        |       |           |       |              |       |         |       |                   |

 

Wecarry over 200 separate product lines. A product line consists of severalprofiles, sizes (of the same tile design, i.e. six inch by six inch, twelveinch by twelve inch) and matching or coordinating borders. Annually we add anddelete lines to keep the selection current with industry and consumertrends.   We estimate that there is a 10%turnover in the lines annually. This translates into approximately 20 new linesadded each year replacing a similar number of deleted lines. We believe we haveample time to transition into the product lines as the time to manufacture andship new lines can exceed nine months. This lead-time, allows us to draw down inventoryof deleted lines to a minimum level before being eliminated from stock.

Wemaintain a wide distribution of price points for our product. We establishbasic price levels based on the volume of product purchased. We also addadditional charges for handling of material. Within price levels there arevariances based on the quality, source and composition of the product. Theaverage wholesale price of ceramic floor and wall tile has declined over thelong term, reaching $0.94 per square foot in 2005. The 2005 price is a slightincrease from the $0.91 per square foot experienced in 2004 but down from the1997 average price of $1.02. According to the industry magazine, Floor CoveringWeekly (July 2005), the market for high- end porcelain tiles and decorative/designertile has been increasing. The 2005 price seems to bare this out. We emphasizethis high-end tile and stone by selectively marketing them to dealers anddistributors with customer bases that demand such products

Weship product to our customers in quantities ranging from “cut order” specificto a consumer’s project to full pallets of a single product to full containerand truckload packages. These larger quantities allow our customers to stocktheir own product to service cash and carry consumers.

Weimport a majority of our products into the Port of Miami. In 2004, we expandedour distribution facilities to Dallas, Texas. Product imported for distributionfrom our Dallas facility arrives via the Port of Houston. In addition, we alsoimport products into the port of Long Beach, California. Orders that areshipped directly from the manufacturer to our customers may enter through anynumber of U.S. ports.

**Inventory**

We arecommitted to maintaining inventory levels that support the sales of our customernetwork. We currently maintain approximately $30.7 million of product ininventory, representing over 2,500 SKU’s (individually numbered product items).We act as the warehouse and fulfillment source for many of our approximately2,700 dealers and wholesale customers. We target an inventory turn over rate of1.5 to 2.0.  This turn rate isestablished to minimize back orders, which are deminis, and to attain our goalof same day shipping for qualified orders. Since we ship most of our customer orders on the day they are received,our backlog of orders is not material.

Industrytrends toward product packages, floor and wall tile combinations and thepre-organized tile, borders, decorative listellos, bull nose and end caps,increases the number of parts we must carry in stock to ensure that ourcustomers can meet the demand of their consumer.

**Freightand Transportation Costs**

Webase our distribution costs on a number of factors including, among others,

·                  factorycost,

·                  freight(international and domestic), and

·                  duties,tariffs, taxes and other regulatory costs.

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Oceanfreight charges differ from country to country therefore, the selling price isbased on factors specific to each international manufacturer. We pay most ofour international manufacturers in U.S. dollars. The strength of the U.S.dollar relative to a specific country’s currency will have an impact on theprice we pay for product. Additionally, we also take into account that title toour products transfers to us at the port of the originating country. Wegenerally ship between 10 and 20 containers at any one time. We currentlyestimate that our maximum exposure for loss of any one shipment of product tous would be approximately $75,000.  Based on maritime loss history, cost of ocean marine insurance and ourultimate ability to subrogate against the freight carrier, we self-insure inthe event of loss after title is taken. Our in-bound freight cost, gasoline,fuel and other surcharges have increased our shipping costs.

**RevenueSource**

Wegenerate all our revenue from the U.S. territory and currently have no salesoutside the country. Within the United States, the majority, over 92%, of ourrevenue is derived from the southern region of the country.

**CustomerBase and Distribution Channels**

WhenIWT first began business in 1994, it started our distribution history focusingon the traditional small and mid-sized floor-covering dealers in thesoutheastern United States. Later, it expanded its distribution channels overlarger regional distributors outside the southeastern United States, homecenter stores and floor-covering dealers that focus on the builders of newconstruction units. We maintain separate and coordinated sales forces for eachchannel of distribution. We sell different product series in each channel toavoid market saturation or channel conflict. No one distributor or independent dealer sells over 5% of our products.

Wecurrently distribute our products through four separate distribution channels.

·                  Theindependent retail floor-covering dealer and stocking distributor market is ourlargest channel. This channel currently accounts for about 43.5% of the salesrevenue. These customers, who sell directly to the public, can be either “cutto order” or “stocking” dealers/regional distributors. We currently serveapproximately 2,000 customers in this channel through our sales personnel. Inaddition, we have sub-distributors that handle specific market territories forlimited numbers of our Tesoro-The Collectionâproduct packages.

·                  Themajor home center “buy-it-yourself/do-it-yourself” store market makes up oursecond distribution channel. These customers typically operate under blanketpurchase orders. There are three basic programs for home center stores. Thefirst is a special order program. Consumers place orders from sample boardsprovided by us to the store. The store representatives forward these orders tous and we ship the product either directly to the consumer or to the store forpick-up by the consumer. The second program is a stocking program, whichprovides for a home center store to maintain specific product inventories fortheir cash and carry trade. The third program is “Special Buys”. Under thisprogram the customers purchase large quantities of specific product for specialpromotions. The home center store channel currently accounts for about 5.6% ofour revenue.

·                  Ourthird channel, accounting for 26.4% of our revenues, is made up of nationalbuying groups. These groups support independently owned, branded floor coveringoutlets with coordinated buying agreements that require us to market directlyto each individual retail outlet. This channel also includes large builders,who staff and maintain captive design centers specifically for their owncustomers.

·                  Ourfourth channel is the bulk sale channel. In this channel we service retailbuyers that purchase full truckloads or containers of specific product that ismanufactured for us specifically for this program. These products can bedrop-shipped from our manufacturer directly to the customer. The customer basefor this channel is the United States and Canada. This channel makes up theremaining 24.5% of our sales.

**Merchandising**

Themarket for ceramic tiles, once characterized by little or no brand recognition,is beginning to enter into branding agreements with well-known designer namessuch as Ralph Lauren and Laura Ashley. In May 2002, IWT introduced ourproprietary brand Tesoro-The Collectionâ.Tesoro is a collection of porcelain tiles and decorative inserts, borders, andaccents that are marketed throughout the United States. We have invested inspecifically designed display racks that communicate the quality and value ofour Tesoro brand that we believe assists our dealers in communicating productcombinations to the consumer. We are continually updating these displays withnew products. We have a fifteen-year

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manufacturer’swarranty program for Tesoro-The Collectionâproducts that we believe elevate the quality position of our products.

Inaddition to the display units, we provide our customers with display boardsthat are smaller and show a single line of product with its accent pieces.These boards are portable so as to allow the dealer to easily show our productor take it to the installation site. Our sales force distributes lose samplepacks, usually an assortment of colors for a single product line, whenever aline or dealer needs restocking. We account for the sample packs and displayunits and sample boards, along with the labor and overhead involved in creatingthem, as promotional expenses, when they are distributed to the customers. Ourpromotional expense represents a significant part of our cost of doingbusiness.

**Creditand Collection Procedures**

·                  Wemaintain strict criteria for credit approval:

·                  Potentialcustomers must complete our credit application;

·                  Creditmust be approved by our credit department; and

·                  Wemay require a personal guaranty.

Onceapproved, typically our dealers receive 30-day terms. Our bulk truckloadcustomers may be offered extended terms of payment. We generally provide a15-day grace period and new orders are held and not shipped once an outstandinginvoice is 60 days or older. We have purchased credit insurance for theseextended term customers to offset some of the risk inherent in the extending oflonger credit terms.

Additionally,to be an IWT customer, a business must, at a minimum:

·                  Havea storefront designed to market tile

·                  Sellto retail customers

·                  Operateat least one forklift

·                  Acceptmaterial in bulk

**Marketing,Promotion and Sales**

Wecurrently employ 1 full-time individual to develop our marketing andadvertising material. Our public relations and marketing activities focus onsupporting our customer’s sales efforts. We use trade magazines articles,specifically designed mailer programs and trade shows as our primarycommunication devices.

Ourcommission based sales force work with dealers to place the products inshowrooms, educate the dealers regarding the quality and variety of productavailable to them and work with our internal customer service staff tofacilitate delivery. IWT employs a twenty-six person full time sales force,most of who have been with us for five years after spending many years invarious facets of the tile business.

**Competition**

Wecompete in the flooring industry with both large national companies that supplyboth soft and hard materials and with smaller regional distributors that focusspecifically on ceramic, porcelain and stone. Vertically integrated companiessuch as Shaw Industries and Mohawk, the two largest flooring providers, accountfor over 60% of the hard surface market in the U.S. While maintaining theirdominant positions in the carpet market, both companies are moving aggressivelyinto the hard flooring sector. Dal-tile, a subsidiary of Mohawk; manufactures,wholesales and retails tile on a national basis.

Regionalcompetitors such as Master Tile, Florida Tile and Arizona Tile act as bothwholesalers and retailers. In their markets, each supplies smaller dealers anddistributors and also operates branded retail outlets. We currently onlydistribute at the wholesale level.

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Webelieve that our competitive strengths include:

·                  *Focusing solely on the wholesale segment of thedistribution process.* We do not own or operate direct to consumerlocations. We work exclusively through dealers and stocking distributors orbuying groups who service the buying public. As a result, we do not competewith our customers. Our customers can buy specific materials from us to meet aconsumer’s need, i.e. “cut orders” or can stock limited amounts of product forcash and carry business by purchasing larger quantities.

·                  *Getting involved in designing products.* Weactively participate in designing and selecting new color, texture and formatsfor emerging style tends. Our field sales force is constantly working with ourcustomers to identify trends in the market. Feedback from these sources iscontinuously shared with the manufacturers. Manufacturer’s representativesfrequently meet with us and our management travels to the manufacturing sitesto communicate the markets needs.

·                  *Building our Tesoro-The Collection**â brand equity.* We are branding our designsand many of our products with our Tesoro Brand. We incorporate products fromdifferent manufacturers and different countries into programs that leverage thebest of each source to create Tesoro collections. Unlike most other tile andceramic products, Tesoro products include a 15-year manufacturer’s warrantyagainst wear.

·                  *Providing superior merchandising and customer supportprograms.* We maintain an active sampling program to ensure thatcustomers have the latest materials in their showrooms. Our field sales forcecontinually updates, refreshes and replaces sales materials. We distributeliterature to consumers referencing our dealer network participants. Our fieldpersonnel work with the customer and train them on the appropriate use and careof the product. Our goal is to make the dealers’ job as easy as possible.

·                  *Implementing our Distribution Philosophy.*We see ourselves as an extension of the dealer warehouse. We aim to beresponsive to our customers’ needs by shipping most orders the same day theyare received. We also carry stock to back-up our customers in the cash andcarry market.

Bymaintaining these competitive strengths, we currently believe that we canprofitably challenge our competitors for a greater share of our targetedmarket.

Additionally,manufacturers generally extend exclusives through their agents to distributorsbased geographically. Therefore, we currently believe specificproduct-to-product competition is rare.

**GovernmentRegulations**

TheFederal Trade Commission regulates our wholesale operations. The Federal MotorCarriers Administration regulates Transport’s freight activities. Internationalis an exempt company subject to Bermudian commercial law. We do not expect toimport product into Bermuda and will therefore maintain our exempt status. Bothfederal and state authorities regulate the distribution and sale of importedproducts. We have obtained all required federal and state permits, licenses andbonds to operate our businesses. We make no assurances that our operations andprofitability will not be subject to more restrictive regulations, oversight,or increased taxation by foreign, federal, state or local agencies.

Wecurrently purchase our products from foreign manufacturers in U.S. dollars. Ourfund transfers are relatively large. The Office of the Comptroller of theCurrency (USOCC) monitors these activities. Should the Euro continue tostrengthen against the US dollar, we could see an increase in our cost ofproduct that we may not be able to pass on to our customers and therefore wecould suffer a detrimental impact on our profitability. Our competitors rely asheavily on imported product as we do. Therefore, we do not see any change inthe competitive landscape for ceramic tile because of the strength of the Euro.

**Acquisitionsand other Interests**

Tesorointends to expand its operating activities through internal geographical growthand through acquisition. We have had preliminary discussions withmanufacturers, product aggregators and agencies in Spain, Italy and Brazil. Inthe United States, we plan to expand our geographical position by acquiring theassets of similar, but smaller, distributors. We cannot assure anyone, however,that any of these discussions will result in the intended acquisitions or thatany acquisitions, if made, will generate the planned revenue or profits.

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**IntellectualProperty**

Weincorporate our proprietary brand Tesoro® in connection with a collection ofporcelain tiles and decorative inserts, borders, and accents. With respect tothis brand, we rely on common law and Lanham act protection. InDecember 2004, we were granted federal trademark protection for our markTesoro The Collectionâ. We make noassurances that any trademark or other protections will be meaningful. We arenot aware of any claims of infringement against us and we have not beeninvolved in any related court proceedings.

**Employees**

IWTTesoro and its subsidiaries currently employ 135 people, of which, 132 arefull-time and 3 are part-time, including 55 warehouse staff and 26 salespeoplecovering sales in the United States and Canada. None of its employees aremembers of any union. The remaining 54 employees include customer service,accounting and administrative positions. IWT believes that its relationshipswith its employees are good. Tesoro currently has three employees while theother subsidiaries do not have any employees.

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**ITEM 1A. RISK FACTORS**

**ImportantRisk Factors Concerning our Business.**

*Youshould carefully consider the following risk factors and all other informationcontained in this Annual Report in evaluating our business and prospects. Therisks and uncertainties described below are not the only ones we face.Additional risks and uncertainties other than those we described below that arenot presently known to us or that we believe are immaterial may also impair ourbusiness operations. If any of the following risks occur, our business andfinancial results could be harmed. You should also refer to the otherinformation contained in this Annual Report, including our consolidatedfinancial statements and the related notes.*

**RISKFACTORS**

Investing in ourcommon stock involves a high degree of risk. You should carefully consider thefollowing important risk factors and the other information contained in thisreport before investing in our stock. The price of our securities could declinebecause of any of these risks, and you could lose all or part of yourinvestment. You also should read and consider the other information included inthis report, including the financial statements and related notes. If any ofthe events described here occur, our business prospects, financial conditionand operating results could be materially affected in a negative manner.

**COMPANYRISKS**

WE HAVE SIGNIFICANT OUTSTANDING INDEBTEDNESS

Our revolving line ofcredit with our primary commercial lender is $26.5 million and matures on June10, 2007. As of December 31, 2006 our outstanding balance was $24.4 million. Ifwe are not able to comply with the covenants and or terms required by ourcommercial lenders, we could be subject to penalties including additionalinterest charges or accelerated repayment of the loans.  On October 24, 2006, we received a noticefrom our senior credit facility that we were in default of certain requirementsof their revolving line of credit.  InNovember 2006, we entered into a forbearance agreement, and as of March 24, 2007,our loan was extended to June 10, 2007. However, while the lender has agreed to forbear, it has not waived anyof its rights resulting from our defaults, and could at any time, exercise anyof its rights against us.  We also haveapproximately $8.7 million of debt with a second lender.  If we are unable to renew or replace ourprimary loan, we could be forced to severely curtail our operations and sellour assets at a loss to repay this obligation. Substantially all of the company’sassets secure our credit facilities.

OUR CREDIT FACILITYREQUIRES US TO MAINTAIN CERTAIN FINANCIAL AND PERFORMANCE COVENANTS

If we are not ableto comply with the covenants and or terms required by our commercial lenders,receive a waiver or forbearance from the lender or cure the violation withinthe time allowed by the contract, we could be subject to penalties includingadditional interest charges or accelerated repayment of the loans.

WE HAVE SIGNIFICANT DEBTSERVICE OBLIGATIONS

If the company isunable to meet its debt service obligations under its existing debt structures,our lenders could claim default and impose penalties including increasedinterest or accelerated repayment of the loans.

A LARGE PORTION OF OURINDEBTEDNESS IS SUBJECT TO INTEREST RATE ADJUSTMENTS BASED ON THE US PRIME RATE

If interest ratesincrease, we would experience an increase in our cost of financing that couldadversely impact our profitability.

WE WILL NEED TORAISE ADDITIONAL FUNDS IN THE FUTURE FOR ACQUISITIONS AND GROWTH.  IF WE CANNOT SECURE ADDITIONAL FUNDS, WE MAYNOT BE ABLE TO EXPAND OUR BUSINESS.

To fund our growth, we will need to sell additionalequity securities and/or accept debt financing. If we need to obtain additionalfinancing, it may not be available or it may not be available on termsacceptable to us.  There is no limit asto the amount of debt we may incur and we have not adopted any ratio of ourequity to debt.  We currently have both asenior

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revolving credit facility in the principal amount of$24.4 million out of a total available of $26.5 million and subordinated debtof  $8.7 million.  ** **If additional funds are raisedthrough issuing stock, the value of our outstanding stock may be significantlydiluted.

WE HAVE SUFFERED NET LOSSES OF APPROXIMATELY$3,439,000, $4,344,000, and $ 1,209,000  FORTHE YEARS ENDED DECEMBER 31, 2006, 2005, and 2004, RESPECTIVELY.   AT DECEMBER 31, 2006, WE HAD A WORKINGCAPITAL DEFICIT OF APPROXIMATELY $5.3 MILLION.

If we are not ableto generate net profits in the future, we could be forced to raise additionalcapital or liquidate assets to support our working capital needs of thecompany.

THE EFFECTS OF SEVEREWEATHER CONDITIONS, SUCH AS RECENT HURRICANES IN THE SOUTHEAST, COULD ADVERSLEYAFFECT OUR SALES.

We do not selldirectly to any end user and; therefore, depend on a network of independentdealers and distributors for our sales. A prolonged interruption of our customers’ ability to sell our product,caused by damage form severe weather, could reduce our sales significantly.

WE MAY BE UNABLETO PASS ON TO OUR CUSTOMERS INCREASES IN TRANSPORTATION COSTS, WHICH COULD HAVEA MATERIAL EFFECT ON OUR PROFITABILITY.

Significantincreases in transportation costs could adversely affect our operating marginsand our business, financial condition and operating results. Although wegenerally attempt to pass on increases in the costs to our customers, ourability to do so, to a large extent, depends on the timing and magnitude of anyincrease, as well as competitive pressures and market conditions for ourproducts. There have been, in the past and may be in the future, periods oftime during which increases in these costs cannot be recovered. During theseperiods, our profitability could be adversely affected. Likewise, the outboundtransportation costs differ depending on how far our products are to beshipped, which may not always be passed on to our customers.

IF WE GROW TOO QUICKLY,WE COULD ENCOUNTER PROBLEMS RELATED TO INCREASED CUSTOMER DEMANDS ON OURLIMITED RESOURCES.

Rapid growth wouldplace a significant strain on our managerial, operational, financial and otherresources. Our systems, procedures, controls and management resources may notbe adequate to support our future operations. Future growth will require us to

·                  implementadditional management information systems,

·                  furtherdevelop our operating, administrative, financial and accounting systems, and

·                  maintainclose coordination between departments.

If we cannotmanage our growth, we could limit our ability to capitalize on new business opportunitiesthat may arise,  implement our businessplan or attain our objectives. Additionally, we cannot assure anyone that ourpersonnel, systems and controls will be adequate to support future growth. Ourinability to manage growth or to maintain the quality of our products andservices could cause us to lose customers and could significantly increase ouroperating expenses.

IF WE ARE UNABLETO RETAIN OUR MANAGEMENT TEAM, OUR BUSINESS OPERATIONS AND OUR GROWTHOBJECTIVES MAY BE ADVERSELY AFFECTED.

Our success inachieving our growth objectives depends upon the efforts of our top managementteam including the efforts of Henry J. Boucher, Jr., our Chief ExecutiveOfficer, David Whitwell, our Chief Financial Officer, and Forrest Jordan,  Paul F. Boucher and Grey Perna, each of whomis a Senior Vice President, as well as other members of our management.  While we do have written employmentagreements with each of these individuals, we currently do not have employmentagreements with all our employees. The loss of the services of any of theseindividuals may have a material adverse effect on our business, financialcondition and operating results. We may not be able to maintain and achieve ourgrowth objectives should we lose any or all of these individuals’ services.

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GENERALLY, WE MUST PAYALL COSTS AND EXPENSES INCURRED WITH DEFENDING ANY ACTIONS ALLEGED AGAINST ANYOF OUR DIRECTORS.

Our articles ofincorporation and bylaws allow us to indemnify our officers and directorsagainst losses sustained or liabilities incurred arising from any transactionin that officer’s or director’s respective capacity.  We have entered into separate indemnityagreements with each of our executive officers and directors.  We purchase Directors and Officers LiabilityInsurance to protect the company against any such allegations.  Any obligations we incur defending any suchallegations that exceed the limits of our insurance coverage could adverselyaffect our cash flow and profitability.

OUR ARTICLES OFINCORPORATION AND BYLAWS CONTAIN CERTAIN PROVISIONS THAT COULD HINDER A CHANGEIN OUR CORPORATE CONTROL.

Certain provisionsof our articles and bylaws may discourage, delay or prevent a merger oracquisition that a stockholder may consider favorable to our stockholders. Onlyour directors may call annual stockholder meetings and only our directors,officers or stockholders holding not less than a majority of all sharesentitled to vote may call a special stockholder meeting.  Likewise, our bylaws require noticeprocedures with regard to stockholder proposals and nominations of candidatesfor electing directors are required. Furthermore, vacancies on our Board,including newly created directorships, may be filled by a majority of ourdirectors then in office and not by our stockholders.

