**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, 2005**

**Commission File No. 000-31267**

 

**IWTTESORO CORPORATION**

(Exact name of registrant as specified in itscharter)

 
| **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)(zip code)

 

**(203) 221-2770**

(Registrant’s telephone number, including area code)

 

Securities registered under Section 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 a well-known seasonedissuer, as defined in Rule 405 of the Securities Act. o Yes  ý No

 

Indicate by check mark if the registrant is not required to file reportspursuant to Section 13 or Section 15(d) of the Act. o Yes  ý No

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports, and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý   No  o

 

Indicate by check mark if disclosure of delinquent filers in response toItem 405 of Regulation S-K is not contained herein will not be contained, tothe best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K. o

 

Indicate by a check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or non-accelerated filer.

 

| Large  accelerated filer   o |   | Accelerated  filer  o |   | Non-accelerated  filer  ý |
|---------------------------------------------|--------|---------------------------------|--------|-------------------------------------|

 

Indicated by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Act). o Yes  ý No

 

State the aggregate market value of the voting and non-voting commonequity held by non-affiliates computed by reference to the price at which the commonequity was last sold, or the average bid and asked prices of such commonequity, as of the last business day of the registrants most recently completedsecond fiscal quarter:  $6,251,010

 

**APPLICABLE ONLY TO CORPORATE REGISTRANTS**

 

Indicate the number of shares outstanding of each of the registrant’sclasses of common equity, as of the latest practicable date:  11,926,900 shares as of May 17, 2006

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

NONE

 

** **

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**Table of Contents**

 
| **Part I**   | ** **                                                                                       | ** ** |
|-------------------|--------------------------------------------------------------------------------------------------|------------|
| Item  1.          | Business                                                                                         | 3          |
| Item 2.           | Properties                                                                                       | 18         |
| Item 3.           | Legal  Proceedings                                                                               | 18         |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                             | 18         |
|              |                                                                                             |       |
| **Part II**  |                                                                                             |       |
| Item  5.          | Market  for Registrant’s Common Equity and Related Stockholder Matter                       | 19         |
| Item  6.          | Selected  Financial Data                                                                         | 20         |
| Item  7.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations      | 21         |
| Item 7A           | Quantitative  and Qualitative Disclosures About Market Risk                                      | 29         |
| Item 8.           | Consolidated  Financial Statements and Supplementary Data                                        | 29         |
| Item 9.           | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure            | 59         |
| Item 9A           | Controls and  Procedures                                                                         | 59         |
| Item 9B           | Other Information                                                                                | 60         |
|              |                                                                                             |       |
| **Part III** |                                                                                             |       |
| Item 10.          | Directors  and Executive Officers of the Registrant                                              | 60         |
| Item 11.          | Executive  Compensation                                                                          | 65         |
| Item 12.          | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters | 69         |
| Item 13.          | Certain  Relationships and Related Transactions                                                  | 71         |
| Item 14.          | Principal  Accountant Fees and Services                                                          | 71         |
|              |                                                                                             |       |
| **Part IV**  |                                                                                             |       |
| Item 15.          | Exhibits  and Financial Statements Schedules.                                                    | 72         |

 

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**PART I**

 

**FORWARD LOOKING STATEMENTS**

 

Statementsmade in this Annual Report are “forward-looking statements” and are nothistorical facts. For example, statements regarding our financial position,business strategy and other plans and objectives for future operations, andassumptions and predictions about future demand for our services and products,supply, costs, marketing and pricing factors are all forward-lookingstatements. When we use words like “intend,” “would”, “anticipate,” “believe,” “estimate,”“plan” or “expect” or the negative of these terms and similar expressions weare making forward- looking statements. You should be aware that theseforward-looking statements are subject to risks and uncertainties. Additionally,our forward-looking statements speak only as of the date of this report. Otherthan as required by law, we undertake no obligation to update or revise thesestatements, whether because of new information, future events or otherwise. Newfactors emerge from time to time that may cause our business not to develop aswe expect, and it is not possible for us to predict all of them. Factors thatmay cause our actual results, performance or achievements to be materiallydifferent from the results, performance or achievements expressed or implied bythe forward-looking statements include, among other things:

 

•      Our ability to successfully implement ourbusiness plan, including expanding our markets, increasing our product lines,and maintaining high quality customer service;

•      Continuing and cultivating our relationshipswith current and new vendors;

•      Funding our growth in a manner that isbeneficial to our stockholders;

•      Trends affecting our financial condition orresults of operations, the impact of competition, the start-up of certainoperations, roll out of products and services and acquisition opportunities;

•      Restraints on pricing flexibility due tocompetitive conditions in the flooring industry, while taking intoconsideration factors beyond our control such as increases in freight andtariff charges, currency risks, and political conditions;

•      Depending on third party suppliers outside theUnited States;

•      The impact of adverse weather conditions, bothin our targeted markets, as well as with respect to our foreign suppliers; and

•      Other risks referenced from time to time inour SEC filings.

 

**ITEM 1.****       ****DESCRIPTION OF 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 three regional warehouses located in Florida, 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 ship direct 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 our customers tocontrol freight costs, including shipping in our own trucks whenever possible

•      Shipping smaller customer orders the same daythey are received

•      Meeting larger customers’ needs for volume by shipping full truck loadsdomestically or container volume direct from the foreign factory

 

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•      Supporting our products with aggressivemarketing and merchandising programs

 

Todate, we have financed our growth with revolving debt facilities currentlyprovided by Bank of America and Laurus Funds. We have also used public andprivate offerings of our common stock. If adequate financing is not available,we will most likely be forced to slow down our growth.

 

### **Background**

### ** **

IWTTesoro Corporation was organized in Nevada on May 3rd, 2000, originallyunder the name “Ponca Acquisition Corporation”. Effective October 1, 2002,Tesoro acquired all of the outstanding common stock of International WholesaleTile, Inc. (IWT) from its three shareholders. IWT was organized in Florida andhas been in continuous operations since 1994. In exchange for the IWT stock,the IWT shareholders each received 3.0 million Tesoro shares, representing87% of Tesoro’s then outstanding common stock

 

Tesorois the parent company and currently has four 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*.Information contained on our web site is not part of this report.

 

**Tesoro’sBusiness Strategy**

 

Webelieve that our corporate strategy to develop or acquire subsidiaries willbring unique expertise and competitive advantages to our targeted markets inthe area of building supply distribution. Each of our current subsidiariesmeets this criterion. Through our subsidiaries, we can offer a wide range ofproduct at attractive price points, whether our customers want to buy a smallamount of product for a specific project or large amount, for inventory andresale. While focused on the same strategy, each subsidiary has slightlydifferent objectives.

 

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

 

IWTbelieves that it has built a reputation for dependability and reliability bysupplying quality products with superior customer service at competitiveprices. As part of our business model, we have established what we consider is aclose relationship with flooring dealers throughout the Sunbelt area of theUnited States. We feel that we currently provide a purchasing and deliveryexperience for our customers that meets their business needs and capacities.

 

Thefollowing are the critical success factors with respect to our strategy andphilosophy:

 

•      Supplying quality products;

•      Providing outstanding customer service;

•      Offering competitive pricing;

•      Introducing high quality new products to themarketplace; and

•      Distributing products only 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 handlingand the reputation we enjoy as, what we feel is a dependable supplier allows usto maintain above average margins. We do not operate any retail outlets. Thisnon-competitive relationship is unique in the ceramic floor and wall tiledistribution industry, has been a key factor in our growth and defines us as a “valueadded reseller” rather than merely a distributor.

 

Otherkeys success factors include:

 

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•      Actively merchandising programs,

•      Assisting our dealers to meet their customers’demand, with products presented in attractive easy to visualize environments,and

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

 

### **Other Tesoro Subsidiaries’ BusinessStrategies**

### ** **

•      IWT Tesoro International (International) aimsto leverage the international purchasing network in order to sustain theexpansion of Tesoro’s business. This subsidiary expects to establishedrelationships in the form of partnerships with a number of granite and tilemanufacturers from around the world, including Italy, Spain, Turkey, Brazil andChina. Based on these partnerships, International hopes to use these advantagesto strengthen our market position within the building products industry.

 

•      IWT Tesoro Transport (Transport), a federallylicensed freight broker (USDOT) that handles inbound and outbound freightoperations. Given that this subsidiary has recently begun generating revenue,although de minimus, Tesoro plans to expand from a regional to a nationaldistribution system following the recent efforts to generate sales nationwide.

 

•      The Tile Club (TTC) intends to acquirelicensing, manufacturing and distribution rights for high-end designer andartistic based decorative tiles and to act as an agent for foreignmanufacturers from whom IWT has acquired exclusive distribution rights.

 

•      Import Flooring Group, Inc. distributesfloor and wall covering materials under exclusive agreements with manufacturersto member customers in the United States, Canada and Mexico. Its primaryobjective is to build a membership based buying group made up of full lineflooring distributors in each service area. Members pay an annual fee to IFGfor rights to sell specific products in specific geographies.

 

### **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 product package is the cut order or project specific unit. Forthe cut order unit, we act as a customer fulfillment center. We pick productfrom full pallets of different material, reassemble and repackage it for thecustomer. The next level of unit includes single pallets of uniform materialshipped individually to the customers’ location. Above the pallet unit is thefull truckload of mixed pallets. We land these to our warehouses and reship tothe customer. We carry significant levels of inventory to meet the demand forthese units and ship most orders within three days of the customers’ order. Ourcustomers can also by product units directly from the factory. These factoryshipped units are full container volumes. The customer can land the product,i.e. pay the freight and duties or purchase the product landed to theirlocation in which case we handle the shipping

 

### **Distribution Centers**

 

Ourwarehousing and distribution centers currently contain over 480,000 square feetof storage space, in which we maintain over 25.0 million square feet of productready for immediate shipment to our customers. In 2005, our warehouseconfiguration included 310,000 square feet in Palm City, FL, 120,000 squarefeet in Dallas, Texas and 40,000 square feet in Pomona, CA. As we expand, wewill likely need additional satellite warehouse locations.

 

### **Branded Products**

 

IWThas created Tesoro The Collection®, a branded collection of high quality porcelainfloor and wall tiles complemented by coordinated decorative borders andlistellos. It supports this collection with an extensive merchandising programincluding grouted display boards and racks, and institutional marketing andadvertising. We prominently display the Tesoro line at all of the national andregional 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 marketpenetration by expanding nationally

•              Establishing sub-distribution centers in theWest, Midwest and Northeast regions,

•              Creating dealer networks in new territories,and

 

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•              Expanding value added services;

•              Deepen our current customer base penetrationby increasing our market share with current dealer customers;

•              Maintain our high level of customer serviceand satisfaction;

•              Obtain adequate capital to support the necessaryinventory levels required by our customers;

•              Continue strengthening our relationships withsuppliers to ensure a continuous flow of high quality, competitively priced contemporarydesigns;

•              Ensure a continuous flow of high quality,current design and competitively priced products;

•              Increase the number and breadth of productswe carry, and

•              Strengthen our consolidated balance sheet byreducing our debt to equity ratio **.**

 

On a short-term basis, we intend to look to acquire assets ofbusinesses with products and services that complement ours. We further intendto grow by acquiring or merging with existing regional distributors. We alsoexpect to expand our international activities to handle our relationships withforeign manufacturers.

 

**The Floor and Wall Tile Covering Industry**

 

TheJuly 18/25, 2005 edition of Floor Covering Weekly (FCW) reported that U.S.floor covering sales for 2004, the last full year for which data is available,reached $22.8 billion, in wholesale dollars, up 8.4% from 2003. The market forceramic floor and wall tile products in the United States, Tesoro’s majorproduct line, reached $2.86 billion in 2004 up 12.6% from 2003. Sales ofceramic floor and wall products reached approximately 3.2 billion square feetin 2004. 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). For2004 Ceramic tile is the second most widely used floor covering material in theU.S., with a market share, according to FCW, of 12.4% behind carpet (62.3%) andahead of hardwood (10.5%).

 

Theper square foot wholesale price for the products in the floor covering marketvaries widely. The average price per square foot in 2004, according to FCW, was$0.83. The price ranges from $2.45 for hardwood to $0.48 for vinyl. Ceramicfloor and wall tile’s average price in 2004 was $0.91 down from an average of$1.02 in 1997. By contrast, the price of hardwood flooring has increased to$2.45 from $1.83 in 1997. Other types of flooring materials, including carpethave remained relatively stable.