In addition,certain provisions of Nevada law where Tesoro is incorporated  could have the effect of making it moredifficult or more expensive for a third party to acquire, or of discouraging athird party from attempting to acquire, control of us. Nevada law provides thatnot less than two-thirds stockholder vote is required to remove a director,which could make it more difficult for a third party to gain control of ourboard of directors. Nevada law also provides that our preferred stock may beissued in series from time to time with such designation, rights, preferencesand limitations as our board of directors determines by resolution and withoutshareholder approval. Our board of directors could issue preferred stock withdilutive or voting preferences to delay, defer or prevent stockholders frominitiating a change in control of the company or reduce the rights ofstockholders to the net assets upon dissolution. Nevada also specifies that ourarticles of incorporation may require not less than two-thirds vote of thestockholders for approval of certain business combinations.

**RISKS INTHE FLOOR AND WALL COVER INDUSTRY.**

THE FLOOR AND WALLCOVERING INDUSTRY CAN BE CYCLICAL AND PROLONGED DECLINES IN RESIDENTIAL ORCOMMERCIAL CONSTRUCTION ACTIVITY COULD ADVERSELY AFFECT OUR BUSINESS.

Our industrydepends on residential and commercial construction activity, including both newconstruction, as well as remodeling. New construction activity and remodelingto a lesser degree, is cyclical in nature and a prolonged decline inresidential or commercial construction activity could have a material adverseeffect on our business, financial condition and operating results.

WE FACE INTENSECOMPETITION IN OUR  INDUSTRY, WHICH COULDDECREASE DEMAND FOR OUR PRODUCTS AND COULD HAVE A MATERIAL ADVERSE EFFECT ONOUR PROFITABILITY.

This industry ishighly competitive. We face competition from a large number of domestic andforeign importers and independent distributors.   Some of our existing and potentialcompetitors may be larger and have greater resources and access to capital thanwe do. Maintaining our competitive position may require us to make substantialinvestments in our product design efforts, distribution network, and sales andmarketing activities. Competitive pressures may also result in decreased demandfor our products and in the loss of market share.  In addition, we face, and will continue toface, pressure on sales prices of our products from competitors, as well asfrom our customers. As a result of any of these factors, there could be amaterial adverse effect on our sales and profitability. Hard flooring productsalso face competition from alternative products such as carpet and vinyl.

**INVESTMENTRISKS**

IN THE FUTURE WEMAY ISSUE MORE SHARES OF OUR SECURITIES, ESPECIALLY INCLUDING COMMON STOCK.THIS WOULD REDUCE INVESTORS PERCENTAGE OF OWNERSHIP AND MAY REDUCE OUR SHAREVALUE.

Our Articles ofIncorporation authorizes our issuing up to 100 million shares of common stockand 25 million shares

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of preferredstock. If we issue all or part of our remaining authorized common stock orpreferred stock, depending on its terms, the percentage of common stock held byexisting stockholders would be diluted. Issuing common or preferred stock forfuture services or acquisitions or other corporate actions may have the effectof diluting the value of the shares held by our investors, and might have anadverse effect on the value of our shares.

OUR COMMON STOCKIS LISTED ON THE OTCBB, AND AS SUCH, IT MAY BE DIFFICULT TO RESELL YOUR SHARESOF STOCK AT OR ABOVE THE PRICE YOU PAID FOR THEM OR AT ALL.

Securities tradingon the Over-The-Counter Bulletin Board like ours ordinarily have much lowertrading volume than on the NASDAQ Capital Market (formerly NASDAQ SmallCap).Very few market makers take interest in shares traded over-the-counter; and,accordingly, the markets for such shares are less orderly than is usual forNASDAQ or the American Stock Exchange (AMEX) traded securities. As a result ofthe low trading volumes ordinarily obtained in over-the-counter markets, salesof our securities in any significant amount can generally not be absorbedwithout a dramatic reduction in price. Moreover, thinly traded shares in theover-the-counter markets are more susceptible to trading manipulations than isordinarily the case for more actively traded shares.  As of the date of this report, our commonstock has traded on a very limited and sporadic basis.

The trading priceof our securities may be highly volatile and could be subject to wide fluctuationsin response to factors such as the active float of our securities could besmall, meaning that relatively small trades of our securities could materiallyeffect the share price and other general economic or stock market conditions,many of which are beyond our control.

OUR STOCK PRICE IS HIGHLY VOLATILE AND INVESTING IN OUR STOCK INVOLVES AHIGH DEGREE OF RISK.

The market pricefor shares of our common stock, has and could likely continue to, fluctuate andbe extremely volatile in the future, as it has in the past.   Our stock has traded between $.51 and $2.70during 2006.  This volatility is a resultof our common stock being so thinly traded.  Factors that have affected and may continue to affect the market priceof our common stock include:

·                  actualand anticipated fluctuation in our operating results;

·                  lackof research coverage for companies with small public floats like us;

·                  adverseweather in the Southeast; and

·                  ourability to control our growth.

Additionally, thefuture sale of a substantial number of shares of common stock by existingstockholders or by us may have an adverse impact on the market price of theshares of common stock being offered hereby. Because our stock price is so volatile, investing in our common stock ishighly risky and a potential investor must be able to withstand the loss oftheir entire investment in our common stock.

IF WE FAIL TO REMAINCURRENT ON OUR REPORTING REQUIREMENTS, WE COULD BE REMOVED FROM THE OTCBULLETIN BOARD WHICH WOULD LIMIT THE ABILITY OF BROKER-DEALERS TO SELL OURSECURITIES AND THE ABILITY OF STOCKHOLDERS TO SELL THEIR SECURITIES IN THESECONDARY MARKET.

Companies tradingon the OTC Bulletin Board, such as us, must be reporting issuers under Section12 of the Securities Exchange Act of 1934, as amended, and must be current intheir reports under Section 13, in order to maintain price quotation privilegeson the OTC Bulletin Board. If we fail to remain current on our reportingrequirements, we could be removed from the OTC Bulletin Board. As a result, themarket liquidity for our securities could be adversely affected by limiting theability of broker-dealers to sell our securities and the ability ofstockholders to sell their securities in the secondary market.  Tesoro has been delinquent in two of itsfilings and the OTC Bulletin Board only permits two delinquencies in any twoyear period. If Tesoro is delinquent with our required listings within the next18 months we would be removed from the OTC Bulletin Board.  Following any removal, Tesoro’s shares again become eligible forquotation on the OTCBB when it has filed periodic reports for one year in atimely manner.

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BECAUSETESORO HAS BEEN DELINQUENT IN ITS PERIODIC FILINGS, ITS DISCLOSURE CONTROLS ANDPROCEDURES MAY BE INEFFECTIVE.

Our Annual Report on Form 10-K for the year ended December 31, 2005 andthe Quarterly Report on Form 10-Q for the quarter ended March 31, 2006 wereboth delinquent.  The delays weresubstantially due to Tesoro’s ineffective monitoring of new SEC releases,discussion and recommendations and became aware of a release that required itto re-analyze its accounting treatments for certain debt instruments.  Tesoro is now actively monitoring the SECwebsite on a timely and consistent basis so that it can incorporate any changesor modifications to its preparation of reporting and other filings.

“PENNY STOCK” REGULATIONSMAY IMPOSE RESTRICTIONS ON MARKETABILITY OF OUR SECURITIES.

The Securities andExchange Commission has adopted regulations which generally define “penny stock”to be any equity security that is not traded on a national securities exchangeor NASDAQ and that has a market price of less than $5.00 per share or anexercise price of less than $5.00 per share, subject to certain exceptions.Since our securities are currently included on the OTC Bulletin Board and aretrading at less than $5.00 per share at any time, our stock may become subjectto rules that impose additional sales practice requirements on broker-dealerswho sell such securities to persons other than established customers andaccredited investors. Accredited investors generally include investors thathave assets in excess of $1,000,000 or an individual annual income exceeding$200,000, or together with the investor’s spouse, a joint income of $300,000.For transactions covered by these rules, the broker-dealer must make a specialsuitability determination for the purchase of the securities and must receivethe purchaser’s written consent to the transaction prior to the purchase.

Additionally, forany transaction involving penny stock, unless exempt, the rules require, amongother things, the delivery, prior to the transaction, of a risk disclosuredocument mandated by the SEC relating to the penny stock market and the risksassociated therewith. The broker-dealer must also disclose the commissionpayable to both the broker-dealer and the registered representative, currentquotations for the securities and, if the broker-dealer is the sole marketmaker, the broker dealer must disclose this fact and the broker-dealer’spresumed control over the market. Finally, monthly statements must be sentdisclosing recent price information for the penny stock held in the account andinformation on the limited market in penny stocks. Consequently, the pennystock rules may restrict the ability of broker-dealers to sell our securitiesand may affect your ability to sell your shares.

SINCE WE HAVE NOT PAIDANY DIVIDENDS ON OUR STOCK AND DO NOT INTEND TO IN THE NEAR FUTURE, A PURCHASEROF OUR STOCK WILL ONLY REALIZE A GAIN ON HIS OR HER INVESTMENT IF THE MARKETPRICE OF OUR SECURITIES INCREASES.

We have neverpaid, and do not intend to pay, any cash dividends on our common stock in thecurrent year. Therefore, an investor in this offering, in all likelihood, willonly realize a profit on his investment, in the short term, if the market priceof our common stock increases in value.

A SMALL NUMBER OFSTOCKHOLDERS WILL STILL OWN MOST OF OUR SECURITIES.

As of March 20,2007, and assuming no conversion of any derivative securities such as warrants,options or convertible notes, our executive officers and directors and theiraffiliates beneficially owned, in the aggregate, approximately 81.6 % of ouroutstanding common stock.  As a result,our executive officers and directors collectively are be able to exercisecontrol over matters requiring stockholder approval, such as the election ofdirectors and the approval of significant corporate transactions. These typesof transactions include transactions involving an actual or potential change incontrol or other transactions that the non-controlling stockholders may deem tobe in their best interests and in which such stockholders could receive apremium for their shares.

**AdditionalInformation**

Tesoromakes available free of charge its annual reports on Form 10-K, quarterlyreports on Form 10-Q, current reports on Form 8-K and any amendmentsfiled or furnished pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934 as soon as reasonably practical after they arefiled or furnished to the Securities and Exchange Commission. Such reports areavailable on the Company’s Web site (http://www.iwttesoro.com) or obtained bycontacting Investors Relations group at 1.203.221.2770 or at IWT TesoroCorporation, 191 Post Road West, Suite 10, Westport, Connecticut 06880.Information contained on our web site is not part of this annual report.

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**ITEM 2.****                        PROPERTIES**

### **Executive Office Space — Connecticut**

Tesoro currently subleases office space in Westport,Connecticut. We pay a base service fee of $2,400 per month and automaticallyrenewed the lease every six months. Tesoro anticipates that it will be securinga more permanent space in the foreseeable future.

**Warehouse and Office Space — Florida**

IWT signed a 15-year operating lease for 300,000 squarefeet of adjacent warehouse facilities in Palm City, FL.  Within the 300,000 square feet warehousefacility there is 20,000 square feet (on two floors) of office space. EffectiveAugust 1, 2006, IWT entered into an agreement to lease 14,000 square feet inPalm City to house our bullnose operation. The lease is a 15-year operatinglease through 2021 and is located adjacent to the existing warehousefacilities.

**Warehouse Space - Texas**

EffectiveDecember 1, 2004, IWT entered into an agreement to lease warehouse spacein Dallas, Texas.  Over the first 18 months IWT phased in the use ofwarehouse space and now occupies the full 120,000 square feet.  The leaseis for 64 months. The average monthly lease amount is approximately $46,000,based on the life of the lease and includes, in addition to the lease space,common area charges, taxes, insurance and management fees. The new warehousespace is our first warehouse facility outside Florida.  IWT expects thatit will support its current customers and sales force in Texas and in theSouthwest.  This new location is also part of IWT’s strategic plan toincrease its sales and customer service throughout the Sunbelt (southern andsouthwestern United States).

### **Contract Warehouse Space - California**

EffectiveJuly 1, 2005 IWT and IFG entered into separate agreements with WSI, awarehouse management company in Pomona, California. The contract provides forflexible storage space based on demand and handling charges.

**Warehouse Space - Canton Ohio**

EffectiveFebruary 15, 2006 IWT assumed the lease for 9,270 square feet of warehouse andoffice space in Canton Ohio.  Monthlyexpense is approximately $6,000 and the lease runs through January 31, 2008.

**Tesoro’soperating lease costs**

Totalestimated costs of our long-term operating leases as of December 31, 2006,are as follows:

| 2007                                               |   | $          | 2,036,000  |   |
|----------------------------------------------------|--------|------------|------------|--------|
| 2008                                               |   | 2,067,000  |       |
| 2009                                               |   | 2,098,000  |       |
| 2010                                               |   | 1,818,000  |       |
| 2011                                               |   | 1,627,000  |       |
| Thereafter  (remaining portion of a 15 year lease) |   | 15,382,000 |       |
| Total payments                                     |   | $          | 25,028,000 |   |

 

**ITEM3.****                        LEGALPROCEEDINGS**

We arenot a party to any material pending legal proceedings and, to the best of ourknowledge; no such action by or against us is contemplated, threatened orexpected.

**ITEM4.****                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

We didnot submit any matters to a vote of our security holders during the fourth quarter of 2006.

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**PART II**

**ITEM 5.****                       ****MARKET PRICE FOR REGISTRANT’SCOMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

*(a)**          MarketInformation*

We have beenfiling periodic reports with the Securities and Exchange Commission sinceOctober 2000. Our common stock has been trading on the OTC Bulletin Board sinceDecember 17, 2003 under the symbol “IWTT” on a limited and sporadic basis andthere is no established public trading market for our common stock nor maythere ever be.  We were delinquent infiling our Annual Report on Form 10-K for the year ended 2005 and our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2006.  During the time our filings were not on time,our stock traded under the symbol “IWTTE.OB” Since then, we have filed our quarterly reports in a timely manner.  The OTC Bulletin Board only permits twodelinquencies in any two year period.  IfTesoro were delinquent again in filing any of its periodic reports throughMarch 31, 2008, our common stock will be delisted from trading on the OTCBB.

The followingtable presents the range of high and low sale prices for the common stock asreported by the OTC Bulletin Board for the period so noted:

|                                | ** ** | **High Bid** | ** ** | **Low Bid** | ** ** |
|--------------------------------|------------|-------------------|------------|------------------|------------|
| **2003**                       | ** ** | ** **        | ** ** | ** **       | ** ** |
| December 17 —  January 31 |       | $                 | 6.50       |             | $          | 6.00 |   |
| **2004**                       | ** ** | ** **        | ** ** | ** **       | ** ** |
| First Quarter                  |       | $                 | 6.25       |             | $          | 5.00 |   |
| Second Quarter                 |       | $                 | 5.25       |             | $          | 4.00 |   |
| Third Quarter                  |       | $                 | 4.25       |             | $          | 2.25 |   |
| Fourth Quarter                 |       | $                 | 3.75       |             | $          | 2.48 |   |
| **2005**                       | ** ** | ** **        | ** ** | ** **       | ** ** |
| First Quarter                  |       | $                 | 2.55       |             | $          | 1.60 |   |
| Second Quarter                 |       | $                 | 2.95       |             | $          | 1.60 |   |
| Third Quarter                  |       | $                 | 3.15       |             | $          | 2.60 |   |
| Fourth Quarter                 |       | $                 | 2.70       |             | $          | 2.10 |   |
| **2006**                       |       |              |       |             |       |
| First Quarter                  |       | $                 | 2.70       |             | $          | 1.14 |   |
| Second Quarter                 |       | $                 | 1.25       |             | $          | .51 |   |
| Third Quarter                  |       | $                 | 2.00       |             | $          | .75 |   |
| Fourth Quarter                 |       | $                 | 2.45       |             | $          | 1.50 |   |
| **2007**                       |       |              |       |             |       |
| January 1 — March 15      |       | $                 | 2.45       |             | $          | 1.20 |   |

 

*(b)**          OurStockholders*

At March 28, 2007,12,028,067 shares of common stock were outstanding, which were held byapproximately 314 stockholders of record. Through December 31, 2006, Tesoro repurchased 6,105 shares at fairmarket through a single broker-dealer.

*(c)**           OurDividend Policy*

We have neverpaid, and do not intend to pay, any cash dividends on our common stock for theforeseeable future.  Therefore in alllikelihood, an investor in this offering will only realize a profit on hisinvestment, in the short term, if the market price of our common stockincreases in value.

(d)*           SecuritiesAuthorized to be Issued Under our Equity Compensation Plans *
| ** **                                              | ** ** | **(a)  Number of Securities  to be issued upon Exercise  of Outstanding options,  warrants and rights(1)** | ** ** | **(b)  Weighted-average  Exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of Securities  remaining available for  future issuance under  equity compensation plans  (excluding securities in  column (a))** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                              | ** ** | ** **                                                                                                                                                   | ** ** | ** **                                                                                                       | ** ** | ** **                                                                                                                                                                                        | ** ** |
| Equity  compensation plans approved by stockholders     |       | 602,249                                                                                                                                                      |       | $                                                                                                                | 3.14       |                                                                                                                                                                                              | 3,397,751  |   |
| Equity  compensation plans not approved by stockholders |       | 0                                                                                                                                                            |       | 0                                                                                                                |       | 0                                                                                                                                                                                                 |       |
| **Total**                                               |       | 602,249                                                                                                                                                      | (2)        | $                                                                                                                | 3.14       |                                                                                                                                                                                              | 3,397,751  |   |

----

(1)           Tesoro’s Stock Incentive Plan includes theright to grant options and to issue restricted stock and the Plan was approvedby Tesoro’s then sole stockholder in December 2001. This number reflects56,800 registered shares issued pursuant to the Plan through December 31,2006. In January 2004, all the shares underlying the Plan were registeredpursuant to a registration statement on Form S-8 and those shares alreadyissued were registered for resale, all pursuant to a registration statement onForm S-8.

(2)           Of the 602,249 options granted, 511,900 arevested.

19

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(e)           **PERFORMANCE GRAPH**

COMPARE CUMULATIVE TOTAL RETURNAMONG IWT TESORO CORPORATIONNASDAQ MARKET INDEX AND HEMSCOTT GROUP INDEX

ASSUMES $100 INVESTED ON DEC. 23, 2003ASSUMES DIVIDEND REINVESTEDFISCAL YEAR ENDING DEC. 31, 2006
| ** **                     | ** ** | **FISCAL YEAR ENDED** | ** ** |
|--------------------------------|------------|---------------------------------|------------|
| **COMPANY/INDEX/MARKET**       | ** ** | **12/23/2003**                  | ** ** | **12/31/2003** | ** ** | **12/31/2004** | ** ** | **12/30/2005** | ** ** | **12/31/2006** | ** ** |
| ** **                     | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **IWT  Tesoro**                |       | 100.00                          |       | 100.00 |   | 41.67 |   | 45.00 |   | 33.33 |   |
| **General Building Materials** |       | 100.00                          |       | 100.00 |   | 123.60 |   | 132.25 |   | 162.22 |   |
| **NASDAQ  Market Index**       |       | 100.00                          |       | 100.00 |   | 109.60 |   | 110.79 |   | 122.16 |   |

 

20

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**ITEM 6.****                       ****SELECTED FINANCIAL DATA**

The following table sets forth the selected financialdata of the Company for the periods indicated which information is derived fromthe consolidated financial statements of the Company. The selected financialdata should be read in conjunction with “Management’s Discussion and Analysisof Financial Condition and Results of Operations” and the Company’s consolidatefinancial statements and notes thereto included elsewhere herein.
| ** **                                  | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002 (1)** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-------------------|------------|
| Statement of  earnings data:                |       |       |       |       |       |       |       |       |       |              |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Net sales                                   |       | 61,606,657 |       | 55,589,223 |       | 44,680,619 |       | 32,604,546 |       | 25,387,708        |       |
| Cost of sales                               |       | 39,627,458 |       | 34,295,418 |       | 27,790,173 |       | 19,814,514 |       | 15,268,535        |       |
| Gross profit                                |       | 21,979,199 |       | 21,293,805 |       | 16,890,446 |       | 12,790,032 |       | 10,119,173        |       |
| Operating  expenses                         |       | 24,472,718 |       | 22,696,358 |       | 17,426,918 |       | 13,562,593 |       | 8,694,101         |       |
| Operating Income (loss)                     |       | (2,493,519 | )          | (1,402,553 | )          | (536,472   | )          | (772,561   | )          | 1,425,072         |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Interest expense                            |       | (5,434,819 | )          | (2,090,765 | )          | (627,439   | )          | (480,139   | )          | (328,920          | )          |
| Change in fair  value of derivative         |       | 4,608,822  |       | (954,462   | )          |       |       |       |       |              |       |
| Other income (expense),  net                |       | (81,988    | )          | 150,005    |       | (45,485    | )          | (15,421    | )          | (15,788           | )          |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Income (loss) before income taxes           |       | (3,401,504 | )          | (4,297,775 | )          | (1,209,396 | )          | (1,268,121 | )          | 1,080,364         |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Income tax  benefit (expense)               |       | (37,875    | )          | (45,682    | )          | —     |       | (597,196   | )          | 597,174           |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Net income (loss)                           |       | $          | (3,439,379 | )          | $          | (4,343,457 | )          | $          | (1,209,396 | )                 | $          | (1,865,317 | ) | $ | 1,677,538 |   |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Earnings (loss)  per share                  |       |       |       |       |       |       |       |       |       |              |       |
| Basic and Diluted                           |       | $          | (0.29      | )          | $          | (0.37      | )          | $          | (0.10      | )                 | $          | (0.17 | ) | $ | 0.15 |   |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Weighted average  common shares outstanding |       |       |       |       |       |       |       |       |       |              |       |
| Basic and diluted                           |       | 11,902,895 |       | 11,699,425 |       | 11,679,028 |       | 11,197,655 |       | 10,845,775        |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Balance sheet  data                         |       |       |       |       |       |       |       |       |       |              |       |
|                                        |       |       |       |       |       |       |       |       |       |              |       |
| Total assets                                |       | $          | 44,271,678 |       | $          | 46,962,569 |       | $          | 33,107,481 |              | $          | 21,702,266 |   | $ | 11,062,676 |   |
| Working capital  (deficit)                  |       | (5,277,348 | )          | (625,079   | )          | 14,203,837 |       | 9,581,191  |       | 2,901,965         |       |
| Long term  obligations                      |       | 2,435,855  |       | 6,686,031  |       | 16,520,165 |       | 10,129,745 |       | 5,486,800         |       |
| Stockholder’s  equity (deficit)        |       | (4,432,191 | )          | (8,377,899 | )          | (4,034,442 | )          | (2,825,046 | )          | (1,351,944        | )          |
|                                        |       |       |       |       |       |       |       |       |       |              |       |

----

(1)                                  Tesoro acquired International Wholesale Tileon October 1, 2002. Financial statements for the year endedDecember 31, 2002 represent pro-forma audited statements. During the firstnine months of 2002, IWT was taxed as an “S” corporation. Accordingly, noprovision or liability for Federal income taxes is reflected. Instead, thestockholders were liable for individual Federal income taxes on theirrespective share of IWT’s taxable income.

21

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**ITEM 7.****                   ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

### **Background**

IWT Tesoro Corporation (Tesoro) was organized inNevada on May 3rd, 2000.  EffectiveOctober 1, 2002, Tesoro acquired all of International Wholesale Tile, Inc.’scommon stock from its three stockholders. In exchange for their InternationalWholesale Tile stock, the three stockholders received shares, representing 83%of Tesoro’s then outstanding common stock. International Wholesale Tile was organized in Florida and has been incontinuous operations since 1994.

Ourprimary business is to merchandise, market, and supply building materials,specifically floor and wall tiles, decorative floor medallions, floor and wallmoldings and borders.  We import productspredominantly from Italy, Spain, South America and China. Tesoro’s primaryoperating subsidiary, International Wholesale Tile distributes productthroughout the US from warehouses in Florida, Texas, California and Ohio.  In September 2006, we installed tileproducing equipment at our Palm City, Florida location and began producing ourown “bullnose” finishing pieces for floor and wall tile.  Profiling our own “bullnose” enables us tobetter coordinate dye lots, reduce inventory carrying costs and reduce leadtimes.

We have two other active subsidiaries. The first isTesoro Direct, Inc. f/k/a Import Flooring Group, Inc., which sells factorydirect, closeouts and agency sales throughout the US. In 2006, we alsoestablished a new subsidiary, American Gres Inc. (AGI), to explore thepossibility of constructing a state-of-the-art tile manufacturing facility inthe Southeastern United States.  AGI hasentered into an agreement with an Italian management company to design, buildand ultimately operate the manufacturing facility.  The agreement is contingent on a number offactors including our successful raising of $15 million worth of new capital.

Tesoro also has several inactive subsidiariesincluding The Tile Club, IWT Tesoro Transport, Inc. and IWT Tesoro International,Ltd.

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.

**BusinessStrategy**

TheTesoro business strategy is to expand our business, both in terms ofdistributing floor and tile coverings throughout the United States and inproducing more of our own products.  Webelieve we have the infrastructure and experience to continue to organicallygrow our business, as well as acquire additional distribution in new regions ofthe US, where we have limited or no presence. We believe we will be able to leverage our existing infrastructure andthus improve the profitability as the revenue base expands.

Ourgrowth over the last few years results from several areas.  We have expanded our truckload and buildersales program especially in the Texas and California markets which we have onlyrecently entered.  We have alsoselectively added additional sales personnel to capture more revenue within keyterritories.

Anotheraspect of our business strategy is to manufacture some of the product wecurrently import.  We believe that havingour own manufacturing capability will allow us to distribute a wider pricerange of products, significantly grow our revenue base and improveprofitability by

·                                          capturingboth the manufacturing and distribution margin,

·                                          enhancingour customer service by shortening order lead and delivery times,

·                                          loweringour inventory carrying costs, and

·                                          moreefficiently utilizing our warehouse

Inthe fourth quarter of 2006 we began manufacturing certain trims and bullnoseaccessories at our Florida distribution facility.

**OurMarket**

Weoperate in a large growing market.  TheUS market for ceramic and porcelain floor and wall coverings is

22

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approximately $3.2billion per year and growing.  Hard floorsurface (wood and tile) sales are growing at an increasing rate as the resultof many factors including population growth, increasing house sizes and thehealth benefit and environmentally friendly nature of stone and tile comparedto carpet. Our market share is approximately 2% of the floor and wall tilesegment.  In addition, the natural stonemarket (marble, travertine and granite), in the U.S. is approximately $3billion.  Our market share of the stonesegment in 2006 was de minimus because we only recently entered this market.

Ourmarkets currently include the United States and Canada. We distribute to ourcustomers from four regional warehouses located in Florida, Ohio, Texas andCalifornia. Tesoro provides value added services for our customers ranging frommaintaining inventories to fulfilling daily orders for smaller customers toselling full truckloads of mixed manufacturers’ product to larger distributorsto shipping containers of product directly to our customers from themanufacturer. We also offer private label programs for branded retail salescustomers, buying groups that serve homebuilders and home center store chains.

Ourcompetition comes from the major full line flooring companies such as Mohawkand Shaw Industries.  These companiessell carpet and wood flooring products in addition to tile and stone. On aregional basis, there are a number of distributors that import competingproducts and distribute too many of the same dealers as we do. Many of theseregional distributors maintain retail operations as well. These largerdistributors are becoming Tesoro’s customers for products that are manufacturedfor us on an exclusive basis, which can ship direct from the factory.

Ourgrowth rate in 2006 slowed to 11% from 25% in previous years.  We believe this slower growth was impacted bythe slowing residential new construction market and the residual impact fromthe 2005 hurricanes in the Southeast. The majority of our dealers and small wholesale customers also serve theremodeling component of the residential construction market, which is generallyless affected by slowing housing starts and changing interest rates.

**Investmentin New Territories**

During the last few years, our operating results havealso been impacted by the significant start-up costs associated with expandinggeographically into Texas and California, two of the largest tile markets inthe US. These costs include leasing and stocking warehouse space, hiring andcompensating a sales force until sales reach commissionable levels, identifyingand setting up new dealers with merchandising support, marketing materials, andin store sampling programs.  We alsoacquired a small warehouse in Canton, Ohio in 2006 to better support theMidwest. We believe it takes three to four years for a new territory togenerate sales capable of covering its operating costs.  To date, the new warehouse locations have notbeen profitable.   In 2007, management isfocused on growing revenues and improving the operating performance of thesenew territories by maintaining our fixed warehouse and operating costs atcurrent levels and increasing our commissioned sales force.

**Profitability**

NetLoss

Tesoro’snet loss for the twelve months ended December 31, 2006 is approximately $3.4million, compared to the fiscal year 2005 loss of $4.3 million.  Included in the 2006 loss is a $4.6 millionchange in the fair value of the derivative liability associated with the $5.0million secured convertible revolving note. Also in 2006 we recognized $2.6million of non-cash amortization of loan discounts in interest expenseassociated with the $5.0 million revolving line of credit and the two $2.0million term loans (see Note 6 of the Financials for more details).  Also included in the 2006 net loss is theTesoro Direct subsidiary loss of $2.3 million, which includes a one-timerestructuring charge of $915,000. Overall the investment in new territories,our high administrative overhead costs associated with being public and ourhigh interest and finance costs associated with our heavy debt have contributedto our losses in the last several years.

GrossMargin

Thegross margin percentage decreased in 2006 to 35.7% of net sales compared to38.3% for 2005. The decrease in gross profit margin was impacted by severalfactors.  First, there was a shift in ourproduct mix towards a greater percentage of truck load and builder programsales, which have a lower gross profit margin, but require less warehouse andoperational support. Additionally, the $1.7 million of Tesoro Direct Inc.revenue was sold at or near cost which lowered the overall gross margin 1.4%.The gross profit margin was also reduced by price increases from our suppliersand increased shipping and importing costs. We phased in a price increase in the fourth quarter.

23

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OperatingCosts

Generally,our operating costs consist of salaries and wages, including commissions,delivery costs, leased warehouse space, other general and administrative cost,insurance, professional fees for auditors and lawyers, and depreciation of ourfixed assets.  Generally in the shortterm the majority of our expenses are fixed with delivery and sales commissionsvarying directly with sales.

ImplementingManagement’s Plan to Help Improve Profitability

Inearly 2006, management implemented a plan to help improve profitability byreducing operating costs, primarily sales and marketing. The company reducedmost of its advertising and promotion expense. For the year ended December 31,2006 operating expenses, excluding restructuring charges, as a percent of saleswas reduced 2.6% to 38.2% from 40.8% for the year ended December 31, 2005.

Additionally,approximately $1.0 million of Tesoro’s annual operating expense was eliminatedwith the restructuring of Tesoro Direct, Inc, as we discuss below.  Finally, in December 2006 we implemented anew real-time warehouse tracking and inventory management system in our Floridawarehouse, which we anticipate will help increase our efficiencies and allow usto handle and ship more products with fewer personnel.  

**Restructuring of Tesoro Direct, Inc.**

In 2006, Tesoro restructured the operations of itssubsidiary and changed the name to Tesoro Direct, Inc. (TDI) from the ImportFlooring Group, Inc.  TDI is now focusedon selling factory direct, non-prime product, close out and agency sales.   Previously, it focused on wholesaling,distributing, and brokering of floor coverings throughout the United States aswell as developing fee based revenue. The revenue from fee based services such as showroom fees, conventionfees and membership fees was anticipated to generate a greater percentage of thetotal overall revenue.  However, less than2.7% of Tesoro’s revenue from July 2005 to June 2006 was a result of this feebased revenue source. Tesoro determined that the cost to provide these feebased services exceeded the potential revenue. Therefore, Tesororestructured  TDI’s operations byeliminating these services and the associated costs, including anoffice/showroom space located in San Clemente, California and the staff basedout of this office. As a part of this restructuring, Tesoro entered into anagreement with a former sales person to acquire a portion of the assets andliabilities related to the fee based revenue activities. TDI retained a portionof the assets and liabilities related to product sales.

Tesoro accounted for restructuring costs pursuant toStatement of Financial Accounting Standards SFAS No. 146, “Accounting forCosts Associated with Exit or Disposal Activities” and recorded a restructuringcharge of approximately $915,000 as more fully explained in Note 3 to the Notesto the Consolidated Financial Statements.

**Liquidity**

We have financed our operating losses and geographicalgrowth with debt.  While the actualexpenses associated with the start-up of the geographical expansion passthrough our operating statement, the cash flow has been provided by our lenders.  We have used a combination of revolving linesof credit and subordinate debt to support the inventory, receivable growth andthe start up costs, including sales personnel, warehouses and in storesampling.  The impact of this financingapproach is two fold.  First, our overalloperating results are negatively impacted by the expenses incurred during thestart up periods, including the carrying costs of the start upinventories.  Second, financing thelosses from our start up territories and our restructured operations with shortterm debt has had a negative impact on our working capital.  We currently have a negative working capitalof approximately $5.3 million.

We have two sources of debt capital.  Our primary lender is a major commercial bankthat provides us with up to $26.5 million dollars of revolving credit.  This revolving credit is based on the valueof our accounts receivable and inventory and changes every day as we collectfrom our customers and sell them more products. The second part of our debt structure is a series of loans that aresubordinate to the commercial bank’s credit. This series of subordinate loans consists of a $5.0 million dollarrevolver similar to the commercial bank’s revolver and two $2.0 million termloans, for a total of $9.0 million of subordinate debt.  These subordinate debts include options,warrants, conversion rights and prepaid interest in the form of shares issuedor issuable to the subordinate debt lender. The fair value of the securities underlying these options, warrants andconversion rights has been recorded as a discount to the loans and credited tothe additional paid in capital of the company. The value of the shares issued as prepaid interest has been netted againstthe related debt in the Company’s balance sheet.  The amortization of discount and the prepaidinterest (approximately $220,000 per month), while not a cash expense, createsa significant burden on the on the earnings of the company.  The remaining life of the amortization isapproximately two years.

24

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Weare in discussions with several banks to restructure and extend our revolvingline of credit and expect to have this completed in the near future.  The Company received notice of default fromits primary lender on November 2, 2006 and the Company has subsequently enteredinto a forbearance agreement with its primary lender.  A key provision of the forbearance agreementwas the requirement to have an outside third party firm review our operations.  Their report concluded that the company’soperations were viable and the base Florida operations generated reasonableprofits.  However, the Texas andCalifornia facilities were not yet profitable and a profitability improvementplan needed to be developed and implemented. The report further identified anopportunity to improve the profitability of one of our customer groups.  The report also noted the need to continuereducing excess inventory and improve the inventory turnover rate.

During2006 we hired an inventory consultant to recommend improvements in inventoryturnover while still maintaining high customer satisfaction. While sales grew11%, our inventory decreased $1.5 million and inventory turnover improved to1.3 times (on an annualized basis) for the twelve months ended December 31,2006 from 1.06 times for the twelve months ended December 31, 2005.  We have targeted inventory turnover of 1.5 to2.0 and are aggressively selling slower moving and excess inventory.

Werecognize the need for additional equity financing to improve our liquidity andhave engaged several investment banks and financial advisory firms to assist usin raising capital.  We are in activediscussions with several entities concerning an equity investment.

**Conclusion**

A combination of slowing sales growth and stablereceivables generates cash flow for Tesoro. In the fourth quarter of 2006 $1.5million in cash from operations was generated of which the majority was used toreduce payables and the revolving line of credit.  Management believes that its profitimprovement initiatives of increasing product prices, lowering cost of goodsand reducing overhead costs where possible, combined with an increased focus onnew territory sales growth will lead to profitable results.  Continued improvement of inventory turns andlonger term financing will improve liquidity.

**Results of Operations**

The following discussions and analyses should be readin conjunction with our financial statements and related notes included in thisAnnual Report on Form 10-K.

*Results of Operations for the Years endedDecember 31, 2006, 2005 and 2004*

We have been in a sustained growth mode overthe last several years while maintaining targeted gross margin rates. However,we have suffered net losses and currently have a working capital deficit.

 
| ** **                          | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                                      | ** ** | ** ** | ** ** | **2005** | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** |
| Revenues                            |       | $                                                             | 61,606,657 |   | 100.0 | % | $ | 55,589,223 |   | 100.0 | % | $ | 44,680,619 |   | 100.0 | % |
| Cost of goods  sold                 |       | 39,627,458                                                    |       | 64.3 |   | 34,295,418 |   | 61.7 |   | 27,790,173 |   | 62.2 |   |
| Gross profit                        |       | 21,979,199                                                    |       | 35.7 |   | 21,293,805 |   | 38.3 |   | 16,890,446 |   | 37.8 |   |
| Operating  expenses                 |       | 24,472,718                                                    |       | 39.7 |   | 22,696,358 |   | 40.8 |   | 17,426,918 |   | 39.0 |   |
| Loss from  operations               |       | (2,493,519                                                    | )          | -4.0 |   | (1,402,553 | ) | -2.5 |   | (536,472 | ) | -1.2 |   |
| Interest expense                    |       | (5,434,819                                                    | )          | -8.8 |   | (2,090,765 | ) | -3.8 |   | (627,439 | ) | -1.4 |   |
| Change in fair  value of derivative |       | 4,608,822                                                     |       | 7.5 |   | (954,462 | ) | -1.7 |   | — |   | 0.0 |   |
| Other income  (expense)             |       | (81,988                                                       | )          | -0.1 |   | 150,005 |   | 0.3 |   | (45,485 | ) | -0.1 |   |
| Loss before  income tax             |       | (3,401,504                                                    | )          | -5.5 |   | (4,297,775 | ) | -7.7 |   | (1,209,396 | ) | -2.7 |   |
| Income tax  expense                 |       | (37,875                                                       | )          | -0.1 |   | (45,682 | ) | -0.1 |   | — |   | 0.0 |   |
| Net loss                            |       | $                                                        | (3,439,379 | ) | -5.6 |   | $  | (4,343,457 | ) | -7.8 |   | $  | (1,209,396 | ) | -2.7 |   |

 

25

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*Year Ended December 31,2006, as compared to December 31, 2005*

Net sales for the year endedDecember 31, 2006 were $61,606,700, reflecting an increase of $6,017,400,or approximately 10.8% over the $55,589,200 reported for the year endedDecember 31, 2005.  This increase isdue to our expansion into new territories. Our growth in the southeast regionwas through adding products to our mix and dealers to our customer base andthrough a general increase in demand for our products. In addition we haveexpended into new territories, as well as into new markets.

Gross profit was $21,979,200(35.7% of net sales) for 2006 and $21,293,800 (38.3% of net sales) for 2005, adecrease of 2.6%. Our gross profit was impacted by higher than expected cost ofgoods sold relating to increase cost to import goods, larger percentage oflower margin truckload sales and approximately $1.7 million in TDI sales at ornear cost.

Our average selling price persquare foot of floor and wall covering in 2006 was $1.27, a decrease of $.05from $1.32 in 2005. Management consistently raises prices to reflect increasedsupplier costs. The most recent price increase was phased in the fourth quarterof 2006.

Quarterly net sales and thepercentage changes in net sales by quarter for 2006 versus 2005 were asfollows:

|                | ** ** | **2006**   | ** ** | **2005**   | ** ** | **Change** | ** ** |
|----------------|------------|------------|------------|------------|------------|------------|------------|
| First quarter  |       | $          | 16,031,219 |       | $          | 13,587,048 |       | 18.0 | % |
| Second quarter |       | 16,940,815 |       | 14,317,461 |       | 18.3       | %          |
| Third quarter  |       | 15,173,449 |       | 13,972,654 |       | 8.6        | %          |
| Fourth quarter |       | 13,461,174 |       | 13,712,060 |       | -1.8       | %          |
| Total Year     |       | $          | 61,606,657 |       | $          | 55,589,223 |       | 10.8 | % |

 

Net sales for the first two quarters of 2006 continueto increase at a consistent rate. However due to a general softening in the newhome construction and remodeling activity in the United States the growth rateslowed down in the third quarter while the fourth quarter sales contracted.

Operating expenses for 2006 were approximately$24,472,700, (39.7% of net sales) compared to $22,696,400 (40.8% of net sales).The approximate 2.7% decrease, net of the 1.5% restructuring charge, isattributable to the expense reduction program implemented at the beginning of2006. The Company continues to evaluate its cost structure for additionalimprovements in 2007.
| ** **                  | ** ** | **2006**   | ** ** | ** ** | ** ** | **2005**  | ** ** | ** ** | ** ** | **Change** | ** ** | ** ** | ** ** |
|-----------------------------|------------|------------|------------|------------|------------|-----------|------------|------------|------------|------------|------------|------------|------------|
|                        |       |       |       |       |       |      |       |       |       |       |       |       |       |
| Warehouse and  distribution |       | 10,110,128 |       | 16.4       | %          | 8,175,607 |       | 14.7       | %          | 1,934,521  |       | 23.7       | %          |
|                        |       |       |       |       |       |      |       |       |       |       |       |       |       |
| Sales and  marketing        |       | 5,667,743  |       | 9.2        | %          | 7,534,823 |       | 13.6       | %          | (1,867,080 | )          | -24.8      | %          |
|                        |       |       |       |       |       |      |       |       |       |       |       |       |       |
| General and  adminsitrative |       | 7,779,653  |       | 12.6       | %          | 6,985,928 |       | 12.6       | %          | 793,725    |       | 11.4       | %          |
|                        |       |       |       |       |       |      |       |       |       |       |       |       |       |
| Restructuring  charge       |       | 915,194    |       | 1.5        | %          | —    |       | 0.0        | %          | 915,194    |       | 100.0      | %          |
|                        |       |       |       |       |       |      |       |       |       |       |       |       |       |
|                        |       | $          | 24,472,718 |       | 39.7       | %         | $          | 22,696,358 |       | 40.8       | %          | $          | 1,776,360  |   |   |   |
|                             |            |            |            |            |            |           |            |            |            |            |            |            |            |  |  |  |

 

The loss from operations for 2006 was approximately$2,493,500 (-4.0% of net sales) compared to the loss from operations for 2005of $1,402,600 (-2.5% of net sales). The percentage increase in the loss fromoperations was attributable to the restructuring charges incurred by TDI andthe unexpected decline in IWT sales in the fourth quarter of 2006 related tothe slowing housing market. Management has implemented a plan to reduce itsoperating costs. The reductions include warehousing and distribution, sales andmarketing and administrative overhead. In additional the Company implemented anew real-time warehouse tracking and inventory management system in our Floridafacility which will increase our efficiencies and allow us to handle and shipmore product with less people.