 

Whileincreasing interest rates may have a temporary impact on the new homeconstruction industry, studies show that over any length of time the impact isminimal. This is particularly true in the Sunbelt (southern and southwesternUnited States) where we have our strongest presence. Of course, we cannotassure anyone that these estimates will be achieved or if met, will occur whenexpected.

 

Thefollowing economic activities positively affect the US floor and wall coveringmarket:

 

•      U.S. population growth, requiring new andrenovated housing and commercial space,

•      Housing starts reached 1.96 millionunits in 2004, growing by 5.9%, which was the best performance in 26 years,

•      In 2004, the new construction market reboundwas driven by a 7.4% surge in the residential sector,

•      2004 issuance of building permits was up 7.1%,

•      New, one-family home sales rose 10.0% in theSouth, our primary market;

•      Low mortgage rates made homes affordable foran expanding number of households while the refinancing of existing mortgagesimproved consumers’ financial positions and provided increased funds forspending for remodeling,

•      Increasing average house size (upapproximately 12% since 1994), and

 

(“US Ceramic Tile Market- 2005 Edition”, published by MarketStudies, Inc., a recognized industry market research firm. As newinformation becomes available, we will update these statistics).

 

Long acknowledged for its durability and functionality, ceramic tilenow means fashion. Consumers can chose from soft hues or primary colors, finishesthat resemble stone, wood or fabric, and can incorporate metal and glassaccents for flexible design. The high growth rate of ceramic tile relative toother flooring options has led to more full service distributorships,manufacturers, and retailers adding ceramic tile to their lines. With morefloor space being devoted to ceramic tile at retail, efforts at productdifferentiation have intensified. Licensing, a relatively new strategy in theceramic tile marketplace, is heating up, including the following partnerships:Shaw Industries with Martha Stewart and Kathy Ireland; Witex with Laura Ashley,Armstrong’s Liz Claiborne line in partnership with Carpet One, and MarrazziGroup with Benetton.

 

Salesin the floor covering industry are influenced by economic and market factorsincluding:

 

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•      consumer confidence;

•      spending for durable goods;

•      interest rates;

•      turnover in housing, the condition of theresidential and commercial construction industries; and

•      the overall strength of the economy.

 

“USCeramic Tile Market- 2005 Edition”, published by Market Studies, pointed to amarket growth rate for ceramic tile of 10.0% in 2004

 

**Products**

 

Wepurchase our products on the world market. We import approximately 50% of ourproducts are from Italy, 30% from Spain and the balance from Brazil, Turkey andChina. Each foreign manufacturer has registered agents in the United Statesthat work with us, as well as with other distributors. We believe that wemaintain close personal contact with our suppliers, visiting the plantsregularly and working with suppliers to influence design, quality andreliability. We do not currently purchase any raw materials, but only finishedgoods. Our principal suppliers and the countries in which each is locatedinclude:

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

 

We carry over 200 separate product lines. A product line consists ofseveral profiles, sizes (of the same tile design, i.e. six inch by six inch,twelve inch by twelve inch) and matching or coordinating borders. Annually weadd and delete lines to keep the selection current with industry and consumertrends. For example, in 2005, we added hardwood, laminate, area rugs and carpetto our product mix. We estimate that there is a 10% turn over in the linesannually. This translates into approximately 20 new lines added each yearreplacing a similar number of deleted lines. We believe we have ample time totransition into the product lines as the time to manufacture and ship new linescan exceed nine months. This lead-time, allows us to draw down inventory ofdeleted lines to a minimum level before being eliminated from stock.

 

We maintain a wide distribution of price points for our product. Weestablish basic price levels based on the volume of product purchased. We alsoadd additional 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 continued to declineover the long term, reaching $0.91 per square foot in 2004. The 2004 price is aslight rebound from its low of $0.89 per square foot experienced in 2003. Accordingto the industry magazine, Floor Covering Weekly (July 2004), the marketfor high- end porcelain tiles and decorative/designer tile has been increasing.The 2004 price seems to bare this out. We emphasize this high-end tile andstone by selectively marketing them to dealers and distributors with customerbases that demand such products

 

We ship product to our customers in quantities ranging from “cut order”specific to a consumer’s project to full pallets of a single product to fullcontainer and truckload packages. These larger quantities allow our customersto stock their own product to service cash and carry consumers.

 

We import a majority of our products into the Port of Miami. In 2004,we expanded our distribution facilities to Dallas, Texas. Product imported fordistribution from our Dallas facility arrives via the Port of Houston. Inaddition, we also import products into the port of Long Beach, California. Ordersthat are shipped directly from the manufacturer to our customers may enter throughany number of U.S. ports.

 

**Inventory**

 

We are committed to maintaining inventory levels that support the salesof our customer network. We currently maintain over $28.8 million ofproduct in inventory, representing over 2,500 SKU’s (individually numberedproduct items). We also act as the warehouse and fulfillment source for many ofour approximately 2,700 dealers and wholesale customers. We target an inventoryturn over rate of 1.5 to 2.0. This turn rate is established to minimize out ofstock situations and to attain our goal of same day shipping for qualifiedorders.

 

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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.

 

**Freight and Transportation Costs**

 

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

 

•      factory cost,

•      freight (international and domestic), and

•      duties, tariffs, taxes and other regulatorycosts.

 

Ocean freight charges differ from country to country therefore, we baseour selling price is based on factors specific to each internationalmanufacturer. We pay most of our international manufacturers in U.S. dollars.The strength of the U.S. dollar relative to a specific country’s currency willhave an impact on the price we pay for product. Additionally, we also take intoaccount that title to our products transfers at the port of the originatingcountry. We generally ship between 10 and 20 containers at any one time. Wecurrently estimate that our maximum exposure for loss would be approximately$150,000. Based on maritime loss history, cost of ocean marine insurance andour ultimate ability to subrogate against the freight carrier, we self-insurein the event of loss after title is taken. Our in-bound freight cost, gasoline,fuel and other surcharges have increased our shipping costs of which we havenot yet passed on to our customers. As such, our gross margins may be lowerbecause we are currently absorbing these increased costs.

 

As a result of increasing out-bound freight costs, we organized IWTTesoro Transportation, Inc., a federally licensed freight carrier. Byworking with this subsidiary to supply a portion of our shipping needs, we hopeto have more control over these costs.

 

**Revenue Source**

 

We generate all our revenue from the U.S. territory and currently haveno sales outside the country. Within the United States, the majority of our revenueis derived from the southeastern quadrant of the country. On a per productbasis, the sales of hard flooring and wall covering materials generate thelargest share of revenue.

 

**Customer Base and Distribution Channels**

 

When IWT first began business in 1994, it started our distributionhistory focusing on the traditional small and mid-sized floor-covering dealersin the southeastern United States. Later, it expanded its distribution channelsover larger 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.

 

We currently distribute our products through four separate distributionchannels.

 

•      The independent retail floor-covering dealerand stocking distributor market is our largest channel. This channel currentlyaccounts for about 54% of the sales revenue. These customers, who sell directlyto the public, can be either “cut to order” or “stocking” dealers/regionaldistributors. We currently serve approximately 2,000 customers in this channelthrough our sales personnel. In addition, we have sub-distributors that handlespecific market territories for limited numbers of our Tesoro-The Collectionâ product packages.

 

•      The major home center “buy-it-yourself/do-it-yourself”store market makes up our second distribution channel. These customerstypically operate under blanket purchase orders. There are three basic programsfor home center stores. The first is a special order program. Consumers placeorders from sample boards provided by us to the store. The storerepresentatives forward these orders to us and we ship the product eitherdirectly to the consumer or to the store for pick-up by the consumer. Thesecond program is a stocking program, which provides for a home center store tomaintain specific product inventories for their cash and carry trade. The thirdprogram is “Special Buys”. Under this program the customers purchase largequantities of specific product for special promotions. The home center storechannel currently accounts for about 8% of our revenue.

 

•      Our third channel, accounting for 16% of ourrevenues, is made up of national buying groups. These groups supportindependently owned, branded floor covering outlets with coordinated buyingagreements that require us to market directly to each individual retail outlet.This channel also includes large builders, who staff and maintain captivedesign centers specifically for their own customers.

 

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•      Our fourth channel is the bulk sale channel.In this channel we service retail buyers that purchase full truckloads orcontainers of specific product that is manufactured for us specifically forthis program. These products can be drop-shipped from our manufacturer directlyto the customer. The customer base for this channel is the United States andCanada. This channel makes up the remaining 22% of our sales.

 

Wemaintain a separate and coordinated sales force for each of the channels ofdistribution. The geographic distribution of our sales is predominately in theSoutheastern United States, which accounts for 80% of our sales, however we domake sales throughout the United States. We also sell different product seriesto each channel to avoid market saturation or channel conflict. Currently, wedo not sell to any single customer, which aggregates to more than 5% of oursales.

 

**Merchandising**

 

The market for ceramic tiles, once characterized by little or no brandrecognition, is beginning to enter into branding agreements with well-knowndesigner names such as Ralph Lauren and Laura Ashley. In May 2002, IWTintroduced our proprietary brand Tesoro-The Collectionâ. Tesoro is a collection of porcelain tilesand decorative inserts, borders, and accents that are marketed throughout theUnited States. We have invested in specifically designed display racks thatcommunicate the quality and value of our Tesoro brand that we believe assistsour dealers in communicating product combinations to the consumer. We arecontinually updating these displays with new products. We have a fifteen-yearmanufacturer’s warranty program for Tesoro-The Collectionâ products that we believe elevate the qualityposition of our products.

 

In addition to the display units, we provide our customers with displayboards that are smaller and show a single line of product with its accentpieces. These boards are portable so as to allow the dealer to easily show ourproduct or take it to the installation site. Our sales force distributes losesample packs, usually an assortment of colors for a single product line,whenever a line or dealer needs restocking. We account for the sample packs anddisplay units and sample boards, along with the labor and overhead involved increating them, as promotional expenses, when they are distributed to thecustomers. Our promotional expense represents a significant part of our cost ofdoing business.

 

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**Credit and Collection Procedures**

 

•      We maintain strict criteria for credit approval:

•      Potential customers must complete our creditapplication;

•      Credit must be approved by our creditdepartment; and

•      We may require a personal guaranty.

 

Once approved, typically our dealers receive 30-day terms. Our bulktruckload customers may be offered extended terms of payment. We generallyprovide a 15-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:

 

•      Have a storefront designed to market tile

•      Sell to retail customers

•      Operate at least one forklift

•      Accept material in bulk

 

**Marketing, Promotion and Sales**

 

Marketing

 

We currently employ 1 full-time individual to develop our marketing andadvertising material. Our public relations and marketing activities focus on supportingour customer’s sales efforts. We use trade magazines articles, specificallydesigned mailer programs and trade shows as our primary communication devices.

 

Sales

 

Our commission based sales force work with dealers to place theproducts in showrooms, educate the dealers regarding the quality and variety ofproduct available to them and work with our internal customer service staff tofacilitate delivery. IWT employs a twenty-three 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. IFG also has an experienced sales forcestaffed by four full time sales people.

 

**Competition**

 

We compete in the flooring industry with both large national companiesthat supply both soft and hard materials and with smaller regional distributorsthat focus specifically on ceramic, porcelain and stone. Vertically integratedcompanies such as Shaw Industries and Mohawk, the two largest flooringproviders, account for over 60% of the hard surface market in the U.S. Whilemaintaining their dominant positions in the carpet market, both companies aremoving aggressively into the hard flooring sector. Dal-tile, a subsidiary ofMohawk; manufactures, wholesales and retails tile on a national basis.

 

Regional competitors such as Master Tile, Florida Tile and Arizona Tileact as both wholesalers and retailers. In their markets, each supplies smallerdealers and distributors and also operates branded retail outlets. We currentlyonly distribute at the wholesale level.

 

We believe that our competitive strengths include:

 

•      *Focusing solely on thewholesale segment of the distribution 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 indesigning 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-TheCollection**â**brand equity.* We are branding our designs and many of our products with our Tesoro

 

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Brand.We incorporate products from different manufacturers and different countriesinto programs that leverage the best of each source to create Tesorocollections. Unlike most other tile and ceramic products, Tesoro productsinclude a 15-year manufacturer’s warranty against wear.

 

•      *Providing superiormerchandising and customer support programs.* We maintain an active sampling program to ensure that customers havethe latest materials in their showrooms. Our field sales force continuallyupdates, refreshes and replaces sales materials. We distribute literature toconsumers referencing our dealer network participants. Our field personnel workwith the customer and train them on the appropriate use and care of theproduct. Our goal is to make the dealers’ job as easy as possible.

 

•      *Implementing ourDistribution Philosophy.* Wesee ourselves as an extension of the dealer warehouse. We aim to be responsiveto our customers’ needs by shipping most orders the same day they are received.We also carry stock to back-up our customers in the cash and carry 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.

 

**Government Regulations**

 

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.

 

**Acquisitions and 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.

 

**Intellectual Property**

 

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 no assurances that any trademark orother protections will be meaningful. We are not aware of any claims ofinfringement against us and we have not been involved in any related courtproceedings.

 

Weare also in preliminary discussions to create unique artwork and high-end tiledesigns for national distribution.

 

**Employees**

 

Tesoroand its subsidiaries currently employ 117 people, of which 113 are full-timeand 4 are part-time, including 41 warehouse staff and 23 salespeople coveringsales in the United States and Canada. None of its employees are members of anyunion. The remaining 49 employees include customer service, accounting andadministrative positions. IWT believes that its relationships with itsemployees are good. Tesoro currently has three employees, Transport has one employeeand IFG has five employees. Neither International nor The Tile Club currentlyhas any employees.

 

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**Important Risk Factors Concerning our Business.**

 

*You should carefully consider the following risk factors andall other information contained in this Annual Report in evaluating ourbusiness and prospects. The risks and uncertainties described below are not theonly ones we face. Additional risks and uncertainties other than those wedescribed below that are not presently known to us or that we believe areimmaterial may also impair our business operations. If any of the followingrisks occur, our business and financial results could be harmed. You shouldalso refer to the other information contained in this Annual Report, includingour consolidated financial statements and the related notes.*

 

**ITEM 1A. RISK FACTORS**

 

WEWILL LIKELY NEED TO RAISE ADDITIONAL FUNDS IN THE FUTURE FOR ACQUISITIONS ANDGROWTH. IF WE CANNOT SECURE ADDITIONAL FUNDS, WE MAY NOT BE ABLE TO EXPANDOUR BUSINESS.

 

To raise additional capital, we may sell additional equity securities,accept debt financing, or obtain financing through a bank or other entity.There is no limit as to the amount of debt we may incur nor have we adopted anyratio of our equity to debt. If we need to obtain additional financing, it maynot be available or it may not be available on terms acceptable to us.Likewise, an offering of our securities may not be successful. If additionalfunds are raised through issuing additional stock, the value of our outstandingstock may be significantly diluted.

 

Ourfuture capital requirements will depend upon many factors, including thefollowing:

 

•      The magnitude of the inventory we must carryto adequately support our customers;

•      The volume of sample material and product wemust have in place with our customers to help merchandise our products;

•      The number of different product variationsdemanded by our customers;

•      Currency fluctuations, particularly withrespect to the Euro Dollar against the U.S. Dollar and

•      The rate at which we expand our operations.

 

WE HAVE SUFFERED NET LOSSES FOR THE YEARS ENDED DECEMBER 31,2005, 2004 AND 2003 RESULTING IN A WORKING CAPITAL DEFICIT.

 

Ourmanagements plan with regard to these matters includes the following:

 

•      Decrease projected operating costs includingsales & marketing and administrative overhead;

•      Reduce product cost by opening regionalwarehouses;

•      Expand national home center customer base.

 

OURQUARTERLY OPERATING RESULTS FLUCTUATE, WHICH COULD RESULT IN A LOWER PRICE FOROUR SECURITIES.

 

Ourquarterly results may be affected by a variety of factors, some of which arebeyond our control, including, for example, the following:

 

•      Introducing new products or pricing programsby our competitors;

•      Increased transportation costs;

•      Increases in selling and marketing expenses,as well as other operating expenses;

•      Adverse weather conditions;

•      Economic conditions specific to our industry.

 

Of these conditions, the 1st, 2nd, 4th and 5th factors arelargely beyond our control.

 

GENERALLY,WE MUST PAY ALL COSTS AND EXPENSES INCURRED WITH DEFENDING ANY ACTIONS ALLEGEDAGAINST ANY OF OUR DIRECTORS.

 

Ourarticles of incorporation and bylaws provide that we may indemnify our officersand directors against losses sustained or liabilities incurred arising from anytransaction in that officer’s or director’s respective managerial capacityunless that officer or director:

 

•      violates a duty of loyalty,

 

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•      did not act in good faith,

•      engages in intentional misconduct orknowingly violated the law, or

•      derives an improper benefit from thetransaction.

 

Additionally,we have also entered into separate indemnity agreements with each of ourexecutive officers and directors to provide added protection unless that personcommitted any of the prohibited acts described above. Any obligations we incurdefending any such actions could adversely affect our cash flow andprofitability.

 

OURARTICLES OF INCORPORATION AND BYLAWS CONTAIN CERTAIN PROVISIONS THAT COULDHINDER A CHANGE IN OUR CORPORATE CONTROL.

 

Certainprovisions of our articles and bylaws may discourage, delay or prevent a mergeror acquisition that a stockholder may consider favorable to our stockholders.Only our 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 bylawsrequire notice procedures with regard to stockholder proposals and nominationsof candidates for electing directors are required. Furthermore, vacancies onour Board, including newly created directorships, may be filled by a majorityof our directors then in office and not by our stockholders.

 

WEMAY BE UNABLE TO OBTAIN PRODUCTS ON A TIMELY BASIS, WHICH COULD MATERIALLYHAVE AN ADVERSE EFFECT ON OUR BUSINESS.

 

Wecurrently do not manufacture any of the products we distribute. Our businessdepends primarily upon a continuous supply of material from third partysuppliers. We currently obtain our products from one domestic and 40 foreignmanufacturers. While we believe this large group of suppliers insulates us fromthe effect of any one supplier, international supply relationships aresensitive to geo-political situations beyond our control. In particular, wedepend on suppliers in Italy and Spain and any disruption in this supply chaincould put us in a difficult position. In addition, any extended interruption inproduct supply would disrupt our operations, which could adversely affect ourbusiness, financial condition and operating results.

 

BECAUSEWE DO NOT CARRY ANY INSURANCE ON PRODUCTS IN TRANSIT, WE RISK LOSING ENTIRESHIPMENTS.

 

Titleto our products transfers either at the port of the originating country or atthe foreign factory in the case of inventories held for direct shipment to ourcustomers. We self-insure in the event of loss after title is taken. We onlyship between ten and twenty containers at any one time. We currently estimatethat our current maximum exposure for loss would be approximately $150,000.Because we often place special orders on behalf of our customers, if anyshipments were lost or damaged, our clients would not be able to receive their productin a timely fashion, which, in turn, could adversely affect our relationshipwith those customers. To date, we have only incurred minimal losses withrespect to products that have been lost after we acquired title.

 

ADVERSEWEATHER CONDITIONS, SUCH AS RECENT HURRICANES IN THE SOUTHEAST, COULD ADVERSELYAFFECT OUR SALES, AS WELL AS OUR ABILITY TO PROVIDE CUSTOMERS WITH PRODUCT ON ATIMELY BASIS.

 

TheSoutheastern part of the United States, sustained major damage during the 2005and 2004 hurricane seasons. While our warehouse facilities were not damaged, anumber of dealers to whom we sell product have been and were unable to dobusiness for several weeks. Likewise, with the threat of any hurricane, we needto take precautions, which often require employees to leave the premises inorder to secure their own properties. Additionally, we have not always receivedproduct on a timely basis because of the inclement conditions. Moreover, newconstruction is affected both pre- and post- hurricane because contractors areneeded to aid those who could be or have been negatively impacted. As a result,our sales following the recent hurricane seasons were adversely affected. Additionally,major international catastrophes such as the tsunami and recent earthquakes couldadversely affect our business in a number of ways, all of which are beyond ourcontrol and cannot be anticipated.

 

IFTHE CONFLICT IN THE MIDDLE EAST ESCALATES, WE MAY HAVE DIFFICULTYOBTAINING PRODUCTS FROM CERTAIN FOREIGN MANUFACTURERS.

 

Todate, we have not been adversely affected in any material way by conflicts inthe Middle East. We have not had problems obtaining product from Turkey,although minor problems with product from Dubai have occurred. However, wepurchase only limited product from Dubai manufacturers and can obtainsubstitute products, if necessary. Protest strikes in the European Unioncountries such as Spain and Italy may slightly delay shipping of products, butto date, these delays have been minor.

 

WEMAY BE UNABLE TO PASS ON TO OUR CUSTOMERS INCREASES IN TRANSPORTATIONCOSTS, WHICH COULD HAVE A MATERIAL EFFECT ON OUR PROFITABILITY.

 

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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 rate 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 this cost 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.

 

IFWE GROW TOO QUICKLY, WE COULD ENCOUNTER PROBLEMS RELATED TO INCREASED CUSTOMERDEMANDS ON OUR LIMITED RESOURCES.

 

Rapidgrowth would place a significant strain on our managerial, operational,financial and other resources. Our systems, procedures, controls and managementresources may not be adequate to support our future operations. Future growthwill require us to

 

•      implement additional management informationsystems,

•      further develop our operating,administrative, financial and accounting systems, and

•      maintain close coordination betweendepartments.

 

Ifwe cannot manage our growth, we could limit our ability to capitalize on newbusiness opportunities that may arise or to implement our business plan orattain 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.

 

WEDEPEND ON OUTSIDE DISTRIBUTORS FOR PRODUCT SALES.

 

Wesell our products primarily through a network of dealers and dealerdistributors. Our dealers and dealer distributors do not have a minimum salesrequirement and are independent contractors. If we do not competitively priceour products, or if the quality of the products is substandard, our dealers anddealer distributors may fail to market aggressively our products for us. If ourdealers or dealer distributors do not successfully sell our products, then ourrevenue and profits may decline.

 

IFWE ARE UNABLE TO RETAIN OUR MANAGEMENT TEAM, OUR BUSINESS OPERATIONS AND OURGROWTH OBJECTIVES MAY BE ADVERSELY AFFECTED.

 

Oursuccess in achieving our growth objectives depends upon the efforts of our topmanagement team including the efforts of Henry J. Boucher, Jr., our ChiefExecutive Officer, Forrest Jordan, our Chief Financial Officer and Senior VicePresident, and Paul F. Boucher and Grey Perna who are Senior Vice Presidents,as well as other of our management members. 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.

 

FUTUREEXCHANGE RATE FLUCTUATIONS OR INFLATION COULD HAVE A MATERIAL ADVERSE EFFECT ONOUR OPERATING RESULTS.

 

Weimport most of the product we sell from countries whose currency is the EuroDollar. We currently write purchase contracts and pay for materials in U. S.dollars. However, the manufacturing facilities pay all their expenses in theircountry’s currency. This means that we realize a benefit when a country’s currencydevalues against the U.S. dollar, although that country’s inflation rate orinternal expenses may offset this benefit. Any future increases in a country’sinflation rate, which are not offset by devaluation of their currency, maynegatively affect our operating results. To the extent that a foreign country’scurrency appreciates against the U.S. dollar, there could be a material adverseeffect on our business, financial condition and operating results.

 

**INDUSTRY RISKS**

 

THEFLOOR AND WALL COVERING INDUSTRY IS CYCLICAL AND PROLONGED DECLINES INRESIDENTIAL OR COMMERCIAL CONSTRUCTION ACTIVITY COULD ADVERSELY AFFECT OURBUSINESS.

 

Ourindustry depends on residential and commercial construction activity, includingboth new construction, as well as remodeling. New construction activity andremodeling to 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. Constructionactivity affected significantly by numerous factors, all of which are beyondour control, including, among others,

 

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•      national and local economic conditions;

•      interest rates;

•      housing demand;

•      employment levels;

•      changes in disposable income;

•      financing availability;

•      commercial rental vacancy rates;

•      seasonal weather conditions;

•      federal and state income tax policies; and

•      consumer confidence.