Interest expense for 2006 wasapproximately $5,418,200 compared to $2,090,800 in 2005. The increase ininterest expense was attributable to our continuing use of debt to finance ourgrowth and the general increase in interest rates and the amortization of thewarrants and options associated with the insurance of debt. In February 2006,we issued a $2,000,000 subordinate convertible note to an institutionalinvestor at a higher rate than our commercial revolving credit line. The

26

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Company issued a warrant and option to purchaseshares of the Company’s common stock, as more fully described in Note 7 to theconsolidated financial statements. Amortization of discounts for the warrantand option were charged to interest expense totaling $509,540 during the yearended December 31, 2006. In May 2006, we issued a $2,000,000 secured term noteto an institutional investor at a annual interest rate equal to 15% per annum.The Company issued a warrant to purchase shares of the Company’s common stock,as more fully described in Note 8 to the consolidated financial statement.Amortization of discounts for the warrant was charged to interest expensetotaling $148,536. An additional $1,666,000 amortization of discounts wascharged to interest expense in connection with the secured revolving noteissued on August 25, 2005 as more fully described in Note 6 to the consolidatedfinancial statement.

*Changesin Financial Position*

Thecurrent assets for 2006 were approximately $41.0 million compared to $43.8 millionin 2005, a decrease of approximately $2.8 million. The decrease in inventoryand deposits on inventory are the primary reasons for this decrease and supportour efforts to improve inventory turns.

Currentliabilities for 2006 were approximately $46.3 million compared to $44.5 millionin 2005, an increase of approximately $1.8 million. The increase is primarilyattributable to the issuance of a $2.0 million convertible note as more fullydescribed in Note 6, issuance of a $2.0 secured term note as more fullydescribed in Note 7 and to the decrease of accounts payable and accruedexpenses of approximately $2.7 million.

Longterm liabilities for 2006 were approximately $2.4 million compared to $6.7million in 2005, a decrease of $4.3 million. The decrease is primarilyattributable to the amendment and restatement of the $5.0 secured convertiblerevolving note which removed the derivative liability of $5.9 million as morefully described in Note 6. The change in long term liabilities is alsoattributable to the long term portion of the convertible debt issued inFebruary 2006 as more fully described in Note7 of the consolidated financialstatements.

*Year Ended December 31, 2005, as compared toDecember 31, 2004*

Net sales for the year ended December 31, 2005 were$55,589,200, reflecting an increase of $10,908,600, or approximately 24.4% overthe $44,680,600 reported for the year ended December 31, 2004.  This increase is due to our expansion intonew territories, as well as entering into the truckload sales market. Ourgrowth in the southeast region was through adding products to our mix anddealers to our customer base and through a general increase in demand for ourproducts. In addition we have expended into new territories, as well as intonew markets.

Gross profit was $21,293,800 (38.3% of net sales) for2005 and $16,890,400 (37.8% of net sales) for 2004, an increase of 1⁄2 of 1%. Ourgross margin is a function of the mix of our products sold and our ability topurchase materials from our suppliers in volumes that produce lower costs. Ourhistorical mix has provided us with a gross margin of between 38% and 40%.However, we expect in the future that our larger volume wholesaler businesseswill operate at a somewhat lower gross margin. Circumstances beyond our controlsuch as the increase in import costs and the competitive pricing environment inwhich we operate could adversely affect our ability to maintain our grossmargin.

Our average selling price per square foot of floorand wall covering in 2005 was $1.32, an increase of $.17 from $1.15 in 2004.Management consistently raises prices to reflect increased supplier costs.

Quarterly net sales and the percentage changes in netsales by quarter for 2005 versus 2004 were as follows:

|                | ** ** | **2005**   | ** ** | **2004**   | ** ** | **Change** | ** ** |
|----------------|------------|------------|------------|------------|------------|------------|------------|
| First quarter  |       | $          | 13,587,048 |       | $          | 9,510,972  |       | 42.9 | % |
| Second quarter |       | 14,317,461 |       | 11,572,793 |       | 23.7       | %          |
| Third quarter  |       | 13,972,654 |       | 10,968,033 |       | 27.4       | %          |
| Fourth quarter |       | 13,712,060 |       | 12,628,821 |       | 8.6        | %          |
| Total Year     |       | $          | 55,589,223 |       | $          | 44,680,619 |       | 24.4 | % |

 

The hurricanes that madelandfall over the entire gulf coast in the September of 2005 significantlyaffected our sales growth. The devastation caused by Hurricane Katrina andother storms had a much longer impact on the building industry

27

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than the same storm season of 2004. The buildingindustry rebounded much faster in 2004 than it did in 2005. Tesoro’s fourthquarter sales were approximately $13,712,100 for the quarter ended December 31,2005 or 8.6% over the sales of $12,628,800 for the same period ending December31, 2004. By contrast, the rebound of builder market, to repair the damagecaused by the severe weather in the fall of 2004, was more rapid. Sales in thefourth quarter of 2004 were 49.3% higher than the sale of $8,457,500 for thequarter ended December 31, 2003.

Operating expenses for 2005were approximately $22,696,400, (40.8% of net sales) compared to $17,426,900(39.0% of net sales). The approximate two percent increase is attributable tothe unexpected fall off in sales growth in the fourth quarter. We were not ableto implement an expense reduction program commensurate with the rapid declinein sales. The Company believes that the building, and, specifically the repair,sector, will recover sufficiently to allow us to regain our growth path.However, we have proposed plans to adjust costs if the recovery takes longerthan expected. The start-up costs of TDI also added to the increase in theexpense to sales ratio for 2005.

We attribute the increases inwarehouse and distribution costs to the additional warehouse facilities webelieve is required to support future sales in Texas and California. Sales andmarketing costs increased as a percentage of sales in 2005 over 2004. Expandinginto new territories and establishing new customers required startup samplepacks and display materials. The decrease in the percentage of general andadministrative cost to sales in 2005 reflects the economies of scale we havereached.
| ** **                  | ** ** | **For the Years Ended December 31** | ** ** |
|-----------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                     | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | **Change** | ** ** | ** ** | ** ** |
|                        |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Warehouse and  distribution |       | 8,175,607                                                    |       | 14.7 | % | 5,489,263 |   | 12.3 | % | 2,686,344 |   | 48.9 | % |
|                        |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Sales and  marketing        |       | 7,534,823                                                    |       | 13.6 | % | 5,829,982 |   | 13.0 | % | 1,704,841 |   | 29.2 | % |
|                        |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
| General and  adminsitrative |       | 6,985,928                                                    |       | 12.6 | % | 6,107,673 |   | 13.7 | % | 878,255 |   | 14.4 | % |
|                        |       |                                                         |       |   |   |   |   |   |   |   |   |   |   |
|                        |       | $                                                            | 22,696,358 |   | 40.8 | % | $ | 17,426,918 |   | 39.0 | % | $ | 5,269,440 |   |   |   |
|                             |            |                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The loss from operations for2005 was approximately $1,402,600 (-2.5% of net sales) compared to the lossfrom operations for 2004 of $536,500 (-1.2% of net sales). The percentageincrease in the loss from operations was attributable to the start up costsincurred by TDI and the unexpected decline in IWT sales in the fourth quarterof 2005. Because of the net operating loss and the continued growth rate, theCompany currently has a working capital deficit. Management has implemented aplan to reduce projected operating costs by approximately $3.6 million. Thereductions include approximately $1.8 million in selling expenses,approximately $1.2 million reduction in institutional marketing costs andapproximately $600,000 in administrative overhead. In February 2006,International Wholesale Tile, Inc. implemented a 3.5% price increase and beganselling products to two additional national home center companies.

Interest expense for 2005 wasapproximately $2,090,800 compared to $627,400 in 2004. The increase in interestexpense was attributable to our continuing use of debt to finance our growth,expansion plans and the general increase in interest rates. In August of 2005,we issued a $5,000,000 subordinate convertible note to an institutionalinvestor at a higher rate (1%) than our commercial revolving credit line. TheCompany issued a warrant and option to purchase shares of the Company’s commonstock, as more fully described in Note 6 to the consolidated financialstatement. Amortization of discounts for the warrant and option were charged tointerest expense totaling $555,552 during the year ended December 31, 2005. Theissuance of this note resulted in the recording of a derivative liability asfurther described in Note 6 to the consolidated financial statement. Theexcess of the fair value of the derivative liabilities over the principalamount of the notes of $860,486 was recorded as an expense in the period ofissuance and the remaining fair value of $5,000,000 was recorded as a discountto the convertible debt to be amortized into expense over the three-year termsof the notes.

# ***Liquidity and Capital Resources***

We had a cash balance of $157,700 at December 31, 2006and $552,000 at December 31, 2005.   Wehave financed our growth with new subordinated debt and increased borrowingsfrom our commercial lender.

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Thecash used in operations during the year ended December 31, 2006 wereapproximately $5.0 million, which is primarily due to the net effect of theincrease in accounts receivable and a decrease in accounts payable. Thiscompares to the $10.2 million of cash used in operating during the year endedDecember 31, 2005, which was primarily due to the increase in accountsreceivable and inventory positively offset by an increase in accounts payable.

Netcash used in investing activities during the year ended December 31, 2006 wasapproximately $656,000 compared to $611,200 for the year ended December 31,2005. Capital expenditures consisted primarily of tile finishing equipmentpurchased to produce our own “bullnose”.

Netcash provided by financing activities during the year ended December 31, 2006was approximately $5.3 million, provided through the issuance of convertibledebt of $2.0 million, the issuance of short-term debt of $2.0 million and theincrease borrowings from our revolving line of credit. This compared to $10.8million during the year ended December 31, 2005. The decrease is primarilyattributable to a slightly slower growth rate and a increased inventoryturnover rate. The cash provided by these financing activities was used to fundour continued sales growth and our geographical expansion.

Duringthe year ended December 31, 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 an additional $2,000,000 term note to thesame institutional investor, as more fully described in Note 8 to theconsolidated financial statements.  Thenotes are subordinate to a revolving credit line with our commerciallender.  The combination of these notesand our revolving credit facilities provides us with up to $33.5 million ofworking capital, subject to our inventory and accounts receivable.

Ourgrowth through geographical expansion and acquisition is expected to continueto require us to seek additional outside capital.  We expect to raise additional equity throughboth the public and private debt and equity markets during 2007.  However, we cannot assure anyone that we willbe able to obtain outside capital, or if we do, that it will be on termsbeneficial to us.

Thebalance due at December 31, 2006 for our subordinated debt was $8.7 million.The balance due at December 31, 2006 to our commercial lender for the use ofthe revolving line of credit was approximately $24.4 million. The loan andsecurity agreement contains certain covenants, which include financialcovenants that require us to maintain a minimum adjusted EBITDA, a requiredminimum fixed charge coverage ratio, and a certain adjusted tangible net worth.At September 30, 2006 the Company was not in compliance with the minimum fixedcharge coverage ratio and the minimum adjusted EBITDA covenants and received anotice of default from its senior lender on October 25, 2006. On November 2, 2006, oursenior lender and the Company entered into a forbearance Agreement whereby thebank agreed to forbear the exercise of its rights to March 10, 2007, providedthat the Company is not in default of any of its other obligations, which itcurrently is not, and the Company engages a management consultant to provide acomprehensive business analysis of the Company’s operations. As of March 24,2007 the revolving line of credit has been extended to June 10, 2007. Wecontinue to operate under the November 2, 2006 forbearance agreement.

Off Balance SheetArrangements

TheCompany does not have off balance sheet arrangements.

**ContractualObligations**

Forthe year ended December 31, 2006, our long-term debt obligations consisted ofnotes payable, capital leases and a line of credit. The future paymentrequirements for these obligations are as follows:
| ** **            | ** ** | **Total**  | ** ** | **2007**  | ** ** | **2008**  | ** ** | **2009**  | ** ** | **2010**  | ** ** | **2011**  | ** ** | **Thereafter** | ** ** |
|-----------------------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|----------------|------------|
|                  |       |       |       |      |       |      |       |      |       |      |       |      |       |           |       |
| Long-term debt        |       | 8,800,366  |       | $         | 2,886,396  |      | $          | 5,822,178 |       | $         | 19,765     |      | $          | 72,026         |       | $ | — |   | $ | — |   |
| Capital leases        |       | 105,012    |       | 61,039    |       | 27,623    |       | 16,350    |       | —    |       |      |       |           |       |
| Operating leases      |       | 25,028,000 |       | 2,036,000 |       | 2,067,000 |       | 2,098,000 |       | 1,818,000 |       | 1,627,000 |       | 15,382,000     |       |
| Purchase  commitments |       | 293,000    |       | 293,000   |       | —    |       | —    |       | —    |       | —    |       | —         |       |
| Total                 |       | $          | 34,226,378 |      | $          | 5,276,436 |       | $         | 7,916,801  |      | $          | 2,134,115 |       | $              | 1,890,026  |   | $ | 1,627,000 |   | $ | 15,382,000 |   |
|                       |            |            |            |           |            |           |            |           |            |           |            |           |            |                |            |  |  |  |  |  |  |  |

 

The capital leases relate to equipment leases. Thelong-term debt includes an existing loan and security agreement for a securedrevolving line of credit with our commercial lender. The line matures on June10, 2007 at which time the

29

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Company plans to renew the debt. However, we cannot assure anyone thatwe will be able to renew the line of credit, or if we do, that it will be onterms beneficial to us. The long term debt also includes a secured revolvingnote in the aggregate amount of $5,000,000 matures on August 25, 2008, as morefully described in Note 6, a secured convertible note in the amount of$2,000,000 with monthly principal payments of $66,667 commencing on August 1,2006, as more fully described in Note 7 and a secured term note in the amountof $2.0 million maturing on May 3, 2007 as more fully described in Note 8. TheCompany entered into an agreement to purchase tile from a vendor, who is also astockholder of the Company and will continue until the agreement is fulfilled.

#### **Critical Accounting Policies**

Inpreparing the consolidated financial statements in conformity with accountingprinciples generally accepted in the United States of America, we must makedecisions, which impact the reported amounts of assets, liabilities, revenuesand expenses, and related disclosures. Such decisions include the selection ofappropriate accounting principles to be applied and the assumptions on which tobase accounting estimates. In reaching such decisions, we apply judgment basedon our understanding and analysis of the relevant circumstances and historicalexperience. Actual amounts could differ from those estimated at the time theconsolidated financial statements are prepared. Since future events and their impact cannot be determined withcertainly, what actual results will inevitably differ from our estimates. Thesedifferences could be material to the financial statements.

The Company’s significant accounting policies aredescribed in Note 1 to the Consolidated Financial Statements for the yearsended December 31, 2006, 2005 and 2004. Some of those significant accounting policies require the Company to makesubjective or complex judgments or estimates. Critical accounting policies aredefined as those that are both most important to the portrayal of a Company’sfinancial condition and results of operations and require management’s mostdifficult, subjective, or complex judgment, often as a result of the need tomake estimates about the effect of matters that are inherently uncertain andmay change in subsequent periods.

The Company believes the following accountingpolicies require it to use judgments and estimates in preparing itsconsolidated financial statements and accordingly represent critical accountingpolicies.

·                  Accountsreceivable and revenues, recognized when shipped and legal title passes to thecustomer. The Company provides an allowance for expected doubtful accountsbased upon historical bad debt and claims experience and periodic evaluation ofspecific customer accounts and the aging of accounts receivable. If thefinancial condition of the Company’s customers were to deteriorate, resultingin an impairment of their ability to make payments, additional allowances maybe required.

·                  Inventories,stated at the average landed cost, which matches current costs with currentrevenues. Inventories on hand are compared against anticipated future usage,which is a function of historical usage and anticipated future selling price,in order to evaluate obsolescence, excessive quantities, and expected salesbelow cost.  A reserve for obsolescencehas been established for product series that are expected to sell below cost.Actual results could differ from assumptions used to value obsolete, excessiveinventory or inventory sold below cost.

·                  Deferredtax assets and liabilities, recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which the temporary differences are expectedto be recovered or settled. The effect on deferred tax assets and liabilitiesof a change in the tax rates is recognized in earnings (loss) in the periodthat includes the enactment date. Additionally, taxing jurisdictions couldretroactively disagree with the Company’s tax treatment of certain items, andsome historical transactions have income tax effects going forward. Accountingrules require these future effects to be evaluated using current laws,rules and regulations, each of which can change at any time and in an unpredictablemanner.

·              Stockbased compensation expense associated with stock options and other forms ofequity compensation prior to December 31, 2005, had no provisions made for and,therefore, no related compensation expense was recorded for awards granted withno intrinsic value. On January 1, 2006 the Company adopted the modifiedprospective transition method provided for under SFAS 123R, and consequentlyhas not retroactively adjusted results for prior periods. Under this transitionmethod, compensation cost associated with stock options include: 1)compensation cost related

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to the remaining unvestedportion of all stock option awards granted prior to December 31, 2005, based onthe grant date fair value estimated in accordance with the original provisionsof SFAS 123; and 2) compensation cost related to all stock option awardsgranted subsequent to December 31, 2005, based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R. The Company recordsexpense over the vesting period using the straight-line method. Compensationexpense for awards under SFAS 123R includes and estimate for forfeitures. SeeNote 14 for further information regarding the Company’s stock-basedcompensation assumptions and expenses, including pro forma disclosures forprior periods as if the Company had recorded stock —based compensation expense.

**Recent Accounting Pronouncements**

In July 2006, theFASB issued Interpretation No. 48 (“FIN 48”), *Accountingfor Uncertainty in Income Taxes*. FIN 48 applies to all tax positionsrelated 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 ahigh degree of uncertainty. FIN 48 utilizes a two-step approach for evaluatingtax positions. Recognition (step one) occurs when an enterprise concludes thata tax position, based solely on its technical merits, is more-likely-than-notto be sustained upon examination. Measurement (step two) is only addressed ifstep one has been satisfied (i.e., the position is more-likely-than-not to besustained). FIN 48 clarifies the accounting for income taxes by prescribing theminimum recognition threshold a tax position must meet before being recognizedin the financial statements. FIN 48 also provides guidance on derecognition,measurement, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. Earlier adoption is permitted as of thebeginning of an enterprise’s fiscal year, provided the enterprise has not yetissued financial statements, including financial statements for any interimperiod, for that fiscal year. Management is currently evaluating therequirements of FIN 48 and has not yet determined the impact on the Company’sconsolidated financial statements.

In September 2006,the SEC Staff issued Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in theCurrent Year Financial Statements” (“SAB No. 108”), which providesinterpretive guidance on the consideration of the effects of prior yearmisstatements for the purpose of materiality assessment. SAB 108 is effectivefor fiscal years ending after November 15, 2006. The Company does not expectthe adoption of SAB No. 108 to have material impact our consolidated financialstatements.

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements” (FAS 157). FAS 157defines fair value, establishes the framework for measuring fair value ingenerally accepted accounting principals and expands disclosures about fairvalue measurements. This Statement applies only to fair value measurements thatare already required or permitted by other accounting standards. Accordingly,this Statement does not require any new fair value measurements. SFAS No. 157is effective for fiscal years beginning after December 15, 2007 The Company iscurrently evaluating the impact, if any, the adoption of SFAS No. 157 will haveon its consolidated financial statements.

In September 2006,the FASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans” (“SFAS No. 158”). SFASNo. 158 requires companies to recognize in their statement of financialposition an asset for a plan’s overfunded status or a liability for a plan’sunderfunded status and to measure a plan’s assets and its obligations thatdetermine its funded status as of the end of the company’s fiscal year.Additionally, SFAS No. 158 requires companies to recognize changes in thefunded status of a defined benefit postretirement plan in the year that thechanges occur and those changes will be reported in comprehensive income. SFASNo. 158 is effective for fiscal years ending after December 31, 2006,and early adoption is encouraged. We do not expect that the adoption of SFASNo. 158 will have a material impact on our consolidated financialstatements.

**Seasonality**

Oursales and operations are not impacted in any material way by particular seasonsor quarters.

**Impact of Inflation**

Inflation affects the Company’s distribution costsand operating expenses. The tile industry has experienced inflation in theprices of fuel-related and import costs beginning in the first quarter of2004.  We generally pass these highercosts along through price increase to its customers.

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**ITEM 7A****                 ****QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK**

Financialexposures managed as an integral part of the Company’s risk management program,which seeks to reduce the potentially adverse effect that the volatility of theexchange rate and lending markets may have on its operating results. TheCompany does not regularly engage in speculative transactions, nor does itregularly hold or issue financial instruments for trading purposes. A summary of our market risk exposures ispresented below.

*Interest Rate Risk*

We have a revolving line of credit agreement withinterest rates that are a certain percentage over Prime or Libor therefore tothe extent that Prime or Libor change we are subject to interest rate risk.

*Foreign Currency Risk*

We currently purchase only a small amount of productin currencies other that the U.S. dollar. Therefore we do not have any materialforeign currency risk.

**ITEM 8.****                       ****FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

The financial statements and supplemental data required by this Item 8follow the index of financial statements that appears at the end of Part Iof this Form 10-K.
| ** **                                                                                                       | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|
| Report of Independent  Registered Public Accounting Firm:                                                        |       |
|                                                                                                             |       |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                               |       |
| Consolidated  Statements of Operations for the years ended December 31, 2006, 2005 and  2004                |       |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2006, 2005 and 2004 |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                |       |
| Notes  to Consolidated Financial Statements                                                                      |       |

 

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## REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM

To the Board of Directors and Stockholders

IWT Tesoro Corporation

Westport, Connecticut

We have audited theaccompanying consolidated balance sheets of IWT Tesoro Corporation andSubsidiaries as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, stockholders’ equity and cash flows for each of thethree years in the period ended December 31, 2006.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of IWT Tesoro Corporation andSubsidiaries as of December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the three years in the period endedDecember 31, 2006, in conformity with U.S. generally accepted accountingprinciples.