 

TheU.S. construction industry has experienced significant downturns in the past,which have adversely affected suppliers to the industry, including suppliers ofceramic and tile floor coverings. The industry could experience similardownturns in the future, which could have a negative impact on our business,financial condition and operating results.

 

WEFACE INTENSE COMPETITION IN THE CERAMIC FLOOR AND WALL TILE INDUSTRY, WHICHCOULD DECREASE DEMAND FOR OUR PRODUCTS AND COULD HAVE A MATERIAL ADVERSE EFFECTON OUR PROFITABILITY.

 

Theindustry is highly competitive. We face competition from a large number ofdomestic and foreign importers and independent distributors of floor coveringproducts. Some of our existing and potential competitors may be larger and havegreater resources and access to capital than we do. Maintaining our competitiveposition may require us to make substantial investments in our product designefforts, distribution network and sales and marketing activities. Competitivepressures may also result in decreased demand for our products and in the lossof market share. In addition, we face, and will continue to face, pressure onsales prices of our products from competitors, as well as from large customers.As a result of any of these factors, there could be a material adverse effecton our sales and profitability. Hard flooring products also face competitionfrom alternative products such as carpet and vinyl. Changes in customerattitudes toward hard flooring and wall covering materials could also adverselyaffect our ability to market and sell our products profitably.

 

**INVESTMENT RISKS**

 

WEHAVE SIGNIFICANT OUTSTANDING INDEBTEDNESS AND DEBT SERVICE OBLIGATIONS.

 

Inorder to finance our operations we have incurred indebtedness.  Substantially all of our assets secure ourcredit facility with our commercial lender (in first priority position) and ourcredit facility with Laurus (in second priority position). The line with ourcommercial lender matures September 10, 2006 and contains certaincovenants requiring the Company to maintain a certain leverage ratio, arequired minimum fixed charge coverage ratio, and a certain inventory turnoverratio. In addition to certain limited financial covenants with our primarylender, both of our credit facilities restrict our ability to incur additionalindebtedness or to pledge our assets. At December 31, 2005 the Company wasnot in compliance with our commercial lender on these covenant ratiorequirements. The lender has granted the Company a waiver of these covenantsfor this report period.  We make noassurances that we will be able to comply with the terms of our commerciallender in the future. 

 

OnAugust, 25. 2005, Tesoro issued a $5.0 million convertible securted note toLaurus Master Fund, Ltd, which matures, on August 25, 2008 and is convertibleinto common stock of the Company at an initial conversion rate of $2.74 pershare. In connection with this convertible note, Tesoro issued Laurus afive-year warrant to purchase 511,883 shares of the Company’s common stock atan exercise price of $3.15 per share and an option to purchase 1,170,110 sharesof the Company’s common stock at an exercise price of $0.001 per share.  

 

OnFebruary 10th, 2006, Tesoro issued an additional $2.0 millionsecured convertible term note to Laurus. This note, which matures on February 10th, 2009, isconvertible into common stock at $2.17 per share.  As a part of the financing arrangement theCompany issued the Purchaser a three-year warrant to purchase up to 460,829shares of the Company’s Common Stock at $2.39 per share and issued 221,198shares of Tesoro common stock to Laurus at closing. Interest accrues on theprincipal balance of the note at an annual interest rate equal to prime plus2.0%, payable monthly, commencing on March 1st, 2006.Amortizing payments of $66,666 plus accrued interest commence on August 1,2006, payable on the first business day of each succeeding month through andincluding the Maturity Date.

 

OnMay 3rd, 2006, Tesoro issued $2.0 million secured term notewith Laurus Master Fund, LTD which matures on May 3rd, 2007. Asa part of the financing arrangement, the Company issued Laurus a ten-yearwarrant to purchase up to 333,333 shares of the Company’s Common Stock at $.001per share. Interest accrues on the principal balance of the note at an annualinterest rate equal to 15.0% per annum, payable monthly, commencing on June 1st,2006.

 

Ourbusiness is subject to all of the risks associated with substantial leverage,including the risk that available cash may not be adequate to make requiredpayments. Our ability to satisfy outstanding debt obligations from cash flowwill be dependent upon our future performance and will be subject to financial,business and other factors, many of which will be beyond our control. In theevent that we do not have sufficient cash resources to satisfy our repaymentobligations, we would be in default, which would have a material adverse effecton our business. To the extent that we are required to use cash resources tosatisfy interest payments to the holders of outstanding debt obligations, wewill have fewer resources available for other purposes. There is no assurancethat we will not increase our leverage in the future, whether as a result ofoperational or financial performance, acquisition or otherwise.

 

INTHE FUTURE WE MAY ISSUE MORE SHARES OF OUR SECURITIES, AND ESPECIALLYINCLUDING OUR COMMON STOCK. THIS WOULD REDUCE INVESTORS PERCENTAGE OF OWNERSHIPAND MAY REDUCE OUR SHARE VALUE.

 

OurArticles of Incorporation authorizes our issuing up to 100 million shares ofcommon stock and 25 million shares of preferred stock. If we issue all orpart of our remaining authorized common stock or preferred stock, depending onits terms, the percentage of common stock held by existing stockholders wouldbe diluted. Issuing common or preferred stock for future services

 

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oracquisitions or other corporate actions may have the effect of diluting thevalue of the shares held by our investors, and might have an adverse effect onthe value of our shares.

 

SHOULDOUR SECURITIES TRADE ONLY ON THE OTCBB, OUR COMMON STOCK’S LIQUIDITYMAY BE SEVERELY LIMITED.

 

Securitiestrading on the Over-The-Counter Bulletin Board like ours ordinarily have muchlower trading volume than on the NASDAQ SmallCap. Very few market makers takeinterest in shares traded over-the-counter; and, accordingly, the markets forsuch shares are less orderly than is usual for NASDAQ or the American StockExchange (AMEX) traded securities. As a result of the low trading volumesordinarily obtained in over-the-counter markets, sales of our securities in anysignificant amount can generally not be absorbed without a dramatic reductionin price. Moreover, thinly traded shares in the over-the-counter markets aremore susceptible to trading manipulations than is ordinarily the case for moreactively traded shares. As of the date of this prospectus our common stock hastraded on a very limited and sporadic basis.

 

Thetrading price of our securities may be highly volatile and could be subject towide fluctuations in response to factors such as the active float of oursecurities could be small, meaning that relatively small trades of oursecurities could materially effect the share price and other general economicor stock market conditions, many of which are beyond our control.

 

Thestock market in general, and the market for shares in tile and ceramic floorcovering companies in particular, have experienced extreme price and volumefluctuations that have often been unrelated or disproportionate to theoperating performance of such companies. We make no assurance that thesetrading prices and price earnings predictions will be sustained.

 

Inaddition, a substantial portion of our future expenses, including most productdesign and selling and marketing expenses must be incurred in advance ofrevenue generation. If our actual revenue does not meet our expectations, thenour operating profit, if any, may fall short of our expectations, or ouroperating loss may be greater than our expectations. We may need to change ourpricing strategy and any adverse changes may affect our quarterly results. Anyone or more of these factors could affect our business, financial condition andoperating results, and this makes the prediction of operating results on aquarterly basis unreliable. As a result, period-to-period comparisons of ourhistorical operating results may not be meaningful and you should not rely onthem as an indication of our future performance. This could adversely affectthe price of our securities.

 

NONE OF OUR SECURITIES QUALIFIESFOR LISTING ON THE NASDAQ SMALLCAP MARKET. OUR SECURITIES MAY CONTINUE ONLYTO TRADE ON THE OVER-THE-COUNTER BULLETIN BOARD AND WE MAY NEVER ATTAINTHE REQUIREMENTS FOR LISTING ON NASDAQ.

 

Underthe current rules relating to the listing of shares on the NASDAQ SmallCapMarket, we must have:

 

•      Three registered and active market makers;

•      Stockholders’ equity of at least$5 million, or market capitalization of at least $50 million, or netincome of at least $750,000 in the most recently completed fiscal year or intwo of the last three most recently completed fiscal years;

•      Operating history of at least one year ormarket capitalization of $50 million;

•      Public float of at least 1,000,000 shares;

•      Market value of public float of at least$5 million;

•      A minimum bid price of $4.00 per share; and

•      At least 300 stockholders who own at least100 shares each, among other requirements.

 

Fora continued listing, a company must maintain:

 

•      Two registered and active market makers, oneof which can be a market maker entering a stabilizing bid;

•      Stockholders’ equity of at least$2.5 million, market capitalization of at least $35 million, or netincome of at least $500,000 in the most recently completed fiscal year or intwo of the last three most recently completed fiscal years;

•      A public float of at least 500,000 shares;

•      Market value of public float of at least$1 million; and

•      A minimum bid price of $1.00 per share, amongother requirements.

 

Untilwe meet all the listing requirements, any trading of our securities conductedon the over-the-counter market on an electronic bulletin board established forsecurities that do not meet the listing requirements of NASDAQ, commonlyreferred to as the “pink sheets.” As a result, an investor may find it moredifficult to dispose of, or to obtain accurate quotations as to the price of,our shares.

 

IFWE FAIL TO REMAIN CURRENT ON OUR REPORTING REQUIREMENTS, WE COULD BE REMOVEDFROM THE OTC BULLETIN BOARD, WHICH WOULD LIMIT THE ABILITY OF BROKER-DEALERS TOSELL OUR SECURITIES AND THE ABILITY OF STOCKHOLDERS TO SELL THEIR SECURITIES INTHE SECONDARY MARKET.

 

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Companies trading on the OTC Bulletin Board, such as us, must be reportingissuers under Section 12 of the Securities Exchange Act of 1934, asamended, and must be current in their reports under Section 13, in orderto maintain price quotation privileges on the OTC Bulletin Board. If we fail toremain current on our reporting requirements, removal from the OTC BulletinBoard is possible. As a result, adversely affecting the market liquidity forour securities by limiting the ability of broker-dealers to sell our securitiesand the ability of stockholders to sell their securities in the secondarymarket.

 

“PENNYSTOCK” REGULATIONS MAY IMPOSE RESTRICTIONS ON MARKETABILITY OF OURSECURITIES.

 

TheSecurities and Exchange Commission has adopted regulations, which generallydefine “penny stock” to be any equity security that is not traded on a nationalsecurities exchange or NASDAQ and that has a market price of less than $5.00per share or an exercise price of less than $5.00 per share, subject to certainexceptions. Since our securities are currently included on the OTC BulletinBoard and are trading at less than $5.00 per share at any time, our stock maybecome subject to rules that impose additional sales practice requirementson broker-dealers who sell such securities to persons other than establishedcustomers and accredited investors. Accredited investors generally includeinvestors that have assets in excess of $1,000,000 or an individual annualincome exceeding $200,000, or together with the investor’s spouse, a jointincome of $300,000. For transactions covered by these rules, the broker-dealermust make a special suitability determination for the purchase of thesecurities and must receive the purchaser’s written consent to the transactionprior to the purchase.

 

Additionally,for any transaction involving penny stock, unless exempt, therules require, among other things, the delivery, prior to the transaction,of a risk disclosure document mandated by the SEC relating to the penny stockmarket and the risks associated therewith. The broker-dealer must also disclosethe commission payable to both the broker-dealer and the registeredrepresentative, current quotations for the securities and, if the broker-dealeris the sole market maker, the broker dealer must disclose this fact and thebroker-dealer’s presumed control over the market. Finally, monthly statementsmust be sent disclosing recent price information for the penny stock held inthe account and information on the limited market in penny stocks.Consequently, the penny stock rules may restrict the ability of broker-dealersto sell our securities and may affect your ability to sell your shares.

 

**Additional Information**

 

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. Informationcontained on our web site is not part of this annual report.

 

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**ITEM 1B.     UNRESOLVED STAFF COMMENTS.  **Not applicable.

 

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

 

### **Executive Office Space – Connecticut**

### ** **

Tesorocurrently subleases office space in Westport, Connecticut. We pay a monthlybase services fee of $2,400 per month and automatically renewed every sixmonths. Tesoro anticipates that it will be securing a more permanent space inthe foreseeable future.

 

**Warehouse and Office Space – Florida**

 

InDecember 2004, IWT signed an agreement to realign its distribution centerfacility on April 1, 2005. This agreement consolidated under one 15-yearoperating lease all 310,000 square feet of our Palm City, FL warehousefacilities. Amongst the consolidation was approximately 80,000 square feet ofwarehouse space in multiple small warehouses. We expanded our warehousecapacity by 70,000 square feet to accommodate expected growth and integrateinto two adjacent warehouses. Of the total 310,000 square feet, 10,000 squarefeet (on two floors) is for office space.

 

***Warehouse Space - Texas***

* *

EffectiveDecember 1, 2004, IWT entered into an agreement to lease warehouse spacein Dallas, Texas.  Over the next 18 months, IWT will use 56,000 squarefeet and will subsequently take over an additional 64,000 square feet, for atotal of approximately 120,000 square feet.  The lease is for 64 months.The average monthly lease amount is approximately $40,000, based on the life ofthe lease and includes, in addition to the lease space, common area charges,taxes, insurance and management fees. The new warehouse space is our firstwarehouse facility outside Florida.  IWT expects that it will support itscurrent customers and sales force in Texas and in the Southwest.  This newlocation is also part of IWT’s strategic plan to increase its sales andcustomer service throughout the Sunbelt (southern and southwestern UnitedStates).

 

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

### ** **

Effective July 1, 2005 IWT and IFG entered into separateagreements with WSI, a warehouse management company in Pomona, California. Thecontract provides for flexible storage space based on demand and handlingcharges.

 

***Office and Show Room Space -California***

* *

EffectiveNovember 1, 2005 IFG entered into a three-year lease for approximately 4,000square feet. IFG will use this space for general office space and show roomfacilities. The cost of these facilities is approximately $11,000 per month.

 

**Tesoro’soperating lease costs**

 

Totalestimated costs of our long-term operating leases as of December 31, 2005,are as follows:

 

| 2006                                               |   | $          | 2,144,000  |   |
|----------------------------------------------------|--------|------------|------------|--------|
| 2007                                               |   | 2,263,000  |       |
| 2008                                               |   | 2,230,000  |       |
| 2009                                               |   | 2,131,000  |       |
| 2010                                               |   | 1,833,000  |       |
| Thereafter (remaining portion of a 15 year  lease) |   | 15,249,000 |       |
| Total payments                                     |   | $          | 25,850,000 |   |

 

**ITEM 3.****       ****LEGAL PROCEEDINGS**

 

We are not a party to any material pending legal proceedings and, tothe best of our knowledge; no such action by or against us is contemplated,threatened or expected.

 

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

 

Wedid not submit any matters to a vote of our security holders during the fourth quarter of 2005.

 

18

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**PART II**

 

**ITEM 5.****       ****MARKET PRICE FOR REGISTRANT’S COMMON EQUITY AND RELATEDSTOCKHOLDER MATTERS**

 

*(a)**         **Market Information*

 

We have been filing periodic reports with theSecurities and Exchange Commission since October 2000. Our common stockhas been trading on the OTC Bulletin Board since December 17, 2003 underthe symbol “IWTT” on a limited and sporadic basis and there is no establishedpublic trading market for our common stock nor may there every be. For theperiods indicated, the following table presents the range of high and low saleprices for the common stock as reported by the OTC Bulletin Board.

 
| ** **                              | ** ** | **High Bid** | ** ** | **Low Bid** | ** ** |
|-----------------------------------------|------------|-------------------|------------|------------------|------------|
| **2003**                                | ** ** | ** **        | ** ** | ** **       | ** ** |
| December 17— December 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       |             | $          | 1.20 |   |
| April 1– May 17                    |       | $                 | 1.20       |             | $          | 1.20 |   |

 

The Securities and Exchange Commission has adopted Rule 15g-9 thatestablishes the definition of a “penny stock”, for purposes relevant to Tesoro,as any equity security that has a market price of less than $5.00 per share orwith an exercise price of less than $5.00 per share, subject to certainexceptions. For any transaction involving a penny stock, unless exempt, therules require

 

(i)            that a broker or dealer approve a person’saccount for transactions in penny stocks, and

 

(ii)           the broker or dealer receive from the investora written agreement to the transaction, setting forth the identity and quantityof the penny stock to be purchased.

 

In order to approve a person’s account for transactions in penny stocks,they must

 

(i)            obtain financial information and investmentexperience and objectives of the person, and

 

(ii)           make a reasonable determination that thetransactions in penny stocks are suitable for that person and that person hassufficient knowledge and experience in financial matters to be capable ofevaluating the risks of transactions in penny stocks.

 

Thebroker or dealer must also deliver, prior to any transaction in a penny stock,a disclosure schedule prepared by the Commission relating to the pennystock market, which, in highlight form,

 

(i)            sets forth the basis on which the broker ordealer made the suitability determination, and

 

(ii)           that the broker or dealer received a signed,written agreement from the investor prior to the transaction. Disclosure alsohas to be made about the risks of investing in penny stocks in both publicofferings and in secondary trading, and about commissions payable to both thebroker-dealer and the registered representative, current quotations for thesecurities and the rights and remedies available to an investor in cases offraud in penny stock transactions.

 

Finally,monthly statements have to be sent disclosing recent price information for thepenny stock held in the account and information on the limited market in pennystocks.

 

*(b)**         **Our Stockholders*

 

AtApril 21, 2006, 11,926,900 shares of common stock were outstanding byapproximately 278 stockholders of record.

 

19

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*(c)**          **Our Dividend Policy*

 

We have never paid, and do not expect to pay, any cash dividends on ourcommon stock in the coming year.

 

(d)           *Securities Authorized to beIssued upon our Equity Compensation Plans*

 

**- Equity Compensation Plan Information –**

 
| ** **                                              | ** ** | **(a)  Number of Securities  to be issued upon Exercise  of Outstanding options,  warrants and rights** | ** ** | **(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     |       | 567,749                                                                                                                                                   |       | $                                                                                                                | 3.21       |                                                                                                                                                                                              | 3,432,251  |   |
|                                                    |       |                                                                                                                                                      |       |                                                                                                             |       |                                                                                                                                                                                              |       |
| Equity compensation plans not  approved by stockholders |       | 0                                                                                                                                                         |       | 0                                                                                                                |       | 0                                                                                                                                                                                                 |       |
|                                                    |       |                                                                                                                                                      |       |                                                                                                             |       |                                                                                                                                                                                              |       |
| **Total**                                               |       | 567,749                                                                                                                                                   | (2)        | $                                                                                                                | 3.21       |                                                                                                                                                                                              | 3,432,251  |   |

 

----

(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 reflects 51,100registered shares issued pursuant to the Plan through December 31, 2005.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 567,749 options granted, 409,883 arevested.

 

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

 

Thefollowing table sets forth the selected financial data of the Company for theperiods indicated which information is derived from the consolidated financialstatements of the Company. The selected financial data should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and the Company’s consolidate financial statementsand notes thereto included elsewhere herein.

 

20

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| ** **                                 | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002 (1)(2)** | ** ** | **2001 (2)** | ** ** |
|--------------------------------------------|------------|------------|------------|------------|------------|------------|------------|----------------------|------------|-------------------|------------|
| Statement of earnings data:                |       |       |       |       |       |       |       |                 |       |              |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Net sales                                  |       | 55,589,223 |       | 44,680,619 |       | 32,604,546 |       | 25,387,708           |       | 19,626,819        |       |
| Cost of sales                              |       | 34,295,418 |       | 27,790,173 |       | 19,814,514 |       | 15,268,535           |       | 12,629,138        |       |
| Gross profit                               |       | 21,293,805 |       | 16,890,446 |       | 12,790,032 |       | 10,119,173           |       | 6,997,681         |       |
| Operating expenses                         |       | 22,696,358 |       | 17,426,918 |       | 13,562,593 |       | 8,694,101            |       | 5,760,552         |       |
| Operating Income (loss)                    |       | (1,402,553 | )          | (536,472   | )          | (772,561   | )          | 1,425,072            |       | 1,237,129         |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Interest expense                           |       | (2,090,765 | )          | (627,439   | )          | (480,139   | )          | (328,920             | )          | (424,527          | )          |
| Other (income) expense, net                |       | (804,457   | )          | (45,485    | )          | (15,421    | )          | (15,788              | )          | 9,789             |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Income (loss) before income taxes          |       | (4,297,775 | )          | (1,209,396 | )          | (1,268,121 | )          | 1,080,364            |       | 822,391           |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Income tax benefit (expense)               |       | (45,682    | )          | —     |       | (597,196   | )          | 597,174              |       | —            |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Net income (loss)                          |       | $          | (4,343,457 | )          | $          | (1,209,396 | )          | $                    | (1,865,317 | )                 | $          | 1,677,538 |   | $ | 822,391 |   |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Earnings (loss) per share                  |       |       |       |       |       |       |       |                 |       |              |       |
| Basic and Diluted                          |       | $          | (0.37      | )          | $          | (0.10      | )          | $                    | (0.17      | )                 | $          | 0.15 |   | $ | 0.09 |   |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Weighted average common shares outstanding |       |       |       |       |       |       |       |                 |       |              |       |
| Basic and diluted                          |       | 11,699,425 |       | 11,679,028 |       | 11,197,655 |       | 10,845,775           |       | 9,000,000         |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Balance sheet data                         |       |       |       |       |       |       |       |                 |       |              |       |
|                                       |       |       |       |       |       |       |       |                 |       |              |       |
| Total assets                               |       | $          | 46,962,569 |       | $          | 33,107,481 |       | $                    | 21,702,266 |              | $          | 11,062,676 |   | $ | 8,163,779 |   |
| Working capital                            |       | (625,079   | )          | 14,203,837 |       | 9,581,191  |       | 2,901,965            |       | 3,220,341         |       |
| Long term obligations                      |       | 6,686,031  |       | 16,520,165 |       | 10,129,745 |       | 5,486,800            |       | 4,640,004         |       |
| Stockholder’s equity                  |       | (8,377,899 | )          | (4,034,442 | )          | (2,825,046 | )          | (1,351,944           | )          | (735,389          | )          |

 

----

(1)           During the first nine months of 2002, IWT wastaxed as an “S” corporation. Accordingly, no provision or liability for Federalincome taxes is reflected. Instead, the stockholders were liable for individualFederal income taxes on their respective share of IWT’s taxable income.

 

(2)           Tesoro acquired International Wholesale Tileon October 1, 2002. Financial statements for the years endedDecember 31, 2002 and 2001 represent pro-forma audited statements.

 

**ITEM 7.****      ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

**General**

 

Wewere incorporated on May 5, 2000 as a Nevada corporation. Our principaloffice is located at 191 Post Road West, Suite 10, Westport, CT 06880. Anyreference in this “Management’s Discussion and Analysis or Plan of Operations”discussion to “the company”, “our”, “we” or “us” refers to Tesoro.

 

EffectiveOctober 1, 2002, we acquired International Wholesale Tile, Inc. (IWT)through a share exchange and IWT became our wholly owned subsidiary. We issuednine million shares of our common stock in exchange for all of the IWT shares.Tesoro has four additional wholly owned subsidiaries. The first is IWT TesoroInternational, Ltd., created to own and manage assets relating to any ofour potential future overseas activities. The second is IWTTransport, Inc., organized to handle our domestic freight operations. Weorganized The Tile Club, Inc. (TTC) in 2004 to acquire licensing,manufacturing and distribution rights for high-end designer and artistic baseddecorative tiles, and to act as a domestic agent for foreign manufactures withwhom we have exclusive distribution rights in the United States and Canada. Themost recent subsidiary is the Import Flooring Group, Inc. (IFG), which weorganized in July 2005. IFG distributes product directly from the factory tofull line flooring distributors under a membership agreement.

 

21

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**Company Overview**

 

Weare a value added distributor of imported floor and wall covering materialsincluding decorative wall tiles. Our warehousing and distribution centerscontain over 480,000 square feet of storage space and over twenty-five millionsquare feet of product ready for immediate shipment to our customers Our totalwarehouse capacity in Palm City, FL is approximately 310,000 square feet. TheDallas, TX facility contains approximately 120,000 square feet. We also have anoutsourced warehouse management contract for 40,000 square feet in Pomona, CA.