As discussed in Note 1 tothe consolidated financial statements, the Company adopted Statement ofFinancial Accounting Standards No 123(R) on January 1, 2006, and changed itsmethod of accounting for share based payments.

The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern.  Asdiscussed in Note 2 to the consolidated financial statements, the Company hassuffered recurring losses from operations and at December 31, 2006, the Companyhas a working capital deficit and its total liabilities exceed its totalassets.  This raises substantial doubtabout the Company’s ability to continue as a going concern.  Management’s plans in regard to these mattersare also described in Note 2.  Thefinancial statements do not include any adjustments that might result from theoutcome of this uncertainty.
| /S/McGLADREY & PULLEN, LLP |   |
|--------------------------------|--------|
|                           |   |

New Haven, Connecticut

March 30, 2007

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2006 AND 2005
| ** **                                                                                                        | ** ** | **2006**    | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|
| ASSETS                                                                                                            |       |        |       |       |       |
| Current Assets:                                                                                                   |       |        |       |       |       |
| Cash                                                                                                              |       | $           | 157,729    |       | $          | 552,042 |   |
| Accounts  receivable, net of allowance for doubtful accounts and returns of $477,674  and $292,662, respectively  |       | 9,780,039   |       | 9,910,551  |       |
| Inventories, net  of allowance for obsolescence of $525,000 and $0, respectively                                  |       | 30,674,860  |       | 32,212,007 |       |
| Deposit on  purchases of inventories                                                                              |       | 167,693     |       | 860,614    |       |
| Prepaid expenses                                                                                                  |       | 210,345     |       | 293,047    |       |
| Total current  assets                                                                                             |       | 40,990,666  |       | 43,828,261 |       |
|                                                                                                              |       |        |       |       |       |
| Property and Equipment,  net                                                                                      |       | 2,264,762   |       | 2,120,422  |       |
|                                                                                                              |       |        |       |       |       |
| Other Assets                                                                                                      |       | 1,016,250   |       | 1,013,886  |       |
| Total assets                                                                                                      |       | $           | 44,271,678 |       | $          | 46,962,569 |   |
|                                                                                                              |       |        |       |       |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                        |       |        |       |       |       |
|                                                                                                              |       |        |       |       |       |
| Current Liabilities:                                                                                              |       |        |       |       |       |
| Accounts payable                                                                                                  |       | $           | 17,014,921 |       | $          | 20,165,306 |   |
| Accrued expenses  and other liabilities                                                                           |       | 2,040,593   |       | 1,561,119  |       |
| Current portion  of equipment leases                                                                              |       | 55,889      |       | 71,770     |       |
| Current portion  of equipment notes                                                                               |       | 30,499      |       | 29,645     |       |
| Note payable,  revolving line of credit                                                                           |       | 24,400,378  |       | 22,625,500 |       |
| Current portion  of convertible debt                                                                              |       | 800,007     |       | —     |       |
| Note payable,  other (net of discounts of $74,273)                                                                |       | 1,925,727   |       | —     |       |
| Total current  liabilities                                                                                        |       | 46,268,014  |       | 44,453,340 |       |
|                                                                                                              |       |        |       |       |       |
| Long-Term Debt:                                                                                                   |       |        |       |       |       |
| Capital leases,  equipment, net of current portion                                                                |       | 41,098      |       | 97,860     |       |
| Notes payable,  equipment, net of current portion                                                                 |       | 47,297      |       | 78,157     |       |
| Note payable,  revolving line of credit (net of discounts of $2,777,792)                                          |       | 2,222,208   |       | —     |       |
| Convertible  debt, net of current portion (net of discounts of $741,408 and $4,444,448,  respectively)            |       | 125,252     |       | 555,552    |       |
| Embedded  derivative liability, at fair value                                                                     |       | —      |       | 5,954,462  |       |
| Total long-term  debt                                                                                             |       | 2,435,855   |       | 6,686,031  |       |
| Total  liabilities                                                                                                |       | 48,703,869  |       | 51,139,371 |       |
|                                                                                                              |       |        |       |       |       |
| Stockholders’ Equity:                                                                                        |       |        |       |       |       |
| Preferred stock,  $0.001 par value, 25,000,000 authorized; none issued                                            |       | —      |       | —     |       |
| Common stock,  $0.001 par value, 100 million shares authorized; 11,928,600 and 11,701,102  issued and outstanding |       | 11,929      |       | 11,701     |       |
| Additional paid  in capital                                                                                       |       | 7,383,305   |       | 4,189,396  |       |
| Accumulated  deficit                                                                                              |       | (11,817,278 | )          | (8,377,899 | )          |
|                                                                                                              |       | (4,422,044  | )          | (4,176,802 | )          |
| Treasury stock,  6,105 shares at cost                                                                             |       | (10,147     | )          | —     |       |
| Total  stockholders’ deficit                                                                                 |       | (4,432,191  | )          | (4,176,802 | )          |
|                                                                                                              |       | $           | 44,271,678 |       | $          | 46,962,569 |   |

 

See Notes to Consolidated Financial Statements

34

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF OPERATIONS

YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
| ** **                                   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                         |       |       |       |       |       |       |       |
| Net Sales                                    |       | $          | 61,606,657 |       | $          | 55,589,223 |       | $ | 44,680,619 |   |
| Cost of Goods  Sold                          |       | 39,627,458 |       | 34,295,418 |       | 27,790,173 |       |
| Gross Profit                                 |       | 21,979,199 |       | 21,293,805 |       | 16,890,446 |       |
| Operating  Expenses:                         |       |       |       |       |       |       |       |
| Warehouse and distribution                   |       | 10,110,128 |       | 8,175,607  |       | 5,489,263  |       |
| Sales and marketing                          |       | 5,667,743  |       | 7,534,823  |       | 5,829,982  |       |
| General and administrative                   |       | 7,779,653  |       | 6,985,928  |       | 6,107,673  |       |
| Restructuring charge                         |       | 915,194    |       | —     |       | —     |       |
|                                         |       | 24,472,718 |       | 22,696,358 |       | 17,426,918 |       |
| Loss from  Operations                        |       | (2,493,519 | )          | (1,402,553 | )          | (536,472   | )          |
| Other Income  (Expenses):                    |       |       |       |       |       |       |       |
| Interest expense                             |       | (5,434,819 | )          | (2,090,765 | )          | (627,439   | )          |
| Change in fair value of derivative           |       | 4,608,822  |       | (954,462   | )          | —     |       |
| Other                                        |       | (81,988    | )          | 150,005    |       | (45,485    | )          |
|                                         |       | (907,985   | )          | (2,895,222 | )          | (672,924   | )          |
| Loss Before  Income Taxes                    |       | (3,401,504 | )          | (4,297,775 | )          | (1,209,396 | )          |
|                                         |       |       |       |       |       |       |       |
| Income Tax  Expense                          |       | 37,875     |       | 45,682     |       | —     |       |
| Net Loss                                     |       | $          | (3,439,379 | )          | $          | (4,343,457 | )          | $ | (1,209,396 | ) |
| Loss Per Share:                              |       |       |       |       |       |       |       |
| Basic and Diluted                            |       | $          | (0.29      | )          | $          | (0.37      | )          | $ | (0.10 | ) |
| Weighted Average  Common Shares Outstanding: |       |       |       |       |       |       |       |
| Basic and  Diluted                           |       | 11,902,895 |       | 11,699,425 |       | 11,679,028 |       |

 

See Notes to Consolidated Financial Statements

35

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTSOF  STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
| ** **                                                                                   | ** ** | **Common Stock** | ** ** | **Treasury** | ** ** | **Additional  Paid in** | ** ** | **Accumulated  Earnings** | ** ** | ** **  | ** ** |
|----------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------|------------|------------------------------|------------|---------------------------|------------|-------------|------------|
| ** **                                                                                   | ** ** | **Shares**            | ** ** | **Amount**   | ** ** | **Stock**                    | ** ** | **Capital**               | ** ** | **Deficit** | ** ** | **Total** | ** ** |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Balance, December  31, 2003                                                                  |       | 11,622,702            |       | $            | 11,623     |                         | $          | —                    |       | $           | 3,883,949  |   | $ | (2,825,046) |   | $ | 1,070,526 |   |
| Year Ended  December 31, 2004:                                                               |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Exercise of warrants                                                                         |       | 45,500                |       | 45           |       | —                       |       | 147,830                   |       | —      |       | 147,875 |   |
| Issuance of shares to consultant for services  rendered                                      |       | 17,000                |       | 17           |       | —                       |       | 98,333                    |       | —      |       | 98,350 |   |
| Issuance of shares to employees and directors for  services rendered (SIP)                   |       | 10,400                |       | 10           |       | —                       |       | 44,065                    |       | —      |       | 44,075 |   |
| Issuance of shares to customers                                                              |       | 1,500                 |       | 2            |       | —                       |       | 4,623                     |       | —      |       | 4,625 |   |
| Net loss                                                                                     |       | —                |       | —       |       | —                       |       | —                    |       | (1,209,396  | )          | (1,209,396 | ) |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Balance, December  31, 2004                                                                  |       | 11,697,102            |       | $            | 11,697     |                         | $          | —                    |       | $           | 4,178,800  |   | $ | (4,034,442) |   | $ | 156,055 |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Year Ended  December 31, 2005:                                                               |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Issuance of shares to employees                                                              |       | 4,000                 |       | 4            |       | —                       |       | 10,596                    |       | —      |       | 10,600 |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Net loss                                                                                     |       | —                |       | —       |       | —                       |       | —                    |       | (4,343,457  | )          | (4,343,457 | ) |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Balance, December  31, 2005                                                                  |       | 11,701,102            |       | $            | 11,701     |                         | $          | —                    |       | $           | 4,189,396  |   | $ | (8,377,899) |   | $ | (4,176,802) |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Year Ended  December 31, 2006:                                                               |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Issuance of shares to employees and directors for  services rendered                         |       | 6,300                 |       | 7            |       | —                       |       | 12,785                    |       | —      |       | 12,792 |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Stock option compensation expense                                                            |       | —                |       | —       |       | —                       |       | 116,724                   |       | —      |       | 116,724 |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Issuance of shares as prepaid interest on  subordinated debt                                 |       | 221,198               |       | 221          |       | —                       |       | 486,415                   |       | —      |       | 486,636 |   |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Discount on 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                                                                       |       | —                |       | —       |       | (10,147                      | )          | —                    |       | —      |       | (10,147 | ) |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Net loss                                                                                     |       | —                |       | —       |       | —                       |       | —                    |       | (3,439,379  | )          | (3,439,379 | ) |
|                                                                                         |       |                  |       |         |       |                         |       |                      |       |        |       |   |   |
| Balance, December 31,  2006                                                                  |       | 11,928,600            |       | $            | 11,929     |                         | $          | (10,147                   | )          | $           | 7,383,305  |   | $ | (11,817,278 | ) | $ | (4,432,191 | ) |

 

See Notes to Consolidated Financial Statements

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCASH FLOWS

YEARS ENDED DECEMBER 31, 2006, 2005 AND2004
| ** **                                                                   | ** ** | **2006**    | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Cash flows from  operating activities:                                       |       |        |       |        |       |        |       |
| Net loss                                                                     |       | $           | (3,439,379 | )           | $          | (4,343,457  | )          | $ | (1,209,396 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |       |        |       |        |       |        |       |
| Non-cash restructuring charge                                                |       | 807,404     |       | —      |       | —      |       |
| Depreciation and amortization                                                |       | 755,196     |       | 443,030     |       | 297,324     |       |
| Amortization of loan discount                                                |       | 2,569,956   |       | 555,552     |       | —      |       |
| Change in fair value of embedded derivatives                                 |       | (4,608,821  | )          | 954,462     |       | —      |       |
| Common stock issued for services and compensation                            |       | 129,516     |       | 10,600      |       | 147,050     |       |
| Provision for doubtful accounts and allowance for  returns                   |       | 423,635     |       | 22,649      |       | 226,089     |       |
| Provision for obsolete inventory                                             |       | 525,000     |       | —      |       | —      |       |
| (Gain) loss on disposal of property and equipment                            |       | 28,427      |       | 8,691       |       | (21,532     | )          |
| Changes in operating assets and liabilities:                                 |       |        |       |        |       |        |       |
| (Increase) Decrease in:                                                      |       |        |       |        |       |        |       |
| Accounts receivable                                                          |       | (1,282,448  | )          | (2,049,444  | )          | (3,257,140  | )          |
| Inventories                                                                  |       | 498,447     |       | (10,583,515 | )          | (8,569,653  | )          |
| Deposit on purchase of inventories                                           |       | 564,315     |       | (361,222    | )          | (409,375    | )          |
| Prepaid expenses and other assets                                            |       | (88,333     | )          | (239,468    | )          | 210,670     |       |
| Increase (Decrease) in:                                                      |       |        |       |        |       |        |       |
| Accounts payable                                                             |       | (2,109,841  | )          | 4,874,099   |       | 5,432,046   |       |
| Accrued expenses and other liabilities                                       |       | 188,509     |       | 520,226     |       | 503,930     |       |
| Net cash used in operating activities                                        |       | (5,038,417  | )          | (10,187,797 | )          | (6,649,987  | )          |
| Cash flows from  investing activities:                                       |       |        |       |        |       |        |       |
| Acquisitions of property and equipment                                       |       | (725,079    | )          | (621,654    | )          | (656,464    | )          |
| Proceeds from sale of equipment                                              |       | 69,029      |       | 10,500      |       | 25,000      |       |
| Net cash used in investing activities                                        |       | (656,050    | )          | (611,154    | )          | (631,464    | )          |
| Cash flows from  financing activities:                                       |       |        |       |        |       |        |       |
| Proceeds from revolving line of credit                                       |       | 67,364,284  |       | 65,641,124  |       | 48,766,998  |       |
| Payments on revolving line of credit                                         |       | (65,462,000 | )          | (58,989,215 | )          | (42,392,747 | )          |
| Collection on notes receivable arising from sale of  stock                   |       | —      |       | —      |       | 550,000     |       |
| Repayment of convertible debt                                                |       | (333,334    | )          | —      |       | —      |       |
| Proceeds from issuance of stock                                              |       | —      |       | —      |       | 147,875     |       |
| Payments of long-term debt and capital lease  obligations                    |       | (102,649    | )          | (126,796    | )          | (126,860    | )          |
| Loan financing costs                                                         |       | —      |       | (76,135     | )          | (23,499     | )          |
| Proceed from issuance of convertible debt and  warrant                       |       | 4,000,000   |       | 5,000,000   |       | —      |       |
| Debt issuance costs                                                          |       | (156,000    | )          | (267,000    | )          | —      |       |
| Treasury stock                                                               |       | (10,147     | )          | —      |       | —      |       |
| Repayment of notes payable, subordinated debt                                |       | —      |       | (338,662    | )          | —      |       |
| Net cash provided by financing activities                                    |       | 5,300,154   |       | 10,843,316  |       | 6,921,767   |       |
| Net Increase  (Decrease) in Cash                                             |       | (394,313    | )          | 44,365      |       | (359,684    | )          |
| Cash, Beginning                                                              |       | 552,042     |       | 507,677     |       | 867,361     |       |
| Cash, Ending                                                                 |       | $           | 157,729    |        | $          | 552,042     |       | $ | 507,677 |   |

 

See Notes to Consolidated Financial Statements

37

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCASH FLOWS

YEARS ENDED DECEMBER 31, 2006, 2005 AND2004
| ** **                                                             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Cash Paid (Received)  During the Period for:                           |       |     |       |     |       |      |       |
| Interest                                                               |       | $        | 2,502,539  |     | $          | 1,430,004 |       | $ | 627,439 |   |
| Income tax                                                             |       | $        | 37,875     |     | $          | 45,682    |       | $ | (359,400 | ) |
| Non-Cash Operating  Activities:                                        |       |     |       |     |       |      |       |
| Inventory  acquired through deposit with vendor                        |       | $        | 315,821    |     | $          | 82,350    |       | $ | 93,318 |   |
| Property and  equipment acquired through lease incentive               |       | $        | 153,000    |     | $          | —    |       | $ | — |   |
| Non-Cash Investing and  Financing Activities:                          |       |     |       |     |       |      |       |
| Acquisition of  property and equipment financed through long-term debt |       | $        | —     |     | $          | 97,155    |       | $ | 136,319 |   |
| Reclassification  of note payable to embedded derivative liability     |       | $        | —     |     | $          | 5,000,000 |       | $ | — |   |
| Issuance of  options and warrants in connection with debt              |       | $        | 1,232,345  |     | $          | —    |       | $ | — |   |
| Issuance of  stock as prepaid interest                                 |       | $        | 486,636    |     | $          | —    |       | $ | — |   |
| Payment of  interest expense through the issuance of common stock      |       | $        | 245,224    |     | $          | —    |       | $ | — |   |
| Elimination of  derivative liability                                   |       | $        | 1,345,640  |     | $          | —    |       | $ | — |   |

 

 

38

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###### **NOTE1.                SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

#### ***Organization and Nature of Operations***

The consolidatedfinancial statements include IWT Tesoro Corporation and its wholly ownedsubsidiaries (collectively the “Company”).

IWT TesoroCorporation was incorporated in the state of Nevada on May 3, 2000.  On October 1, 2002, IWT Tesoro Corporationacquired 100% of the outstanding stock of International Wholesale Tile, Inc.(IWT) in exchange for 83% of its outstanding common stock in a transactionaccounted for as a recapitalization of IWT. A total of 9,000,000 shares ofcommon stock were issued for the acquisition. For accounting purposes, theacquisition has been treated as a capital transaction and as a recapitalizationof International Wholesale Tile, Inc. The financial statements became those ofInternational Wholesale Tile, Inc., with adjustments to reflect the changes inequity structure.

InternationalWholesale Tile, Inc. is principally a value added reseller of ceramic floor andwall covering products (primarily ceramic, porcelain and stone tile) to the newconstruction and remodeling industries for commercial and residentialmarketplaces. In addition to IWT, Tesoro’s primary operating subsidiary,Tesoro, has five additional wholly owned subsidiaries. These include IWT TesoroTransport, a USDOT licensed common carrier; IWT Tesoro International, LTD., aBermuda corporation to act as a holding company for foreign operations; TheTile Club, Inc., formed in 2004, organized to acquire licensing, manufacturingand distribution rights; Tesoro Direct, Inc., formally known as Import FlooringGroup, Inc. a wholly owned subsidiary of The Tile Club formed in 2005 todevelop an agency business; and American Gres, Inc. formed in November 2006,organized to produce domestic ceramic tile.

#### ***Principles of Consolidation***

The consolidatedfinancial statements include IWT Tesoro Corporation and its wholly ownedsubsidiaries: International Wholesale Tile, Inc., IWT Tesoro International,Ltd, IWT Tesoro Transport, Inc., American Gres, Inc. and The Tile Club, Inc andThe Tile Club, Inc.’s wholly owned subsidiary Tesoro Direct, Inc., formerlyknown as Import Flooring Group, Inc. All significant inter-company balances andtransactions have been eliminated in consolidation.

#### ***Use of Estimates***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

#### ***Cash***

Cash equivalentsinclude short-term, highly liquid investments that are readily convertible toknown amounts of cash and are of an original maturity of three months or less.

39

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#### ***Accounts Receivable***

Accounts receivable are carried at the amount billedto a customer, net of the allowance for doubtful receivables and an allowancefor returns. The allowance for doubtful accounts is an estimate for creditlosses based on a review of all outstanding amounts on a monthly basis.  Management determines the allowance fordoubtful accounts by regularly evaluating individual customer receivables andconsidering a customer’s financial condition, credit history and currenteconomic conditions.  Accounts receivableare written off when deemed uncollectible. Recoveries of accounts receivable previously written off are recordedwhen received. The allowance for returns is an estimate for material returnsbased on a review of all credits issued on a monthly basis. Managementdetermines the allowance for returns by regularly evaluating merchandisereturns and their corresponding reason.

#### ***Concentration of Credit Risk***

Financialinstruments that potentially subject the Company to concentrations of creditrisk are cash and accounts receivable.

**Cash**

At various timesduring the year, the Company had deposits in financial institutions in excessof the federally insured limits. At December 31, 2006, the Company had depositsin excess of federally insured limits of approximately $722,000. The Companymaintains its cash with high quality financial institutions which the Company believeslimits these risks. The Company has not sustained any losses as a result ofthis concentration.

**Accounts Receivable**

The Company doesbusiness and extends credit based on an evaluation of the customers’ financialcondition, generally without requiring collateral. Exposure to losses onreceivables is expected to vary by customer due to the financial condition ofeach customer. The Company monitors exposure to credit losses and maintainsallowances for anticipated losses considered necessary under the circumstances.The Company allows for extended credit terms beyond the normal credit terms forcustomer that purchase in bulk. Additionally, the Company maintains creditinsurance for certain of these extended term customer accounts, which mitigatesthe credit risk. Allowance for doubtful accounts and returns on accountsreceivable balances were approximately $478,000 and $293,000 as of December 31,2006 and 2005, respectively.

#### ***Inventories***

Inventories arevalued at the lower of cost or market, with cost determined on the average costmethod and include freight in, duty and handling costs. Inventories consist offinished goods and merchandise in transit from overseas factories. The Companyperforms periodic assessments to determine the existence of obsolete, slow-movingand non-salable inventories, and records necessary provisions to reduce suchinventories to net realizable value. Allowance for obsolescence on inventorybalances were $525,000 and $0 as of December 31, 2006 and 2005, respectively.