 

Managementbelieves that the critical success factors to our business are its ability to:

 

•      Maintain relationships with and serve agrowing base of independent dealers, distributors and wholesalers by providingadequate stocks on in demand product at reasonable and competitive prices;

•      Stay ahead of the trends in color, texture andformat that drive demand for our fashion based products; and

•      Make the correct investments in productinventories, relationships with suppliers and logistics and support services toensure our continuing capability to meet our customers’ expectations.

 

Ourprimary source of revenue is the sale of hard and soft flooring and wallcovering materials and our primary costs relate to the acquisition, warehousingand delivery of those products. While we make sales throughout the UnitedStates, the majority of our current sales are in the southeastern quadrant ofthe country. Our primary sources of working capital are an asset based $ 25.0million (US) revolving line of credit from a large US commercial bank, an assetbased $5.0 million convertible subordinate revolving note from a largeinstitutional investor, our suppliers who extend us payment terms and ourstockholders’ equity.

 

On December 17, 2003, we began trading our stock on the OTCBulletin Board under the symbol IWTT. During 2006, we expect to raiseadditional equity through both the public and private equity and debt markets.We will use any new capital raised to strengthen our balance sheet, make acquisitionsand to provide capital for continued growth.

 

**Results of Operations**

 

We are a wholesale distributor of floor and wall covering in a growingmarket. We continue to enter new markets and to add new products. As a resultwe anticipate being able to grow faster than the market as a whole for the nextseveral years. Currently, the ceramic floor and wall tile industry in theUnited States is $2.86 billion and growing at a seven to ten percent rate.We estimate that our share of this market is approximately 1.6%.

 

Thefollowing discussions and analyses should be read in conjunction with ourfinancial statements and related notes included in this Annual Report onForm 10-K.

 

*Results of Operations for the Years ended December 31,2005, 2004 and 2003*

 

The Company has sustained a strong growth rate overthe last several years while maintaining targeted gross margin rates. However,the Company has suffered net losses and currently has a working capital deficit.Management has implemented a plan to reduce projected operating cost byapproximately $3.6 million. The reductions include sales & marketing andadministrative overhead. In February 2006, International Wholesale Tile, Inc.implemented a 3.5% price increase and began selling products to two additionalnational home center companies. Also in February 2006, International WholesaleTile, Inc. opened a small regional warehouse to support the Midwest customerbase.

 

22

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| ** **             | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------|------------|---------------------------------------------------------------|------------|
| ** **             | ** ** | **2005**                                                      | ** ** | ** ** | ** ** | **2004** | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** |
| Revenues               |       | $                                                             | 55,589,223 |   | 100.0 | % | $ | 44,680,619 | ** ** | 100.0 | % | $ | 32,604,546 | ** ** | 100.0 | % |
| Cost of goods sold     |       | 34,295,418                                                    |       | 61.7 |   | 27,790,173 |   | 62.2 |   | 19,814,514 |   | 60.8 |   |
| Gross profit           |       | 21,293,805                                                    |       | 38.3 |   | 16,890,446 |   | 37.8 |   | 12,790,032 |   | 39.2 |   |
| Operating expenses     |       | 22,696,358                                                    |       | 40.8 |   | 17,426,918 |   | 39.0 |   | 13,562,593 |   | 41.6 |   |
| Loss from operations   |       | (1,402,553                                                    | )          | -2.5 |   | (536,472 | ) | -1.2 |   | (772,561 | ) | -2.4 |   |
| Interest expense       |       | (2,090,765                                                    | )          | -3.8 |   | (627,439 | ) | -1.4 |   | (480,139 | ) | -1.5 |   |
| Other income (expense) |       | (804,457                                                      | )          | -1.4 |   | (45,485 | ) | -0.1 |   | (15,421 | ) | 0.0 |   |
| Loss before income tax |       | (4,297,775                                                    | )          | -7.7 |   | (1,209,396 | ) | -2.7 |   | (1,268,121 | ) | -3.9 |   |
| Income tax expense     |       | (45,682                                                       | )          | -0.1 |   | — |   | 0.0 |   | (597,196 | ) | -1.8 |   |
| Net loss               |       | $                                                             | (4,343,457 | ) | -7.8 |   | $ | (1,209,396 | ) | -2.7 |   | $ | (670,925 | )  | -2.1 |   |

 

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

 

Netsales for the year ended December 31, 2005 were $55,589,200, reflecting anincrease of $10,908,600, or approximately 24.4% over the $44,680,600 reportedfor the year ended December 31, 2004. This growth follows a 37.0% increasefor the year ended December 31, 2004 from the year ended December 31,2003. The Company suffered from a general slow down in the building andremodeling activity in the southern and gulf coast regions of the United Statesduring the forth quarter of 2005. Tesoro expects to be able to regain andmaintain its strong growth rate for the foreseeable future.

 

Grossprofit was $21,293,800 (38.3% of net sales) for 2005 and $16,890,400 (37.8% ofnet sales) for 2004. We believe we have been able to maintain a consistent mixof product and price points while implementing focused price increases. Thishas resulted in an increase in our gross margin for the year endingDecember 31, 2005 from the year ending December 31, 2004. Our grossmargin 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 businesses willoperate at a somewhat lower gross margin. We also anticipate that the operatingcosts relating to the larger volume customers to be lower due to the reducedhandling costs. We expect that we will be able to maintain this margin range aswe grow. However, circumstances beyond our control such as the increase inimport costs and the competitive pricing environment in which we operate couldadversely affect our ability to maintain our gross margin.

 

Ouraverage selling price per square foot of floor and wall covering in 2005 was$1.32, an increase of $.17 from $1.15 in 2004. This increase was primarily dueto a general price increase implemented in the first quarter of 2005 and from improvingour mix of products sold.

 

Quarterlynet sales and the percentage changes in net sales by quarter for 2005 versus2004 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 made landfall over the entire gulf coast in theSeptember of 2005 significantly affected our sales growth. The devastationcaused by Hurricane Katrina and other storms had a much longer impact on thebuilding industry than the same storm season of 2004. The building industryrebounded much faster in 2004 than it did in 2005. Tesoro’s forth quarter saleswere 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 December 31, 2004. Bycontrast, the rebound of builder market, to repair the damage caused by thesevere weather in the fall of 2004, was more rapid. Sales in the forth quarterof 2004 were 49.3% higher than the sale of $8,457,500 for the quarter endedDecember 31, 2003.

 

Operating expenses for 2005 were approximately $22,696,400, (40.8% ofnet sales) compared to $17,426,900 (39.0% of net sales). The approximate twopercent increase is attributable to the unexpected fall off in sales growth inthe fourth quarter. We were not able to implement an expense reduction programcommensurate with the rapid loss in sales. The Company believes that the

 

23

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building,and, specifically the repair, sector, will recover sufficiently to allow us toregain our growth path. However, we have proposed plans to adjust costs if therecovery takes longer than expected. The start-up costs of IFG also added tothe increase in the expense to sales ratio for 2005.

 

We attribute the increases in warehouse and distribution costs to theadditional warehouse facilities we believe is required to support future salesin Texas and California. Sales and marketing costs increased as a percentage ofsales in 2005 over 2004. Expanding into new territories and establishing newcustomers required startup sample packs and display materials. The decrease inthe percentage of general and administrative cost to sales in 2005 reflects theeconomies of scale we have reached.

 
| ** **                 | ** ** | **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 for 2005 was approximately $1,402,600 (-2.5% ofnet sales) compared to the loss from operations for 2004 of $536,500 (-1.2% ofnet sales). The percentage increase in the loss from operations wasattributable to the start up costs incurred by IFG and the unexpected declinein IWT sales in the fourth quarter of 2005. Because of the net operating lossand the continued growth rate, the Company currently has a working capitaldeficit. Management has implemented a plan to reduce projected operating costsby approximately $3.6 million. The reductions include sales & marketing andadministrative overhead. In February 2006, International Wholesale Tile, Inc.implemented a 3.5% price increase and began selling products to two additionalnational home center companies.

 

Interestexpense for 2005 was approximately $2,090,800 compared to $627,400 in 2004. Theincrease in interest expense was attributable to our continuing use of debt tofinance 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 aninstitutional investor at a higher rate (1%) than our commercial revolvingcredit line. The Company issued a warrant and option to purchase shares of theCompany’s common stock, as more fully described in Note 6 to the consolidatedfinancial statement. Amortization of discounts for the warrant and option werecharged to interest expense totaling $555,552 during the year ended December31, 2005. The issuance of this note resulted in the recording of a derivativeliability as further described in Note 6 to the consolidated financialstatement. The excess ofthe fair value of the derivative liabilities over the principal amount of thenotes of $860,486 was recorded as an expense in the period of issuance and theremaining fair value of $5,000,000 was recorded as a discount to theconvertible debt to be amortized into expense over the three-year terms of thenotes.

 

*Changes in Financial Position*

 

The current assets for 2005 are approximately$43.8 million compared to $30.6 million in 2004. The increase is primarilyattributable to an increase in the accounts receivable, which increased fromapproximately $7.9 million at the beginning of 2005 to $9.9 million at December31, 2005 and inventories, which increased from approximately $21.6 million atthe beginning of 2005 to $32.2 million at December 31, 2005. The increases wereprimarily attributable to our expansion efforts into new territories andopening two new warehouse facilities.

 

Current liabilities for 2005 areapproximately $44.4 million compared to $16.4 million in 2004. The increase isprimarily attributable to an increase in the accounts payable, which increasedfrom approximately $15.3 million at the beginning of 2005 to $20.2 million atDecember 31, 2005 and the revolving line of credits reclassification from longterm debt to short term debt and the increase from approximately $15.9 millionat the beginning of 2005 to $22.6 million at December 31, 2005. Thereclassification is attributable to the maturity date of September 10th,2006, as more fully described in Note 5 of the consolidated financialstatements.

 

Long term liabilities for 2005 areapproximately $6.7 million compared to $16.5 million in 2004. The decrease isprimarily attributable to the revolving line of credits reclassification fromlong term debt to short term debt and the increase from approximately $15.9million at the beginning of 2005 to $22.6 million at December 31, 2005. Thereclassification is attributable to the maturity date of September 10th,2006, as more fully described in Note 5 of the consolidated financialstatements. The change in long term liabilities is also attributable to the newconvertible debt, warrant and options and associated embedded derivativeliability, as more fully described in Note 6 of the consolidated financialstatements.

 

24

----

 

*Year Ended December 31, 2004, as  compared to December 31, 2003*

 

Netsales for the year ended December 31, 2004 were approximately $44,680,600,reflecting an increase of $12,076,100, or approximately 37.0%, over the $32,604,500reported for the year ended December 31, 2003. This growth follows a 28.4%increase for the year ended December 31, 2003 from the year endedDecember 31, 2002. The Company expects to be able to maintain its stronggrowth rate for the foreseeable future.

 

In2004, we continued to expand our wholesale customer base business. Weanticipated that sales to this wholesaler business would operate at a somewhatlower gross margin resulting in a decrease in our gross margin to 37.8% for theyear ending December 31, 2004 from 39.2% for the year endingDecember 31, 2003. The initial products related to the dealer businesswere at a lower price point and gross margin; however the margin for thesesales increased slightly, as existing markets mature and new products areintroduced.

 

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. Wedistribute products that have a wide range of both price point and margin. Ourhistorical mix has provided the Company with a gross margin of between 38% and40%. We expect that we will be able to maintain this margin range as we grow. However,circumstances beyond our control such as the increase in import costs and thecompetitive pricing environment in which we operate could adversely affect ourability to maintain our gross margin.

 

Theaverage selling price per square foot in 2004 was $1.15, down $.04 from $1.19in 2003. This decrease was primarily due to volume variance in our mix ofproducts.

 

Quarterlynet sales and the percentage changes by quarter for 2004 versus 2003 were asfollows:

 
| ** **     | ** ** | **2004**   | ** ** | **2003**  | ** ** | **Change** | ** ** |
|----------------|------------|------------|------------|-----------|------------|------------|------------|
| First quarter  |       | $          | 9,510,972  |      | $          | 6,713,810  |       | 41.7 | % |
| Second quarter |       | 11,572,793 |       | 8,477,575 |       | 36.5       | %          |
| Third quarter  |       | 10,968,033 |       | 8,955,693 |       | 22.5       | %          |
| Fourth quarter |       | 12,628,821 |       | 8,457,468 |       | 49.3       | %          |
| Total Year     |       | $          | 44,680,619 |      | $          | 32,604,546 |       | 37.0 | % |

 

Salesgrowth in the third quarter of 2004 was impacted by several hurricanes thatmade landfall over the entire state of Florida, impacting dealer and buildersales markets. During the fourth quarter of 2004, our sales returned toexpected levels.

 

Grossprofit was approximately $16,890,400 (37.8% of net sales) for 2004 and$12,790,000 (39.2% of net sales) for 2003. The reduction in percentage wasprimarily attributable to the increase in transportation and import costs.

 

Operatingexpenses for 2004 were approximately $17,426,900, (39.0% of net sales) comparedto $13,562,600 (41.6% of net sales). Our ability to decrease its currentpercentage rate of operating expenses was due to ongoing efforts to increaseefficiency while expanding into new markets and new product lines. Theincreases in warehouse costs are attributable to the additional warehousefacilities required to support the increase in sales. The increase indistribution and sales costs directly related to the increase in sales. Theincreases in marketing costs related to our effort to expand into three newdistribution channels.

 
| ** **                 | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------|------------|---------------------------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                                      | ** ** | ** ** | ** ** | **2003** | ** ** | ** ** | ** ** | **Change** | ** ** | ** ** | ** ** |
|                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Warehouse and distribution |       | 5,489,263                                                     |       | 12.3 | % | 3,807,845 |   | 11.7 | % | 1,681,418 |   | 44.2 | % |
|                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing        |       | 5,829,982                                                     |       | 13.0 | % | 4,311,558 |   | 13.2 | % | 1,518,424 |   | 35.2 | % |
|                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| General and adminsitrative |       | 6,107,673                                                     |       | 13.7 | % | 5,443,190 |   | 16.7 | % | 664,483 |   | 12.2 | % |
|                       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
|                       |       | $                                                             | 17,426,918 |   | 39.0 | % | $ | 13,562,593 |   | 41.6 | % | $ | 3,864,325 |   |   |   |
|                            |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Theoperating loss for 2004 was approximately $536,500 (-1.2% of net sales)compared to the operating loss for 2003 of $772,561 (-2.4% of net sales). Thepercentage decrease in operating losses was attributable to the Company’sability to increase efficiency while expanding info three new distributionchannels..

 

25

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Interestexpense for 2004 was approximately $627,400 compared to $480,100 in 2003. Theincrease in interest expense was attributable to the Company’s expansionefforts and increasing interest rates.

 

**Liquidity and Capital Resources**

 

Wehad cash balances of approximately $552,000 at December 31,2005 and $507,700at December 31, 2004. We have financed our growth with new equity capitaland increased borrowings from our commercial lender and other debt financingentities.

 

The cash outflows used in operations for 2005were approximately $10.2 million compared to $6.6 million in 2004. Theincreased outflow was primarily attributable to an increase in accountsreceivable, which increased from approximately $7.9 million at the beginning of2005 to $9.9 million at December 31, 2005 and inventories, which increased fromapproximately $21.6 million at the beginning of 2004 to $32.2 million atDecember 31, 2005. The increases were primarily attributable to our expansionefforts into new territories and opening two new warehouse facilities.

 

Net cash used in investing activities in 2005was approximately $611,000 compared to $631,000 in 2004. Capital expenditureswere incurred primarily to purchase warehouse equipment and enhance ourinformation technology capabilities.

 

Net cash provided by financing activities in2005 was approximately $10.8 million compared to $6.9 million in 2004. Theincrease is primarily attributable to the increased outstanding balance on ourrevolving line of credit and the proceeds from the issuance of convertibledebt, warrants and options of $5.0 million. The cash provided by thesefinancing activities was used to fund our expansion efforts.

 

During2005, we issued a $5,000,000 convertible subordinated revolving note to aninstitutional investor as more fully described in Note 6 to the consolidatedfinancial statements. The note is subordinate to a revolving credit line withour commercial lender. The combination of these two revolving credit facilitiesprovides us with up to $30 million of working capital. We expect that thesecredit lines will be sufficient to support our normal growth in accountsreceivable and inventory through 2006. However, our growth through geographicalexpansion and acquisition is expected to continue to require us to seek additionaloutside capital to supplement earnings and to strengthen our balance sheet. Weexpect to raise additional equity through both the public and private debt andequity markets during 2006. However, we cannot assure anyone that we will beable to obtain outside capital, or if we do, that it will be on termsbeneficial to us.

 

Thebalance due at December 31, 2005 to our commercial lender for the use ofthe revolving line of credit was approximately $21.5 million. The loan andsecurity agreement contains certain covenants, which include financialcovenants that require us to maintain a certain leverage ratio, limit ourunfunded capital expenditures, a required minimum fixed charge coverage ratio,and a certain inventory turnover ratio. At December 31, 2005 the Companywas not in compliance with these covenant ratio requirements. On March 29th,2006 the Company obtained a waiver of these covenants from our commerciallender. We believe that our relationship with our commercial lender is good andthat they will continue to support the Company.

 

**Contractual Obligations**

 

Forthe year ended 2005, our long-term debt obligations consisted of notes payable,capital leases and a line of credit. The future payment requirements for theseobligations are as follows:

 
| ** **           | ** ** | **Total**  | ** ** | **2006**  | ** ** | **2007**   | ** ** | **2008**  | ** ** | **2009**  | ** ** | **2010**  | ** ** | **Thereafter** | ** ** |
|----------------------|------------|------------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|----------------|------------|
|                 |       |       |       |      |       |       |       |      |       |      |       |      |       |           |       |
| Long-term debt       |       | 27,733,302 |       | $         | 22,655,145 |       | $          | 30,887    |       | $         | 5,022,171  |      | $          | 19,765         |       | $ | 5,333 |   | $ | — |   |
| Capital leases       |       | 196,337    |       | 82,423    |       | 65,055     |       | 32,509    |       | 16,350    |       |      |       |           |       |
| Operating leases     |       | 25,850,000 |       | 2,144,000 |       | 2,263,000  |       | 2,230,000 |       | 2,131,000 |       | 1,833,000 |       | 15,249,000     |       |
| Purchase commitments |       | 1,872,000  |       | 1,872,000 |       | —     |       | —    |       | —    |       | —    |       | —         |       |
| Total                |       | $          | 55,651,639 |      | $          | 26,753,568 |       | $         | 2,358,942  |      | $          | 7,284,680 |       | $              | 2,167,115  |   | $ | 1,838,333 |   | $ | 15,249,000 |   |
|                      |            |            |            |           |            |            |            |           |            |           |            |           |            |                |            |  |  |  |  |  |  |  |

 

Thecapital leases relate to equipment leases. The long-term debt includes anexisting loan and security agreement for a line of credit with our commerciallender a secured revolving convertible note. The line matures onSeptember 10, 2006 at which time the Company plans to renew the debt.However, we cannot assure anyone that we will be able to renew the line ofcredit, or if we do, that it will be on terms beneficial to us. The securedrevolving convertible note in the aggregate amount of $5,000,000 matures onAugust 25, 2008. The Company entered into an agreement to purchase tile from avendor, who is also a stockholder of the Company. The agreement is for a termof 18 months expiring in March 2006.

 

26

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**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.

 

TheCompany’s significant accounting policies described in Note 1 to theconsolidated financial statements included elsewhere in this report. Some ofthose significant accounting policies require the Company to make subjective orcomplex judgments or estimates. Critical accounting policies are defined asthose that are both most important to the portrayal of a Company’s financialcondition and results of operations and require management’s most difficult,subjective, or complex judgment, often as a result of the need to makeestimates about the effect of matters that are inherently uncertain and maychange in subsequent periods.

 

TheCompany believes the following accounting policies require it to use judgmentsand estimates in preparing its consolidated financial statements and couldrepresent critical accounting policies.

 

•      Accounts receivable and revenues,recognized when shipped and legal title passes to the customer. The Companyprovides an allowance for expected doubtful accounts based upon historical baddebt and claims experience and periodic evaluation of specific customeraccounts and the aging of accounts receivable. If the financial condition ofthe Company’s customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.

 

•      Inventories, stated at the average landedcost, which matches current costs with current revenues. Inventories on handare compared against anticipated future usage, which is a function ofhistorical usage and anticipated future selling price, in order to evaluate obsolescence,excessive quantities, and expected sales below cost. Actual results coulddiffer from assumptions used to value obsolete, excessive inventory orinventory sold below cost.

 

•      Deferred tax assets and liabilities,recognized for the future tax consequences attributable to differences betweenthe financial statement carrying amounts of existing assets and liabilities andtheir respective tax bases. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich the temporary differences are

 

27

----

 

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 anunpredictable manner.

 

**Recent Accounting Pronouncements**

 

InNovember 2004, the FASB issued SFAS No. 151 “Inventory Costs” an   amendment to Accounting Research BulletinNo. 43, “Inventory Pricing,” to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs and wasted material. ThisStatement requires that those items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal.”  Additionally this statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. The provisions of SFASNo. 151 are effective for fiscal years beginning after June 15, 2005.The adoption of SFAS 151 is not expected to have an impact on our consolidatedresults of operations, financial position or cash flows.

 

InDecember 2004, the FASB issued SFAS No. 153, *“Exchanges of Nonmonetary Assets”* anamendment to Accounting Principles Board Opinion No. 29, “*Accounting for Nonmonetary Transactions,”*which is based on the principle that exchanges of nonmonetary assets should bemeasured based on the fair value of the assets exchanged. The guidance in thatOpinion, however, included certain exceptions to that principle. This Statementamends Opinion 29 to eliminate the exception for nonmonetary exchanges ofsimilar productive assets and replaces it with a general exception forexchanges in which the future cash flows of the entity are not expected tochange significantly as a result of the exchange. The provisions of SFASNo. 153 are effective for nonmonetary asset exchanges in fiscal periods beginningafter June 15, 2005. The adoption of SFAS 153 is not expected to have animpact on our consolidated results of operations, financial position or cashflows.

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004)(“SFAS No.123R”), “*Share-Based Payment*,” which requiresthat the compensation cost relating to share-based payment transactions berecognized in the financial statements. SFAS No. 123R replaces SFASNo. 123, “Accounting for Stock-Based Compensation,” and supersedes APBOpinion No. 25, “Accounting for Stock Issued to Employees.” Share-basedcompensation arrangements include share options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans. SFAS No. 123R requires all share-based payments to employees be valuedusing a fair value method on the date of grant and expensed based on that fairvalue generally over the applicable vesting period. SFAS No. 123R also amendsSFAS No. 95 “statement of Cash Flows,” requiring the benefits of tax deductionsin excess of recognized compensation cost be reported as financing cash inflowrather than as a reduction of taxes paid. In March 2005, the Securities andExchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107, (“SAB No.107”) which expresses the SEC’s views regarding the interaction between SFASNo. 123R and certain SEC rules and regulations and, accordingly, providesguidance related to share-based payment transactions for public companies. TheCompany will be required to apply SFAS No. 123R as of the annual reportingperiod that begins after June 15, 2005 The Company’s approximate compensationexpense for the year ended December 31, 2006 is $39,000. The financial impactof any stock options granted in the future will be determined using theBlack-Scholes option-pricing model with the following assumptions: optionprice, dividend yield, expected volatility, risk free interest rate and theexpected life.

 

InMarch 2005, the FASB issued FIN 47 as an interpretation of FASB Statement 143,*Accounting for Asset Retirement Obligations*(FASB143). This interpretation clarifies that the term conditional asset retirementobligation as used in FASB 143 and refers to a legal obligation to perform anasset retirement activity in which the timing and/or method of settlement areconditional on a future event that may or may not be within the control of theentity. The obligation to perform the asset retirement activity isunconditional even though uncertainly exists about the timing and/or method ofsettlement. Accordingly, an entity is required to recognize a liability for thefair value of a conditional asset retirement obligation if the fair value ofthe liability can be reasonably estimated. This interpretation also clarifieswhen an entity would have sufficient information to reasonably estimate thefair value of an asset retirement obligation. FIN 47 is effective no laterthan the end of fiscal years ending after December 15, 2005. The Companyadopted FIN 47 for the fiscal year ended December 31, 2005, which did not havea material impact on its financial statements.