40

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#### ***Property and Equipment***

Property andequipment are stated at cost. Equipment under capital leases is stated at thepresent value of minimum lease payments at the date of acquisition.Depreciation is calculated on a straight-line basis over the assets’ estimatedremaining useful lives, which range from 3 to 10 years. Leasehold improvementsare capitalized and amortized on the straight-line method over the shorter ofthe lease term or the life of the improvement. Betterments and large renewals, which extend the life of the asset, arecapitalized, whereas maintenance and repairs and small renewals are expensed asincurred.

#### ***Income Taxes***

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

#### ***Revenue Recognition***

Revenue isrecognized when goods are shipped except for material that is shipped directlyto our customer from our vendor then revenue is recognized when received by ourcustomer. Allowances for product returns are recorded as a reduction of salesat the time revenue is recognized based on historical data. These allowancesare adjusted to reflect actual returns.

#### ***Impairment of Long-Lived Assets***

The Companyreviews the recoverability of our long-lived assets to determine whether eventsor changes in circumstances occurred that indicate the carrying value of theasset may not be recoverable. The assessment of possible impairment is based onits ability to recover the carrying value of the asset from the expected futurecash flows of the related operations. If these cash flows are less than thecarrying value of such asset, an impairment loss is recognized for thedifference between the estimated fair value and carrying value. The measurementof impairment requires management to make estimates of these cash flows relatedto long-lived assets, as well as other fair value determinations.

#### ***Shipping and Handling Costs***

#### Shippingand handling costs, included in warehouse and distribution expense in theconsolidated statements of operations, were approximately $3,633,000, $3,097,000and $2,357,000 for the years ended December 31, 2006, 2005 and 2004,respectively.

41

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#### ***Advertising and Promotion***

Advertising andpromotion expenses are charged to expense during the period in which they areincurred. Promotional merchandise, which includes boards and sample packs, areheld in other inventories until they are shipped to the customer at which pointthey are expensed. Advertising and promotion expenses, included in sales andmarketing expenses in the consolidated statement of operations, wasapproximately $1,034,000, $2,465,000 and $1,990,000 for the years endedDecember 31, 2006, 2005 and 2004, respectively.

#### ***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.

***Stock-Based Compensation***

Effective January 1, 2006, the Company began recordingcompensation expense associated with stock options and other forms of equitycompensation in accordance with Statement of Financial Accounting Standards No.123R, *Share-Based Payment*, (“SFAS123R”) as interpreted by SEC Staff Accounting Bulletin No. 107. Prior toDecember 31, 2005, the Company accounted for stock options granted to employeesaccording to the provisions of Accounting Principles Board (“APB”) Opinion No.25, *Accounting for Stock**Issued to Employees*, and relatedinterpretations, as permitted by SFAS 123, *Accountingfor Stock-Based Compensation*, and, therefore, no relatedcompensation expense was recorded for awards granted with no intrinsic value.The Company adopted the modified prospective transition method provided forunder SFAS 123R, and consequently has not retroactively adjusted results forprior periods. Under this transition method, compensation cost associated withstock options include: 1) compensation cost related to the remaining unvested portionof all stock option awards granted prior to December 31, 2005, based on thegrant date fair value estimated in accordance with the original provisions ofSFAS 123; and 2) compensation cost related to all stock option awards grantedsubsequent to December 31, 2005, based on the grant-date fair value estimatedin accordance with the provisions of SFAS 123R. The Company records expenseover the vesting period using the straight-line method. Compensation expensefor awards under SFAS 123R includes an estimate for forfeitures. See Note 14for further information regarding the Company’s stock-based compensationassumptions and expenses, including pro forma disclosures for prior periods asif the Company had recorded stock  –basedcompensation expense.

#### ***DeferredLoan Costs***

The Company has incurred debt issuance costs which areamortized over the life of the applicable debt term using a straight linemethod which approximates the effective interest method. At December 31, 2006and 2005, net debt issuance costs were approximately $244,000 and $310,000,respectively and are included in Other Assets in the accompanying ConsolidatedBalance Sheets.

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#### ***Accountingfor Operating Leases***

The Company has entered into non-cancelable operatinglease agreements primarily involving warehouse space. Certain of these leasescontain escalating lease payments and the Company recognizes expense on astraight line basis which is more representative of the time pattern in whichthe leased property is physically used. In certain instances the Company isalso entitled to reimbursements for part or all of leasehold improvements madeand records a deferred credit for such reimbursements which is amortized overthe remaining life of the lease term and a reduction in the lease expense.

#### ***FairValue of Financial Instruments***

The carrying amount of cash and cash equivalents,accounts receivable, accounts payable and accrued expenses approximate fairvalue due to short-term maturities of these instruments. The carrying value ofthe Company’s line of credit approximates fair value because the interest rateused with this instrument fluctuates with the market rate. The fair values ofsubordinated long-term debt are estimated based on current rates offered to theCompany for debt with comparable maturities and similar collateral requirements(see Note 6, 7 and 8). The fair value of all other long-term debt approximatestheir carrying value.

***Derivative Financial Instruments***

The Company occasionally enters into a financialinstrument that contains a derivative instrument that is embedded in thefinancial instrument. Upon entering into the instrument, the Company assesseswhether the economic characteristics of the embedded derivative are clearly andclosely related to the economic characteristics of the remaining component ofthe financial instrument (i.e. the host contract) and whether a separateinstrument with the same terms as the embedded instrument would meet thedefinition of a derivative instrument. When it is determined that (1) the embeddedderivative possesses economic characteristics that are not clearly and closelyrelated to the economic characteristics of the host contract, and (2) aseparate instrument with the same terms would qualify as a derivativeinstrument, the embedded derivative is separated from the host contract andcarried at fair value. In cases where (1) host contract is measured at fairvalue, with changes in fair value reported in current earnings or (2) theCompany is unable to reliably identify and measure an embedded derivative forseparation from the host contract, the entire contract is carried on thebalance sheet at fair value. The fair value is determined using theBlack-Scholes option valuation model using the weighted-average assumptions asdescribed in Note 6.

#### ***SegmentInformation***

The Company’s revenues are all from floor coveringproducts and services sold throughout the United States with no single customeraccounting for more than 10% of net sales. All of the Company’s long-termassets are located in the United States. The Company’s chief operating decisionmaker is considered to be the Company’s CEO. The CEO reviews financialinformation presented on a consolidated basis for purposes of making operatingdecisions and assessing financial performance.Therefore the Company operates inone segment for management reporting purposes.

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***RecentAccounting Pronouncements***

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 iscurrently evaluating the requirements of FIN 48 and has not yet determined theimpact on the Company’s consolidated financial statements.

In September 2006, the SEC Staff issued StaffAccounting Bulletin No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in the Current Year FinancialStatements” (“SAB No. 108”), which provides interpretive guidance on theconsideration of the effects of prior year misstatements for the purpose ofmateriality assessment. SAB 108 is effective for fiscal years ending afterNovember 15, 2006. The adoption of SAB No. 108 did not have an impact ourconsolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements” (FAS 157). FAS 157 defines fair value, establishes the frameworkfor measuring fair value in generally accepted accounting principals andexpands disclosures about fair value measurements. This Statement applies onlyto 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.

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**NOTE 2****                   LIQUIDITY AND PROFITABILITY CONSIDERATIONS**

The accompanying consolidated financial statementshave been prepared assuming the Company will continue as a going concern. TheCompany has suffered net losses of approximately $3,439,000, $4,344,000, and$1,209,000 for the years ended December 31, 2006, 2005 and 2004, respectively.As reflected in the consolidated balance sheet as of December 31, 2006 theCompany had a working capital deficit of approximately $5,277,000 and its totalliabilities exceed its total assets.

**Management’splan with regard to these matters is described below:**

***Profitability***

The Company’s net loss for the twelve months endedDecember 31, 2006 is approximately $3,439,000. The loss was reduced by the $4,600,000 change in the fair value of thederivative liability which is more fully described in Note 6 and was increasedby $2,570,000 of non cash amortization of loan discounts and other costs whichare included in interest expense.  Alsoincluded in the 2006 net loss is the Tesoro Direct Subsidiary, formerly theImport Flooring Group, loss of $2,259,000 which includes a one-timerestructuring charge of $915,000 (see note 3 for additional details). The 2006loss from operations excluding restructuring charges increased to $1,578,000from $1,402,000 in 2005. 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.

Revenues continued to grow in 2006 but at a slowerpace than in prior years.   In 2005 weopened new warehouses in Texas and California which are two of the largest tilemarkets in the US.  In 2006 we alsoacquired a small warehouse facility in Ohio. In order to be successful longterm in the new territories, we have invested in warehouse space, salespersonnel, marketing and sampling supplies as well as inventory.  Management recognizes that revenues need tocontinue to grow in these new territories in order to cover the warehouse andoperational costs associated with these territories.

Gross margin percentage decreased in 2006 to 35.7% ofnet sales compared to 38.3% for the same twelve month period ended December 31,2005. The decrease in gross profit margin was impacted by several factorsincluding a shift in our product mix towards a greater percentage of truck loadsales which have a lower gross profit margin but require less warehouse andoperational support. The $1.7 million of Tesoro Direct Inc (formerly ImportFlooring Group) sales at or near cost reduced the overall company gross profitmargin.  The gross profit margin was alsoreduced by price increases from our suppliers and increased shipping andimporting costs.  We were unable tocontinue absorbing the higher supplier and shipping costs and thus phased in aprice increase in the fourth quarter.

In October 2006 we began producing “bullnose”finishing pieces for floor and wall tile from our recently installed profilingmanufacturing equipment. By manufacturing our own “bullnose” we are able tolower the cost of sales for this group of products as well as lower inventoryand carrying costs since the lead time is reduced to days from months.  The profiling equipment is expected to reducethe cost of goods on “bullnose” products and is an integral part of the Company’sstrategy to control the cost of goods sold by focusing on the production sideof our industry’s value chain.

In early 2006 management implemented a plan to improveprofitability by reducing operating costs including warehousing and handling,sales and marketing and administrative overhead. For the year ended December31, 2006 operating expenses as a percent of sales was reduced 1.1% to 39.7%from 40.8% for the year ended December 31, 2005.  Our ongoing operating expenses were furtherreduced (after one-time charges) from restructuring the operations of itssubsidiary Tesoro Direct, Inc.(TDI), formerly known as Import Flooring Group,Inc., as more fully described in Note 3. Approximately $1.0 million of ongoingoperating expense was eliminated with the restructuring of Tesoro Direct whichwill now focus on selling slower moving and discontinued inventory.  Finally, in December 2006 we implemented anew real-time warehouse tracking and inventory management system in our Floridawarehouse which will increase our efficiencies and allow us to handle and shipmore product with less personnel.

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###### ***Liquidity***

Asreflected in the consolidated balance sheet as of December 31, 2006, theCompany had a working capital deficit of approximately $5,277,000, adeterioration of approximately $4,652,000 from December 31, 2005 at which timewe had a working capital deficit of approximately $625,000.  The increase in working capital deficit wasimpacted by our operating loss of $2,493,000 and new short term and convertibledebt (see Note 7 and 8 for details).  Therevolving line of credit also increased in 2006 by $1.8 million, partiallyoffset by a decrease in accounts payable and accrued expenses of approximately$2.8 million versus 2005.

Weare in discussions with several banks to restructure and extend our revolvingline of credit and expect to have this completed in the near future.  As more fully discussed in note 6, theCompany received notice of default from its primary lender on November 2, 2006and the Company has subsequently entered into a forbearance agreement with itsprimary lender.  A key provision of theforbearance agreement was the requirement to have an outside third party firmreview our operations.  Their reportconcluded that the company’s operations were viable and the base Floridaoperations generated reasonable profits. However, the Texas and California facilities were not yet profitable anda profitability improvement plan needed to be developed and implemented. Thereport further identified an opportunity to improve the profitability of one ofour customer groups.  The report alsonoted the need to further reduce excess inventory and improve the inventoryturnover rate.

During 2006 we hired an inventory consultant toimprove inventory turnover while still maintaining high customer satisfaction.While sales were growing 11%, our inventory decreased $1.5 million andinventory turnover improved to 1.3 times (on an annualized basis) for thetwelve months ended December 31, 2006 from 1.06 times for the twelve monthsended December 31, 2005.  We havetargeted inventory turnover of 1.5 to 2.0 and are aggressively selling slowermoving and excess inventory.  Our 2006accounts receivable balance of $9.8 million decreased $100,000 from theDecember 31, 2005 balance while our sales increased 11%.  We have improved the receivable turnoverratio (annualized) to 4.18 at December 31, 2006 from 4.01 at December 31, 2005.

InFebruary 2006, as more fully described in Note 7 herein, the Company obtained$2.0 million through the issuance of a three year subordinated convertible termnote. In May 2006, as more fully described in Note 8 herein, the Companyobtained $2.0 million through the issuance of a one year subordinated termnote. These funds are being used for the Company’s working capital requirementsincluding our Texas and California operations.

We recognize the need for additional equity financingand have engaged several investment banks and financial advisory firms toassist us in raising capital.  We are inactive discussions with several entities concerning an equity investment. TheCompany’s sales growth rate is slowing which increases cash flow as more iscollected from receivables than is sold and subsequently partially financedthrough the Company’s revolving credit line. In the 4th Quarter of 2006 we generated $1.5 million incash from operations, the majority of which was used to reduce payables and ourrevolving line of credit.  Managementbelieves that its profit improvement initiatives of increasing margins throughprice increases, lowering cost of goods, such as the in house bullnoseoperation and reducing overhead costs where possible will lead to profitableresults.  Reduced inventory and longerterm financing will improve liquidity. Successful execution should allow the company to meet its performanceand debt covenant requirements in the future.

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

The Company has restructured the operations of itssubsidiary Tesoro Direct, Inc. (TDI), formerly known as Import Flooring Group,Inc. TDI is now focused on selling discontinued series and slower movinginventory. Previously Import Flooring Group generated revenue through thewholesale, distribution and brokering of floor coverings throughout the UnitedStates as well as fee based revenue such as “showroom fees”, charged to vendorsfor allocating a portion of the California Office/Showroom to display thevendor’s products, “convention fees”, for participating in the annual TDI FloorCovering Convention and “membership fees” charged to customers forparticipating in exclusivity agreements was anticipated to generate a greaterpercentage of the total overall revenue. However, only 2.7% of the totalrevenue from July 1, 2005 through June 30, 2006 was a result of this fee basedrevenue source. IWT Tesoro Corporation determined that the cost to providethese fee based services exceeded the revenue. Therefore, the Companyrestructured its operations eliminating these services and the associatedcosts. These costs included the office/showroom space located in San Clemente,California and the office and sales staff based out of this office. As a partof this restructuring the Company entered into an agreement with a former salesperson to acquire a portion of the assets and liabilities related to the feebased revenue activities.  TDI retained aportion of the assets and liabilities related to product sales and continues tosell products throughout the United States. TDI will facilitate all agency and direct shipment revenue whiledeveloping channels for close out lines.

In connection with this restructuring plan TDI incurred the followingcosts:

1.               One-TimeTermination Benefits of $30,435 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 agreement.

3.               Other associatedcosts of approximately $822,487, 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 $22,914, recognized an expense of$313,932 in uncollectible receivables and an additional $128,606 related to thewrite off on a non-refundable deposit for inventory.

The Company accounted for restructuring costs pursuantto Statement of Financial Accounting Standards (SFAS” No. 146, “Accounting forCosts Associated with Exit or Disposal Activities”. SFAS 146 requires that aliability for a cost associated with an exit or disposal activity be recognizedwhen the liability is incurred, as opposed to when there is a commitment to arestructuring plan. As of June 30, 2006, the date of restructuring,restructuring charges aggregated $585,700, subsequent to that date the Companyidentified an additional $329,500 related to the restructuring which wascharged to operations. For the year ended December 31, 2006, the Companyrecorded a restructuring charge in the amount of approximately $915,200 inconnection with the restructuring activities. The Company does not anticipateincurring any additional costs with respect to this restructure. Restructuringcharges are reflected in a separate line item in the accompanying consolidatedstatements of operations.

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###### **NOTE4.                INVENTORIES**

Inventoriesconsisted of the following:

 

|                             | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2006**              | ** ** | **2005**              | ** ** |
| Tiles                       |       | $                     | 30,033,507 |                  | $          | 28,858,620 |   |
| Inventory in  transit       |       | 1,166,353             |       | 3,353,387             |       |
|                        |       | 31,199,860            |       | 32,212,007            |       |
| Allowance for  obsolescence |       | 525,000               |       | —                |       |
|                        |       | $                     | 30,674,860 |                  | $          | 32,212,007 |   |

 

Inventory intransit consists of merchandise purchased overseas, which has not yet beenreceived in the warehouse. The Company obtains legal title at the shippingpoint.

###### **NOTE5.                PROPERTY AND EQUIPMENT**

Property and equipment consisted of the following:

 

|                                | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2006**              | ** ** | **2005**              | ** ** |
|                           |       |                  |       |                  |       |
| Furniture and  fixtures        |       | $                     | 318,128    |                  | $          | 423,806 |   |
| Machinery and  equipment       |       | 1,154,913             |       | 859,996               |       |
| Vehicles                       |       | 321,572               |       | 307,195               |       |
| Office and  computer equipment |       | 720,216               |       | 676,304               |       |
| Leasehold  improvements        |       | 888,533               |       | 676,094               |       |
|                           |       | 3,403,362             |       | 2,943,395             |       |
| Less accumulated  depreciation |       | 1,138,600             |       | 822,973               |       |
|                           |       | $                     | 2,264,762  |                  | $          | 2,120,422 |   |

 

Depreciationexpense for the years ended December 31, 2006, 2005 and 2004 was approximately$456,000, $341,000 and $264,000, respectively.

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###### **NOTE6.                NOTE PAYABLE, REVOLVINGLINES OF CREDIT**

Below is a summaryof the future payments acquired though debt referenced in Note 6, 7 and 8:

 
| ** **                  | ** ** | ** ** | ** ** | **Revolving**                | ** ** | **Revolving**         | ** ** | **Convertible** | ** ** | **Other**             | ** ** |
|-----------------------------|------------|------------|------------|------------------------------|------------|-----------------------|------------|-----------------|------------|-----------------------|------------|
| ** **                  | ** ** | **Total**  | ** ** | **Line of Credit** | ** ** | **Note Payable** | ** ** | **Debt**        | ** ** | **Note Payable** | ** ** |
| 2007                        |       | $          | 27,200,385 |                         | $          | 24,400,378            |       | $               | —     |                  | $          | 800,007 |   | $ | 2,000,000 |   |
| 2008                        |       | 5,800,007  |       | —                       |       | 5,000,000             |       | 800,007         |       | —                |       |
| 2009                        |       | 66,653     |       | —                       |       | —                |       | 66,653          |       | —                |       |
|                        |       | 33,067,045 |       | 24,400,378                   |       | 5,000,000             |       | 1,666,667       |       | 2,000,000             |       |
| Less accretion  of discount |       | (3,593,473 | )          | —                       |       | (2,777,792            | )          | (741,408        | )          | (74,273               | )          |
| Total payments              |       | $          | 29,473,572 |                         | $          | 24,400,378            |       | $               | 2,222,208  |                  | $          | 925,259 |   | $ | 1,925,727 |   |

 

***Revolving Line ofCredit***

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 8.344% to 8.375% atDecember 31, 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 December 31, 2006 and December 31, 2005 was $24,370,278 and$22,625,500, respectively. The line matures June 10, 2007 and contains certaincovenants requiring the Company to maintain a certain minimum adjusted EBITDA,a required minimum fixed charge coverage ratio, and certain adjusted tangiblenet worth. On September 10, 2006 the Company was not in compliance with theminimum fixed charge coverage ratio and the minimum adjusted EBITDA covenantsand received a notice of default from its primary lender on October 25, 2006.

 On November 2,2006, the primary lender and the Company entered into a forbearance agreementwhereby the bank agreed to forbear the exercise of its rights to demand paymentuntil December 10, 2006, provided that the Company is not in default of any ofits other obligations, which it currently is not, and the Company engages amanagement consultant to provide a comprehensive business analysis of theCompany’s operations. The Company continues to operate under the November 2nd, 2006 forbearance agreement.Effective March 10, 2007, the Company entered into the Seventh Amendment to theAmended and Restated Loan Agreement with its senior credit Facility, Bank ofAmerica, N.A.  The Seventh Amendment extends the term of its $26.5 millionline of credit to June 10, 2007 and includes new monthly EBITDA covenants. TheCompany was not in compliance with the January and February EBITDA covenants.

In November 2006, the Company entered into anunsecured revolving line of credit agreement for its newly created subsidiaryAmerican Gres, Inc., with its primary lender providing up to $95,000 ofavailable borrowings with interest rates ranging from 11.24% to 13.24% atDecember 31, 2006 payable monthly. The balance due at December 31, 2006 was $30,100.

For the years ended December 31, 2006, 2005 and 2004, interest expenserelated to the revolving credit line amounted to $1,965,000, 1,344,000 and$578,000 respectively

 

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***Revolving NotePayable***

On August 25, 2005, the Company issued a securedconvertible revolving note in the aggregate amount of $5,000,000 resulting innet 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 certain non-standardanti-dilution provisions and requirements to settle any conversion option withregistered shares, the Company was required to account for the conversionoption as an embedded derivative requiring separate accounting treatment inaccordance with *SFAS No. 133 Accounting for DerivativeInstruments and Hedging Activities*. Based upon the closing price per share of the Company’s common stock onthe date of issuance, the Company estimated the fair value of the embeddedconversion option and classified $2,068,317 as a derivative liability that wasadjusted to fair value at each reporting date with changes in fair valuereported in earnings.  In connection withthe convertible notes, the Company issued to the holder of the note a five-yearwarrant to purchase 511,883 shares of the Company’s common stock at an exerciseprice of $3.15 per share and an option to purchase 1,170,110 shares of theCompany’s common stock at an exercise price of $0.001 per share which expire onAugust 25, 2010.  Based upon the closingprice per share of the Company’s common stock on the date of issuance, theCompany estimated the fair value of the warrant and option and classified$3,099,835 and $692,334, respectively, as derivative liabilities that wereadjusted to fair value at each reporting date with changes in fair valuereflected in operations. The fair values of the options, warrants, and embeddedconversion option 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 tothe Security Agreement, dated August 25, 2005 and the Convertible MinimumBorrowing Note, dated August 25, 2005. As a result of the Amendment, theCompany is no longer required to make any modifications to the fixed conversionprice, or issue additional securities in the event the Company issues commonstock at a price less 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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###### *** ***

Thebalance of the note net of unamortized discounts as of December 31, 2006 is asfollows:

| 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 December 31, 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                   |   | 2,222,208  |      |
| Balance as of December  31, 2006, net of unamortized discounts |   | $          | 2,222,208 |   |

 

######  

For the year ended December 31, 2006, interest expenserelated to the revolving note amounted to $452,000. Interest expense related tothe revolving note amounted to $149,000 during the period of August 25, 2005 toDecember 31, 2005.

Accretion of discounts for the conversion feature andwarrant related to the revolving note resulted in charges to interest expensefor the years ended December 31, 2006 and 2005 of $ 588,000 and $196,000,respectively.

Accretion of discounts for the detachable warrantrelated to the revolving note resulted in charges to interest expense for theyears ended December 31, 2006 and 2005 in the amount of $1,078,000 and$359,000, respectively.

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.

#### Theholder of the note had agreed that it will not convert the note, or exerciseany warrant or option, into common stock in amounts that would cause the holder’saggregate beneficial ownership of the Company’s common stock to exceed 4.99%,without 120 days prior notice, or 19.199%, without stockholder approval.

###### **NOTE 7              NOTEPAYABLE — 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 December 31, 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-year warrantto purchase 460,829 shares of the Company’s common stock at an exercise priceof $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 beamortized into interest expense over the three-year term of the note using theeffective interest method. The aggregate discount allocated to the beneficialconversion feature and the options and warrants was recorded as additional paidin capital at the date of issuance. The fair value of the warrant was estimatedat the date of issuance using the Black-Scholes option-pricing model using thefollowing

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assumptions: risk-free rate of 4.59%, dividend yieldsof 0%, and a volatility factor of the expected market price of the Company’scommon stock of 58.2%.  The Company alsoissued to the holder, 221,198 shares of the Company’s common stock asprepayment of interest in the amount of $486,636, which was calculated basedupon the closing price per share of the Company’s common stock on the date ofissuance of $2.20 per share. The prepaid interest is presented as a discount onthe note to be amortized into interest expense over the three year term usingthe effective interest method.

The balance of the note, net of unamortized discountsas of December 31, 2006 is as follows:

| Principal amount of notes                                      |   | $        | 1,666,667 |   |
|----------------------------------------------------------------|--------|----------|-----------|--------|
| Fair value -  Conversion feature                               |   | (553,593 | )         |
| Fair value -  Warrants                                         |   | (942,579 | )         |
| Accretion of  discount to interest expense                     |   | 754,764  |      |
| Balance as of  December 31, 2006, net of unamortized discounts |   | $        | 925,259   |   |
|                                                           |   |     |      |
| Current                                                        |   | 800,007  |      |
| Non-current                                                    |   | 125,251  |      |
|                                                           |   | $        | 925,259   |   |

 

Interest expense related to the note amounted to$245,225 for the year ended December 31, 2006.

Accretion of discounts for the beneficial conversionfeature and warrant resulted in charges to interest expense totaling $279,412for the year ended December 31, 2006.

Accretion of discounts for the detachable warrantresulted to charges to interest expense totaling $230,128 for the year endedDecember 31, 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.

#### Theholder of the note has agreed that it will not convert the note, or exerciseany warrant or option, into common stock in amounts that would cause the holder’saggregate beneficial ownership of the Company’s common stock to exceed 4.99%,without 120 days prior notice, 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 per share.  The Company estimated the fair value of thewarrant and allocated $222,809 of the proceeds of the debt to the warrant,which is presented as a discount on the note to be amortized into expense overthe one-year term of the note.  The fairvalue of the warrant was estimated at the date of issuance using theBlack-Scholes option-pricing model using the following assumptions: risk-freerate of 5.06%, dividend yields of 0%, and a volatility factor of the expectedmarket price of the Company’s common stock of 59.18%.

52

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###### The balance of the note as of December 31,2006, net of unamortized discounts is a follows:

| Principal amount of notes                                      |   | $        | 2,000,000 |   |
|----------------------------------------------------------------|--------|----------|-----------|--------|
| Fair value -  Warrants                                         |   | (222,809 | )         |
| Accretion of  discount into interest expense                   |   | 148,536  |      |
| Balance as of December  31, 2006, net of unamortized discounts |   | $        | 1,925,727 |   |

 

Interest expense related to the note amounted to$201,665 for the year ended December 31, 2006.

Amortization of discounts for the detachable warrantresulted in charges to interest expense totaling $148,536 for the year endedDecember 31, 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.

#### Theholder of the note has agreed that it will not convert the note, or exerciseany warrant or option, into common stock in amounts that would cause the holder’saggregate beneficial ownership of the Company’s common stock to exceed 4.99%,without 120 days prior notice, or 19.199%, without stockholder approval.

###### **NOTE 9.                CAPITALLEASE OBLIGATIONS - EQUIPMENT**

#### The Company leases certain machinery and equipment undercapital leases which expire at various dates through 2009. The future minimumlease payments required are as follows:

| 2007                                     |   | $       | 61,039 |   |
|------------------------------------------|--------|---------|--------|--------|
| 2008                                     |   | 27,623  |   |
| 2009                                     |   | 16,350  |   |
|                                     |   | 105,012 |   |
| Less amount  representing interest       |   | 8,026   |   |
| Present value of  minimum lease payments |   | 96,987  |   |
| Less current  portion                    |   | 55,889  |   |
|                                     |   | $       | 41,098 |   |

 

#### Assetsacquired under capital leases are presented in property and equipment in theaccompanying balance sheet. Balances of assets under capital leases at December31, 2006 and 2005 were as follows:

 

|                                | ** ** | **2006** | ** ** | **2005** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Property and  Equipment        |       | $        | 434,522    |     | $          | 437,716 |   |
| Less accumulated  depreciation |       | 160,035  |       | 148,989  |       |
|                           |       | $        | 274,487    |     | $          | 288,727 |   |

 

For the years ended December 31, 2006, 2005 and 2004, interest expenserelated to the capital leases amounted to $9,000, 15,000 and $18,000respectively.

53

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###### **NOTE 10.              NOTESPAYABLE - EQUIPMENT**

 

|                                                                                                                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Various  equipment notes, payable in monthly installments ranging from $521 to $889;  maturing at various dates through July 2010 |       | 77,796   |       | 107,802  |       |
|                                                                                                                              |       |     |       |     |       |
| Less current  portion                                                                                                             |       | 30,499   |       | 29,645   |       |
|                                                                                                                              |       | $        | 47,297     |     | $          | 78,157 |   |
|                                                                                                                                   |            |          |            |          |            |  |  |

 

| Year ending December 31: | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2007                                    |       | $          | 30,500     |   |
| 2008                                    |       | 22,171     |       |
| 2009                                    |       | 19,765     |       |
| 2010                                    |       | 5,359      |       |
|                                    |       | $          | 77,796     |   |

 

For the years ended December 31, 2006, 2005 and 2004, interest expenserelated to the equipment notes amounted to $3,000, 3,000 and $2,000respectively.

###### **NOTE 11.              COMMITMENTSAND CONTINGENCIES**

***Operating Leases***

The Company leasesoffice and warehouse facilities in various locations under operating leasesexpiring through July 31, 2021.

Future minimumlease payments under non-cancelable operating leases are estimated as follows:

 

| 2007           |   | $          | 2,036,000  |   |
|----------------|--------|------------|------------|--------|
| 2008           |   | 2,067,000  |       |
| 2009           |   | 2,098,000  |       |
| 2010           |   | 1,818,000  |       |
| 2011           |   | 1,627,000  |       |
| Thereafter     |   | 15,382,000 |       |
| Total payments |   | $          | 25,028,000 |   |

 

Rent expense wasapproximately $2,852,000, $2,308,000 and $1,435,000 for the years endedDecember 31, 2006, 2005 and 2004, respectively.

 

54

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***Purchase Commitments***

On December 29,2003, the Company entered into an agreement to purchase tile from a vendor, whois also a stockholder of the Company and paid a deposit of $550,000 on thispurchase commitment during 2004, which is reduced by 20% of each purchasethroughout the term of the agreement. The agreement is for a term of 18 months from the date of the initialdelivery and commits the Company to purchase a total of $2,750,000 of tile. Asof December 31, 2006, the Company had a remaining purchase commitment under theagreement of approximately $293,000 and the remaining balance of deposits onfuture purchases is approximately $59,000 which is included in the depositsfrom inventories on the accompanying consolidated balance sheet. Thiscommitment previously due to expire March 2006 has been extended until theentire deposit is utilized.

***401K Employee Benefit Plan***

The Companysponsors a 401(k) plan known as the International Wholesale Tile, Inc. 401(k)Profit Sharing Plan & Trust (the “401K Plan”). The 401K Plan provides taxdeferred salary reductions for eligible employees. Employees become eligiblesixty days after the date hired, as defined in the 401K Plan. The Companyprovides matching contributions equal to 100% of the employee’s contributionsup to a maximum of 4% of eligible pay. The contribution expense related to the 401K Plan was approximately$299,000, $169,000 and $121,000 for the years ended December 31, 2006, 2005 and2004, respectively. Included in the year ended December 31, 2006 contributionexpense of $299,000, approximately $45,000 relates to corrective contributionsfor years beginning at plan inception through December 31, 2005.

***MarketingAgreement***

Effective March28, 2007, IWT Tesoro Corporation entered into a three year agreement withGlobal Media Fund, Inc.  (GMF), wherebyGMF will produce and distribute $5.0 million worth of nationally syndicatednewspaper features, nationally syndicated radio features and other media onbehalf of the Company, using the industry standard advertising rates currentlyutilized by GMF. In consideration for these services, Tesoro gave GMF $2.0million of its common stock. GMF received 1.0 million IWT Tesoro shares(875,000 restricted and 125,000 unrestricted) at $2 per share based on the fairmarket price of the IWT’s stock on March 28, 2007.

### ** **

### **NOTE 12. STOCKHOLDERS’ DEFICIT**

***CommonStock***

*** ***

During the year endedDecember 31, 2004, the Company issued 45,500 shares of common stock pursuant towarrants exercised at $3.25 per share, for a total of $147,875.

 

During the year endedDecember 31, 2004, the Company issued 17,000 shares of common stock toconsultants for services rendered, based on the trading price at the date ofissuance, for a total of $98, 350, resulting in an equivalent charge tooperations. 

 

On May 26, 2004, TheCompany issued 10,000 shares of common stock to a director under the StockIncentive Plan for services rendered, based on the contemporaneous tradingprice, for a total of $42,500, resulting in an equilvalent charge tooperations. 

 

On April 15th, 2004, theCompany cancelled 100 shares of common stock issued to an employee based on thetrading price at the date of issuance, for a total of $550, resulting in anequivalent reduction in charge to operations. 

 

On July 20th, 2004, theCompany issued 500 shares of common stock to an employee under the originalterms of an employment agreement, based on the trading price at the date ofissuance, resulting in an equivalent charge to operations of $2,125.

 

55

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### ***Common Stock***

During the yearended December 31, 2004, the Company issued 1,500 shares of common stock toexisting customers as a promotional project, based on the trading price at thedates of issuance for a total of $4,625, resulting in an equivalent charge tooperations.

On June 2nd, 2005, the Company issued4,000 shares of common stock to employees, based on the trading price at thedate of issuance for a total of $10,600, resulting in an equivalent charge tooperations.

On January 6th,2006, the Company issued 4,600 shares of common stock to employees, based onthe trading price at the date of issuance for a total of $11,500, resulting inan equivalent charge to operations.

On June 28 2006,the Company issued 1,700 shares of common stock to employees, based on thetrading price at the date of issuance for a total of $1,292, resulting in anequivalent charge to operations.

***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 year endedDecember 31, 2006, the Company purchased 6,105 shares of IWT Tesoro commonstock for a total cost of $10,147, at fair market value in the open market.

***Note Receivable Arisingfrom Sale of Stock***

In December 2003, theCompany completed a private placement of securities and signed an agreementwith an investor to purchase 100,000 units at $5.50 per unit. Each unitconsisted of one share of common stock and one warrant to purchase oneadditional share at $7 per share. In addition, the investor signed a stockpledge agreement and a promissory note for $550,000, at 3% interest per year,with a maturity date of March 31, 2004. In March 2004, the Company receivedfull payment for the promissory note.

56

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###### **NOTE 13.              COMMONSTOCK WARRANTS**

A summary of warrantsissued and outstanding in connection with equity transactions as discussedabove is presented below.  Upon exercise,warrants are convertible into an equal number of the Company’s common stock.The warrants are exercisable immediately.

 
| ** **                                     | ** ** | **Year Ended Decemebr 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | ** **                                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                     | ** ** | ** **                                 | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                     | ** ** | ** **                                 | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                     |       | **Warrants**                               |       | **Price** | ** ** | **Warrants** | ** ** | **Price** | ** ** | **Warrants** | ** ** | **Price** |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  the beginning of the period    |       | 1,061,383                                  |       | $ | 4.77 |   | 549,500 |   | $ | 5.91 |   | 595,000 |   | $ | 5.35 |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Granted at fair  value                         |       | 794,162                                    |       | $ | 1.86 |   | 511,883 |   | $ | 3.15 |   | — |   | $ | — |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Expired                                        |       | (350,000                                   | )          | $ | 7.00 |   | — |   | $ | — |   | — |   | $ | — |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Exercised                                      |       | —                                     |       | $ | — |   | — |   | $ | — |   | (45,500 | ) | $ | 3.25 |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  the end of the period          |       | 1,505,545                                  |       | $ | 2.85 |   | 1,061,383 |   | $ | 4.77 |   | 549,500 |   | $ | 5.91 |   |
|                                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Warrants exercisable at  the end of the period |       | 1,505,545                                  |       | $ | 2.85 |   | 1,061,383 |   | $ | 4.77 |   | 549,500 |   | $ | 5.91 |   |

 

The followingtable summarizes information for warrants outstanding at December 31, 2006:

|                   | ** **   | **Weighted**         | ** ** | **Weighted**      | ** ** | ** **   |
|-------------------|--------------|----------------------|------------|-------------------|------------|--------------|
| **Range of** | ** **   | **Number**           | ** ** | **Average**       | ** ** | **Average**  |
| **Exercise**      | ** **   | **Outstanding**      | ** ** | **Remaining**     | ** ** | **Exercise** |
| **Prices**        | ** **   | **at 12/31/06** | ** ** | **in Years** | ** ** | **Price**    |
|              |         |                 |       |              |       |         |
| $                 | 1.12 to 3.15 |                 | 1,306,045  |              | 5.2        |         | $ | 2.36 |
| $                 | 6.00         |                 | 199,500    |              | 1.0        |         | $ | 6.00 |
|              |         |                 |       |              |       |         |

 

57

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The followingtable summarizes information for warrants outstanding at December 31, 2005:

|                   | ** **  | ** **           | ** ** | **Weighted**      | ** ** | **Weighted** |
|-------------------|-------------|----------------------|------------|-------------------|------------|--------------|
| **Range of** | ** **  | **Number**           | ** ** | **Average**       | ** ** | **Average**  |
| **Exercise**      | ** **  | **Outstanding**      | ** ** | **Remaining**     | ** ** | **Exercise** |
| **Prices**        | ** **  | **at 12/31/05** | ** ** | **in Years** | ** ** | **Price**    |
|              |        |                 |       |              |       |         |
| $                 | 3.15 - 5.00 |                 | 711,383    |              | 3.9        |         | $ | 3.67 |
| $                 | 7.00        |                 | 350,000    |              | 0.9        |         | $ | 7.00 |
|              |        |                 |       |              |       |         |

 

###### **NOTE 14.              COMMONSTOCK OPTIONS**

***Stock Option Plan***

The Companyentered into a Stock Incentive Plan on December 27, 2001. The plan providesthat eligible employees, consultants, and affiliates may be granted shares ofcommon stock. Under the plan, the options granted are non-qualified stockoptions, incentive stock options and restricted stock. The aggregate totalcommon stock that may be issued under the plan is 4,000,000 shares. The sharesissued to employees were recorded at the fair value on the grant date.

Under the Plan, a totalof 6,300, 4,000 and 28,900 restricted shares were issued to employees,directors and consultants for services rendered for the years ended December31, 2006, 2005 and 2004, respectively.

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 year ended December 31, 2006,includes compensation cost for all share-based payments granted prior to, butnot yet vested as of January 1, 2006, based on the grant date fair valueestimated in accordance with the original provisions of Statement 123, andcompensation cost for all share-based payments granted subsequent to January 1,2006, based on the grant-date fair value estimated in accordance with theprovisions of SFAS No. 123R. Prior periods were not restated to reflect theimpact of adopting the new standard.

As a result of adoptingSFAS No. 123R on January 1, 2006, during the year ended December 31, 2006, theCompany recognized additional compensation costs of $116,724 which is includedin the basic and diluted earnings per share for the year ended December 31,2006.

58

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###### The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofStatement 123(R) to options granted under the Company’s stock option plan forthe years ended December 31, 2005 and 2004. No stock option-based employeecompensation cost is reflected in net loss for the years ended December 31,2005 and 2004, as all options granted under those plans had an exercise priceequal to the market value of the underlying common stock on the date of thegrant.   For purposes of this proformadisclosure, the value of the options is estimated using the Black-Scholesoption-pricing model and amortized to expense over the options’ vestingperiods.

|                                                                                                                                   | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** |
| ** **                                                                                                                        | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Net loss                                                                                                                          |       | $                                           | (4,343,457 | ) | $ | (1,209,396 | ) |
|                                                                                                                              |       |                                        |       |   |   |
|                                                                                                                              |       |                                        |       |   |   |
| Add: total  stock-based compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (67,444                                     | )          | (6,334 | ) |
|                                                                                                                              |       |                                        |       |   |   |
| Pro forma net  loss                                                                                                               |       | $                                           | (4,410,901 | ) | $ | (1,215,730 | ) |
|                                                                                                                              |       |                                        |       |   |   |
| Loss per share -  Basic and Diluted:                                                                                              |       |                                        |       |   |   |
| As reported                                                                                                                       |       | $                                           | (0.37      | ) | $ | (0.10 | ) |
| Pro forma                                                                                                                         |       | $                                           | (0.38      | ) | $ | (0.10 | ) |

 

The followingassumptions were utilized in the Black-Scholes option pricing model used toestimate the fair value of stock-based awards.

|                                         | ** ** | **Year Ended December 31** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                    |       |                                      |       |   |   |   |   |
| Dividend yield                          |       | 0                                         | %          | 0 | % | 0 | % |
| Expected  volatility                    |       | 58.8                                      | %          | 75.6 | % | 57.5 | % |
| Risk-free  interest rate                |       | 4.4                                       | %          | 4.3 | % | 3.5 | % |
| Expected life of  options (in years)    |       | 5.5                                       |       | 5.5 |   | 6.1 |   |
| Weighted-average  grant-date fair value |       | $                                         | 1.42       |   | $ | 1.70 |   | $ | 1.40 |   |
|                                         |            |                                           |            |  |  |  |  |  |  |  |

 

The assumptionsabove are based on multiple factors, including exercise patterns of employeesin relative homogenous groups with respect to exercise and post-vestingemployment termination behaviors, expected future exercising patterns for thesesame homogenous groups and the implied volatility of our stock price.

At December 31,2006, there was approximately $140,000 of unrecognized compensation costrelated to share-based payments which is expected to be recognized over aweighted-average period of 1.95 years.

59

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The followingtable represents employee based stock option activity for the years endedDecember 31, 2006, 2005 and 2004:
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                               | ** ** | ** **                                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                               | ** ** | ** **                                 | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                                               | ** ** | ** **                                 | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                                               | ** ** | **Shares**                                 | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| ** **                                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at the beginning of the period |       | 567,749                                    |       | $ | 3.21 |   | 517,749 |   | $ | 3.14 |   | 306,667 |   | $ | 3.00 |   |
| ** **                                                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Granted at fair  value                                                   |       | 50,000                                     |       | $ | 2.50 |   | 50,000 |   | $ | 2.55 |   | 216,082 |   | $ | 3.42 |   |
|                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Forfeited                                                                |       | (15,500                                    | )          | $ | 3.83 |   | — |   | $ | — |   | (5,000 | ) | $ | 6.00 |   |
|                                                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at the end  of the period                                    |       | 602,249                                    |       | $ | 3.14 |   | 567,749 |   | $ | 3.21 |   | 517,749 |   | $ | 3.14 |   |

 
| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                      | ** ** | ** **                                 | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                                      | ** ** | ** **                                 | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                                      | ** ** | **Shares**                                 | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Shares** | ** ** |
|                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Options  Exercisable at the end of the period   |       | 511,900                                    |       | 3.17 |   | 409,883 |   | 3.31 |   | 331,667 |   | $ | 3.03 |   |
|                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average fair  value of options granted |       |                                       |       | $ | 1.42 |   |   |   | $ | 1.66 |   |   |   | $ | 1.01 |   |
|                                                 |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The followingtable summarizes information for stock options outstanding at December 31,2006:

|                   | ** ** | **Options Outstanding** | ** ** | ** **        | ** ** | **Options Exercisable** | ** ** |
|-------------------|------------|------------------------------|------------|-------------------|------------|------------------------------|------------|
| ** **        | ** ** | ** **                   | ** ** | **Weighted**      | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **        | ** ** | ** **                   | ** ** | **Average**       | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **        | ** ** | ** **                   | ** ** | **Contractual**   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| **Range of** | ** ** | **Number**                   | ** ** | **Term**          | ** ** | **Average**                  | ** ** | ** ** | ** ** | **Number** | ** ** | **Average** | ** ** |
| **Exercise**      | ** ** | **Outstanding**              | ** ** | **Remaining**     | ** ** | **Exercise**                 | ** ** | ** ** | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** |
| **Prices**        | ** ** | **at 12/31/06**         | ** ** | **in Years** | ** ** | **Price**                    | ** ** | ** ** | ** ** | **at 12/31/06** | ** ** | **Price** | ** ** |
|              |       |                         |       |              |       |                         |       |   |   |   |   |   |   |
| 2.55 - 3.00       |       | 557,249                      |       | 3.34              |       | $                            | 2.91       |   |   |   | 466,900 |   | $ | 2.90 |   |
| 6.00              |       | 45,000                       |       | 7.04              |       | $                            | 6.00       |   |   |   | 45,000 |   | $ | 6.00 |   |
|              |       | 602,249                      |       |              |       |                         |       |   |   | 511,900 |   |   |   |

 

60

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Shares availablefor future stock option grants to employees and directors under the existingplan at December 31, 2006, 2005 and 2004 were 3,243,918, 3,293,918 and 3,343,918.At December 31, 2006 the aggregate intrinsic value of the shares outstandingwas $1,095,211, and the aggregate intrinsic value of options exercisable was$944,642. The total intrinsic value of the options exercised was $0 for theyear ended December 31, 2006.

***CommonStock Options***

During August 2005, the Company granted a five-yearoption to purchase up to 1,170,110 shares of common stock at an exercise priceof $0.001 per share in connection with the secured convertible revolving note(see Note 6).

**NOTE 15.              INCOME  TAXES**

The current income taxprovision for the years ended December 31, 2006 and 2005 are $37,875 and$45,682, respectively and for the year ended 2004 the deferred provision wasfully valued.

The following is areconciliation of the income tax benefit computed at the Federal Statutory rateto the provision for income taxes:

|                                       | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**   | ** ** |
|---------------------------------------|------------|------------|------------|----------|------------|------------|------------|
| ** **                            | ** ** | **Amount** | ** ** | **%**    | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
|                                  |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Income tax  benefit at statutory rate |       | (1,156,511 | )          | (34.0    | )          | $          | (1,461,244 | ) | (34.0 | ) | $ | (411,193 | ) | (34.0 | ) |
| Permanent items:                      |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Accretion of loan discounts           |       | 454,245    |       | 13.5     |       | 66,663     |       | 1.5 |   | — |   | — |   |
| Change in fair value of derivative    |       | (1,566,999 | )          | (46.7    | )          | 324,517    |       | 7.5 |   | — |   | — |   |
| Other                                 |       | 1,440      |       | 0.1      |       | 14,582     |       | 0.4 |   | 29,925 |   | 2.5 |   |
|                                  |       | (1,111,314 | )          |     |       | 405,762    |       |   |   | 29,925 |   |   |   |
|                                  |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Change in  valuation allowance        |       | 2,547,351  |       | 74.7     |       | 1,003,446  |       | 23.4 |   | 421,974 |   | 34.9 |   |
|                                  |       |       |       |     |       |       |       |   |   |   |   |   |   |
| State taxes, net  of federal benefit  |       | (204,249   | )          | (5.8     | )          | (67,006    | )          | (1.6 | ) | (40,706 | ) | (3.4 | ) |
|                                  |       |       |       |     |       |       |       |   |   |   |   |   |   |
| Changes in  deferred items            |       | (37,401    | )          | (0.4     | )          | 164,724    |       | 3.9 |   | — |   | — |   |
|                                       |            |            |            |          |            |            |            |  |  |  |  |  |  |  |  |

 

Deferred taxassets and liabilities are determined based on the estimated future tax effectsof temporary differences between the financial statement and tax bases ofassets and liabilities, as measured by the current enacted tax rates. Deferredtax expense (benefit) is the result of changes in the deferred tax asset andliability.  A valuation allowance isrecorded to reduce the carrying amounts of deferred tax assets if there isuncertainty regarding their realization.

61

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The tax effects of temporary differences that give rise to significantcomponents of deferred tax assets and deferred tax liabilities at December 31,2006 and 2005 are presented below:

|                                            | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2006**              | ** ** | **2005**              | ** ** |
|                                       |       |                  |       |                  |       |
| Deferred tax  asset:                       |       |                  |       |                  |       |
| Net operating loss carry forward           |       | $                     | 3,652,915  |                  | $          | 1,228,235 |   |
| Accounts receivable                        |       | 116,869               |       | 52,630                |       |
| Accrued expense                            |       | 24,303                |       | 25,355                |       |
| Deferred compensation — stock options |       | 294,790               |       | 250,867               |       |
| Accumulated depreciation                   |       | 618,983               |       | 822,168               |       |
| Return Reserve                             |       | 62,880                |       | 57,499                |       |
| Inventory Reserve                          |       | 197,558               |       | —                |       |
| Other                                      |       | 40,143                |       | 24,336                |       |
|                                       |       | 5,008,441             |       | 2,461,090             |       |
| Less: Valuation allowance                  |       | (5,008,441            | )          | (2,461,090            | )          |
|                                       |       | $                     | —     |                  | $          | — |   |

 

The following table summarizes the classification of the deferred taxasset as of December 31, 2006 and 2005.

|                         | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------|------------|------------|------------|------------|------------|
|                    |       |       |       |       |       |
| Current                 |       | $          | 419,683    |       | $          | 140,998 |   |
| Non-current             |       | 4,588,758  |       | 2,320,092  |       |
| Total                   |       | 5,008,441  |       | 2,461,090  |       |
| Valuation allowance     |       | (5,008,441 | )          | (2,461,090 | )          |
| Net deferred tax  asset |       | $          | —     |       | $          | — |   |

 

At December 31, 2006, theCompany had net operating loss carryforwards for federal income tax purposes ofapproximately $9,707,000, which are available to offset future federal taxableincome through 2026.

62

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**NOTE 16.              QUARTERLY FINANCIAL INFORMATION(UNAUDITED)**
| ** **                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| 2006                               |       |                   |       |   |   |   |   |   |   |
| Net sales                          |       | $                      | 16,031,219 |   | $ | 16,940,815 |   | $ | 15,173,449 |   | $ | 13,461,174 |   |
| Gross profit                       |       | 5,813,429              |       | 6,192,344 |   | 5,595,120 |   | 4,378,306 |   |
| Net income (loss)                  |       | $                      | 2,850,142  |   | $ | (1,508,201 | ) | $ | (1,407,104 | ) | $ | (3,374,216 | ) |
|                               |       |                   |       |   |   |   |   |   |   |
| Basic earnings (loss)  per share:  |       | $                      | 0.24       |   | $ | (0.13 | ) | $ | (0.12 | ) | $ | (0.28 | ) |
| Diluted earnings (loss) per share: |       | $                      | 0.22       |   | $ | (0.13 | ) | $ | (0.12 | ) | $ | (0.28 | ) |

 
| ** **                                    | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|
| ** **                                    | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| 2005                                          |       |                   |       |   |   |   |   |   |   |
| Net sales                                     |       | $                      | 13,587,048 |   | $ | 14,317,461 |   | $ | 13,972,654 |   | $ | 13,712,060 |   |
| Gross profit                                  |       | 5,024,055              |       | 5,715,065 |   | 5,605,380 |   | 4,949,305 |   |
| Net income (loss)                             |       | $                      | 51,481     |   | $ | 164,312 |   | $ | (1,561,233 | ) | $ | (2,998,017 | ) |
|                                          |       |                   |       |   |   |   |   |   |   |
| Basic and diluted  earnings (loss) per share: |       | $                      | 0.00       |   | $ | 0.01 |   | $ | (0.13 | ) | $ | (0.26 | ) |

 
| ** **                         | ** ** | **Quarter Ended** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| 2004                               |       |                   |       |   |   |   |   |   |   |
| Net sales                          |       | $                      | 9,510,972  |   | $ | 11,572,793 |   | $ | 10,968,033 |   | $ | 12,628,821 |   |
| Gross profit                       |       | 3,710,601              |       | 4,365,910 |   | 4,235,649 |   | 4,578,287 |   |
| Net loss                           |       | $                      | (640,504   | ) | $ | (66,786 | ) | $ | (453,125 | ) | $ | (48,981 | ) |
|                               |       |                   |       |   |   |   |   |   |   |
| Basic and  diluted loss per share: |       | $                      | (0.06      | ) | $ | (0.01 | ) | $ | (0.04 | ) | $ | (0.00 | ) |

 

63

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**ITEM 9.****                       ****CHANGES IN AND DISAGREEMENTSWITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None

**ITEM 9A.****               CONTROLS ANDPROCEDURES**

*DisclosureControls and Procedures*

As of December 31, 2006, the end of the periodcovered by this report, our Chief Executive Officer and Chief FinancialOfficer, reviewed and evaluated the effectiveness of the Company’s disclosurecontrols and procedures, (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (“ExchangeAct”) to ensure that material information required to be disclosed in thereports filed or submitted under the Exchange Act is recorded, processed,summarized, and reported within the period specified by the SEC’srules 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 is sufficient i)to ensure that data errors, control problems, or acts of fraud are detected andii) to confirm that appropriate corrective action, including processimprovements, is undertaken in a timely manner.

Attached asExhibits 31.1 and 31.2 to this Annual Report are certifications of the CEO andthe CFO, 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.

We are in theprocess of implementing the requirements of Section 404 of theSarbanes-Oxley Act of 2002 which requires our management to assess theeffectiveness of our internal control over financial reporting and include anassertion in our 2007 annual report as to the effectiveness of our internalcontrols over financial reporting. Subsequently, our independent registeredpublic accounting firm, McGladrey & Pullen LLP, will be required toattest to whether our assessment of the effectiveness of our internal controlsover financial reporting is fairly stated in all material respects andseparately report on whether it believes we maintained, in all materialrespects, effective internal control over financial reporting as ofDecember 31, 2008. We are in the process of performing the system andprocess documentation, evaluation and testing required for management to makethis assessment and for the registered public accounting firm to provide itsattestation report. We have not completed this process or its assessment, andthis process will require significant amounts of management time and resources.In the course of evaluation and testing, management may identify deficienciesthat would need to be addressed and remediated.

**ITEM 9B.****               OTHER INFORMATION**

None

**PART III.**

**Item 10.****                       Directors, Executive Officersand Corporate Governance**

The informationrequired by this item concerning our executive officers, directors, compliancewith Section 16 of the Securities and Exchange Act of 1934 and our code ofethics that applies to our principal executive officer, principal financialofficer and principal accounting officer is incorporated by reference to theinformation set forth in the sections entitled “Election of Directors,” “Section 16(a) BeneficialOwnership Reporting Compliance” and “Election of Directors—Corporate GovernanceMatters—Code of Conduct” in our Proxy Statement for our 2007 Annual Meeting ofStockholders to be filed with the Securities and Exchange Commission not laterthan April 30, 2007  which is 120 daysafter the fiscal year ended December 31, 2006.

**Item 11.****                       Executive Compensation**

The informationrequired by this item is incorporated by reference to the information set forthin the sections entitled “Election of Directors—Director Compensation” and “ExecutiveCompensation” in the Proxy Statement.

64

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**Item 12.****                       Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

The informationrequired by this item is incorporated by reference to the information set forthin the sections entitled “Security Ownership of Certain Beneficial Owners andManagement” and “Equity Compensation Plan Information” in the Proxy Statement.

**Item 13.****                       Certain Relationships andRelated Transactions, and Director Independence**

The informationrequired by this item is incorporated by reference to the information set forthin the section entitled “Certain Transactions” in the Proxy Statement.

**Item 14.****                       Principal Accounting Fees and Services**

The informationrequired by this item is incorporated by reference to the information set forthin the section entitled “Ratification of Appointment of Independent RegisteredPublic Accounting Firm—Accounting Fees” in the Proxy Statement.

**ITEM 15.****                 EXHIBITS andFINANCIAL STATEMENT SCHEDULES**

**(a)**           **Documents filedas part of this report:**

(1)   FinancialStatements

Reference is made to the Index to ConsolidatedFinancial Statements of IWT Tesoro Corporation under Item 8 of Part IIhereof.

(2)   Consolidated FinancialStatement Schedules

(i)       Report OfIndependent Registered Public Accounting Firm on Financial Statement Schedule:

McGladrey &Pullen, LLP - As of December 31, 2006, December 31, 2005 andDecember 31, 2004, and each of the years then ended.

(ii)      Schedule II- Consolidated Valuation and Qualifying Accounts

(3)   **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)                                     |

 

65

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

 

66

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| 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)                                                                     |
| 10.39 |   | Amended and restated securities Agreement effective  as of July 21, 2006 Note (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, 2006, 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 Restated Registration Rights Agreement  effective as of July 21, 2006, amending and restated a restated registration  rights agreement dated as of May 3, 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 of $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 6, 2006)..                                                       |
| 10.44 |   | Form of Forbearance Agreement between Bank of  America and Tesoro, dated December 2, 2006 filed as an exhibit to the Company’s  periodic filing on Form 8-K, filed with the Securities and Exchange  Commission on December 3, 2006).                                                                                 |
| 10.45 |   | Form of Project Development and Management Agreement  dated November 20, 2006 (filed as an exhibit to the Company’s periodic filing  on Form 8-K, filed with the Securities and Exchange Commission on November  21, 2006).                                                                                           |
| 10.46 |   | Form of Amended and Restated Loan Agreement with  Bank of America and the Revolving Line of Credit, each dated December 10,  2006 filed as an exhibit to the Company’s periodic filing on Form 8-K, filed  with the Securities and Exchange Commission on January 8, 2007).                                           |
| 10.47 |   | Form of Employment Agreement between David W.  Whitwell and Tesoro dated January 2, 2007 (filed as an exhibit to the Company’s  periodic filing on Form 8-K, filed with the Securities and Exchange  Commission on January 8, 2007).                                                                                  |
| 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 Registration Statement on Form S-1, filed with the Securities and  Exchange Commission on September 27, 2006)                                                                                                                                                      |
| 31.1  |   | Certification of Henry J.  Boucher, Jr., Chief Executive Officer pursuant to Section 302 of  the Sarbanes-Oxley Act.*                                                                                                                                                                                            |
| 31.2  |   | Certification of David W.  Whitwell, 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 David W.  Whitwell, 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. |
|---|--------|----------------------------------------------------------------------------------------------|

 

*Filed herewith.

67

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SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act of1934, the Company caused this Registration Statement to be signed on its behalfby the undersigned thereunto duly authorized.

IWT TESORO CORPORATION
| By:                                                                                                                                                                          | /s/ Henry J. Boucher, Jr. |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------|--------|
| Henry J. Boucher, Jr., President                                                                                                                                        |                           |   |
|                                                                                                                                                                         |                           |   |
| Date: April 2, 2007                                                                                                                                                          |                           |   |
|                                                                                                                                                                         |                           |   |
| In accordance with the Exchange Act, this report has  been signed below by the following persons on behalf of the Company and in  the capacities and on the dates indicated. |
|                                                                                                                                                                         |                           |   |
| /s/ Henry J.  Boucher, Jr.                                                                                                                                              |    April 2, 2007     |   |
| Henry J. Boucher, Jr., Principal Executive  Officer                                                                                                                     |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ David W. Whitwell                                                                                                                                                        |    April 2, 2007     |   |
| David W. Whitwell, Principal Financial Officer                                                                                                                               |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Henry J. Boucher, Jr.                                                                                                                                               |    April 2, 2007     |   |
| Henry J. Boucher, Jr., Director                                                                                                                                         |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ James R. Edwards, Director                                                                                                                                               |    April 2, 2007     |   |
| James Edwards, Director                                                                                                                                                      |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Paul F. Boucher                                                                                                                                                          |    April 2, 2007     |   |
| Paul F. Boucher, Director                                                                                                                                                    |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Forrest Jordan                                                                                                                                                           |    April 2, 2007     |   |
| Forrest Jordan, Director                                                                                                                                                     |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Grey Perna                                                                                                                                                               |    April 2, 2007     |   |
| Grey Perna, Director                                                                                                                                                         |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Joseph Equale                                                                                                                                                            |    April 2, 2007     |   |
| Joseph Equale, Director                                                                                                                                                      |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Allen Rosenberg                                                                                                                                                          |    April 2, 2007     |   |
| Allen Rosenberg, Director                                                                                                                                                    |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Carl G. Anderson, Jr.                                                                                                                                               |    April 2, 2007     |   |
| Carl G. Anderson, Jr., Director                                                                                                                                         |                           |   |
|                                                                                                                                                                         |                           |   |
| /s/ Robert Rogers                                                                                                                                                            |    April 2, 2007     |   |
| Robert Rogers, Director                                                                                                                                                      |                           |   |
|                                                                                                                                                                              |                                |        |  |  |  |

 

 

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|  |
|--|

 

## REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

## ON FINANCIAL STATEMENT SCHEDULE

To the Board of Directors

IWT Tesoro Corporation and Subsidiaries

Westport, Connecticut

Our audits of theconsolidated financial statements referred to in our report dated March 30,2007,  (included elsewhere in this AnnualReport on Form 10K) also included the consolidated financial statementschedules for the years ended December 31, 2006, 2005 and 2004, listed in item15(a) of this form 10-K..  Theseschedules are the responsibility of IWT Tesoro’s management.  Our responsibility is to express an opinionbased on our audits of the consolidated financial statements.

In our opinion, thefinancial statement schedules, when considered in relation to the basicconsolidated financial statements taken as a whole, present fairly, in allmaterial respects, the information set forth therein.
| **/S/McGLADREY & PULLEN, LLP** | ** ** |
|------------------------------------|------------|
| ** **                         |
| New Haven, Connecticut             |
| March 30, 2007                     |

 

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Schedule II

**IWT TESORO CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS**

**YEARS ENDED DECEMBER 31, 2006 , 2005 AND 2004**
| ** **                                           | ** ** | **Balance**           | ** ** | **Additions**       | ** ** | ** **              | ** ** | **Balance**      | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|-------------------------|------------|------------------|------------|
| ** **                                           | ** ** | **at Beginning** | ** ** | **Charged**         | ** ** | ** **              | ** ** | **at End**  | ** ** |
| **Description**                                      | ** ** | **of Year**      | ** ** | **to Expense** | ** ** | **Deductions (1)** | ** ** | **of Year** | ** ** |
|                                                 |       |                  |       |                |       |                    |       |             |       |
| Year ended  December 31, 2004 (as restated):    |       |                  |       |                |       |                    |       |             |       |
| Allowance for  returns, claims and doubtful accounts |       | $                     | 175,000    |                | 196,102    |                    | 101,089    |             | $          | 270,013 |   |
|                                                 |       |                  |       |                |       |                    |       |             |       |
| Year ended  December 31, 2005                   |       |                  |       |                |       |                    |       |             |       |
| Allowance for  returns, claims and doubtful accounts |       | $                     | 270,013    |                | 180,100    |                    | 157,451    |             | $          | 292,662 |   |
|                                                 |       |                  |       |                |       |                    |       |             |       |
| Year ended  December 31, 2006                   |       |                  |       |                |       |                    |       |             |       |
| Allowance for returns,  claims and doubtful accounts |       | $                     | 292,662    |                | 423,635    |                    | 238,623    |             | $          | 477,674 |   |

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(1) Representscharge offs, net of recoveries, to the valuation account
| ** **                            | ** ** | **Balance**           | ** ** | **Additions**                  | ** ** | ** **     | ** ** | ** **                          | ** ** |
|---------------------------------------|------------|-----------------------|------------|--------------------------------|------------|----------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **at Beginning** | ** ** | **Charged to Costs** | ** ** | ** **     | ** ** | **Balance**                         | ** ** |
| **Description**                       | ** ** | **of Period**    | ** ** | **and Expenses**          | ** ** | **Deductions** | ** ** | **at end of Period** | ** ** |
|                                  |       |                  |       |                           |       |           |       |                                |       |
| Year ended December 31,  2006         |       | $                     | —     |                           | $          | 525,000        |       | $                                   | —     |   | $ | 525,000 |   |
| Allowance for inventory  obsolencence |       |                  |       |                           |       |           |       |                                |       |
|                                       |            |                       |            |                                |            |                |            |                                     |            |  |  |  |  |

 

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