 

OnJune 1, 2005, the FASB issued Statement No. 154, *Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and FASB Statement No. 3(SFAS 154)*. The Statement applies to all voluntary changes inaccounting principle, and changes the requirements for accounting for andreporting of a change in accounting principle. As of December 31, 2005, we didnot have any changes in accounting principles and, accordingly, SFAS 154 had noimpact on our financial statements.

 

28

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**Impactof Inflation**

 

Inflationaffects the Company’s distribution costs and operating expenses. The tileindustry has experienced significant inflation in the prices of fuel-relatedand import costs beginning in the first quarter of 2004. In the past the tileindustry experienced moderate inflation in these costs and has generally passedthem along through price increase to its customers.

 

**Seasonality**

 

TheCompany is a calendar year-end company and its results of operations for thefirst and fourth quarter tends to be the weakest. The second and third quarterstypically produce higher net sales and operating income. These results areprimarily due to consumer residential spending patterns for floor covering,which historically have decreased during the last two months of each year andthe first two months of each year. Our recent increase in the market share ofwholesale dealers that purchase in anticipation of retail customers hasweakened the impact of consumer spending trends.

 

**ITEM 7A      QUANTITATIVE AND QUALITATIVE DISCLOSUREABOUT 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*

 

Wehave a revolving line of credit agreement with interest rates that are a certainpercentage over Prime or Libor therefore to the extent that Prime or Liborchange we are subject to interest rate risk.

 

*Foreign Currency Risk*

 

Wecurrently purchase our products from foreign manufacturers in U.S. dollars andforeign currencies. Our fund transfers are relatively large. The Office of theComptroller of the Currency (USOCC) monitors these activities. Should the Eurocontinue to strengthen against the U.S. dollar, we could see an increase in ourcost of product that could, in time, be passed on to our customers andtherefore have a detrimental impact on our profitability. The nature of theagreement with our commercial lender would require any hedge or forwardpurchase transactions be offset against our borrowing base therefore, reducingour access to the funds under our borrowing base. We currently do not hedge againstthe risk of exchange rate fluctuations and do not intend to in the foreseeablefuture.

 

**ITEM 8.        FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA**

 

Thefinancial statements and supplemental data required by this Item 8 follow theindex of financial statements that appears at the end of Part I of thisForm 10-K.

 
| ** **                                                                                                       | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|
| Reports of Independent  Registered Public Accounting Firms:                                                      |       |
| McGladrey & Pullen, LLP – As of  December 31, 2005 and 2004, and the years then ended         |       |
| Kantor,  Sewell & Oppenheimer, PA – For the year ended December 31, 2003                                |       |
|                                                                                                             |       |
| Consolidated  Balance Sheets as of December 31, 2005 and 2004                                               |       |
| Consolidated Statements of  Operations for the years ended December 31, 2005, 2004 and 2003                 |       |
| Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2005, 2004 and  2003 |       |
| Consolidated Statements of  Cash Flows for the years ended December 31, 2005, 2004 and 2003                 |       |
| Notes  to Consolidated Financial Statements                                                                      |       |

 

29

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors

IWT Tesoro Corporation

Westport, Connecticut

 

We have audited theaccompanying consolidated balance sheets of IWT Tesoro Corporation andSubsidiaries as of December 31, 2005 and 2004, and the related consolidatedstatements of operations, stockholders' equity and cash flows for each of the twoyears in the period ended December 31, 2005. These financial statements are the responsibility of the Company'smanagement.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable 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, 2005 and 2004, and the results of theiroperations and their cash flows for each of the two years in the period endedDecember 31, 2005 in conformity with U.S. generally accepted accountingprinciples.

 

The accompanying consolidatedfinancial statements have been prepared assuming that the Company will continueas a going concern.  As discussed in Note2 to the consolidated financial statements, the Company has suffered recurring lossesfrom operations and at December 31, 2005, the Company has a working capitaldeficit and its total liabilities exceed its total assets.  This raises substantial doubt about theCompany’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 1,  2006, except for Note 16,        |
|  as to which the date is May 12, 2006 |

 

McGladrey & Pullen, LLP isa member firm of RSM International,

an affiliation of separate andindependent legal entities.

 

30

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Kantor, Geisler & Oppenheimer, PA

 

**Certified Public Accountants & Associates**

7705 Davie Road Extension

Hollywood, Florida  33024

(954) 432-3100   (305)620-0616   (954) 436-6898 Fax

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

To the Board of Directors

IWT Tesoro Corporation and Subsidiaries

Westport, CT

 

We have audited theaccompanying consolidated balance sheet of IWT Tesoro Corporation andSubsidiaries as of December 31, 2003, and the related consolidated statementsof operations, changes in stockholders’ equity, and cash flows for the yearthen ended. These consolidated financial statements are the responsibility ofthe Company's management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audit.  

 

We conducted our audit in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  TheCompany is not required to have, nor were we engaged to perform, an audit ofits internal control over financial reporting. Our audit included considerationof internal control over financial reporting as a basis for designing audit proceduresthat are appropriate in the circumstances, but not for the purpose ofexpressing an opinion on the effectiveness of the Company’s internal controlover financial reporting.  Accordingly,we express no such opinion. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallconsolidated financial statement presentation. We believe that our auditprovides a reasonable 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, 2003, and the results of its operations, andits cash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

 
| /s/ KANTOR,  GEISLER & OPPENHEIMER, PA |   |
|--------------------------------------------|--------|
|                                       |
| Hollywood,  Florida                        |
| August 30,  2005                           |

 

Member of the American Institute of Certified Public Accountants

Member of the Center for Public Company Audit Firms

Member of the Florida Institute of Certified Public Accountants

 

31

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2005 AND 2004

 
| ** **                                                                                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ASSETS                                                                                                           |       |       |       |       |       |
| Current Assets:                                                                                                  |       |       |       |       |       |
| Cash                                                                                                             |       | $          | 552,042    |       | $          | 507,677 |   |
| Accounts receivable, net of allowance for  doubtful accounts and returns of $292,662 and $270,013, respectively  |       | 9,910,551  |       | 7,883,756  |       |
| Inventories                                                                                                      |       | 32,212,007 |       | 21,628,492 |       |
| Deposit on purchases of inventories                                                                              |       | 860,614    |       | 409,375    |       |
| Prepaid expenses                                                                                                 |       | 293,047    |       | 205,798    |       |
| Total current assets                                                                                             |       | 43,828,261 |       | 30,635,098 |       |
|                                                                                                             |       |       |       |       |       |
| Property and Equipment, net                                                                                      |       | 2,120,422  |       | 1,762,065  |       |
|                                                                                                             |       |       |       |       |       |
| Other Assets                                                                                                     |       | 1,013,886  |       | 710,318    |       |
| Total assets                                                                                                     |       | $          | 46,962,569 |       | $          | 33,107,481 |   |
|                                                                                                             |       |       |       |       |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                       |       |       |       |       |       |
|                                                                                                             |       |       |       |       |       |
| Current Liabilities:                                                                                             |       |       |       |       |       |
| Accounts payable                                                                                                 |       | $          | 20,165,306 |       | $          | 15,291,207 |   |
| Accrued expenses and other liabilities                                                                           |       | 1,561,119  |       | 1,040,893  |       |
| Current portion of capital lease  obligations                                                                    |       | 71,770     |       | 80,943     |       |
| Current portion of notes payable, other                                                                          |       | 29,645     |       | 18,218     |       |
| Note payable, revolving line of credit                                                                           |       | 22,625,500 |       | —     |       |
| Total current liabilities                                                                                        |       | 44,453,340 |       | 16,431,261 |       |
|                                                                                                             |       |       |       |       |       |
| Long-Term Debt:                                                                                                  |       |       |       |       |       |
| Note payable, revolving line of credit                                                                           |       | —     |       | 15,973,591 |       |
| Note payable, convertible debt (net of  discounts of $4,444,448)                                                 |       | 555,552    |       | —     |       |
| Embedded derivative liability, at fair  value                                                                    |       | 5,954,462  |       | —     |       |
| Capital lease obligations, net of current  portion                                                               |       | 97,860     |       | 170,425    |       |
| Subordinated notes payable, stockholders                                                                         |       | —     |       | 338,662    |       |
| Notes payable other, net of curent portion                                                                       |       | 78,157     |       | 37,487     |       |
| Total long-term debt                                                                                             |       | 6,686,031  |       | 16,520,165 |       |
| Total liabilities                                                                                                |       | 51,139,371 |       | 32,951,426 |       |
|                                                                                                             |       |       |       |       |       |
| Stockholders’ Equity:                                                                                       |       |       |       |       |       |
| Preferred stock, $0.001 par value,  25,000,000 authorized; none issued                                           |       | —     |       | —     |       |
| Common stock, $0.001 par value, 100 million  shares authorized; 11,701,102 and 11,697,102 issued and outstanding |       | 11,701     |       | 11,697     |       |
| Additional paid in capital                                                                                       |       | 4,189,396  |       | 4,178,800  |       |
| Accumulated deficit                                                                                              |       | (8,377,899 | )          | (4,034,442 | )          |
| Total stockholders’ (deficit) equity                                                                        |       | (4,176,802 | )          | 156,055    |       |
|                                                                                                             |       | $          | 46,962,569 |       | $          | 33,107,481 |   |

 

See Notes to Consolidated Financial Statements

 

32

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OF OPERATIONS

YEARSENDED DECEMBER 31, 2005, 2004 AND 2003

 
| ** **                                  | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Sales                                   |       | $          | 55,589,223 |       | $          | 44,680,619 |       | $ | 32,604,546 |   |
| Cost of Goods Sold                          |       | 34,295,418 |       | 27,790,173 |       | 19,814,514 |       |
| Gross Profit                                |       | 21,293,805 |       | 16,890,446 |       | 12,790,032 |       |
| Operating Expenses:                         |       |       |       |       |       |       |       |
| Warehouse and distribution                  |       | 8,175,607  |       | 5,489,263  |       | 3,807,845  |       |
| Sales and marketing                         |       | 7,534,823  |       | 5,829,982  |       | 4,311,558  |       |
| General and administrative                  |       | 6,985,928  |       | 6,107,673  |       | 5,443,190  |       |
|                                        |       | 22,696,358 |       | 17,426,918 |       | 13,562,593 |       |
| Loss from Operations                        |       | (1,402,553 | )          | (536,472   | )          | (772,561   | )          |
| Other Income (Expenses):                    |       |       |       |       |       |       |       |
| Interest expense                            |       | (2,090,765 | )          | (627,439   | )          | (480,139   | )          |
| Change in fair value of derivative          |       | (954,462   | )          | —     |       | —     |       |
| Other                                       |       | 150,005    |       | (45,485    | )          | (15,421    | )          |
|                                        |       | (2,895,222 | )          | (672,924   | )          | (495,560   | )          |
| Loss Before Income Taxes                    |       | (4,297,775 | )          | (1,209,396 | )          | (1,268,121 | )          |
|                                        |       |       |       |       |       |       |       |
| Income Tax Expense                          |       | (45,682    | )          | —     |       | (597,196   | )          |
| Net Loss                                    |       | $          | (4,343,457 | )          | $          | (1,209,396 | )          | $ | (1,865,317 | ) |
| Loss Per Share:                             |       |       |       |       |       |       |       |
| Basic and Diluted                           |       | $          | (0.37      | )          | $          | (0.10      | )          | $ | (0.17 | ) |
| Weighted Average Common Shares Outstanding: |       |       |       |       |       |       |       |
| Basic and Diluted                           |       | 11,699,425 |       | 11,679,028 |       | 11,197,655 |       |

 

See Notes to Consolidated Financial Statements

 

33

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTSOF  STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

 
| ** **                                                                 | ** ** | **Common Stock** | ** ** | **Additional  Paid in** | ** ** | **Accumulated  Earnings** | ** ** | ** **  | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------|------------|------------------------------|------------|---------------------------|------------|-------------|------------|
| ** **                                                                 | ** ** | **Shares**            | ** ** | **Amount**                   | ** ** | **Capital**               | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance, December 31, 2002                                                 |       | 10,587,834            |       | $                            | 10,588     |                      | $          | —      |       | $ | (1,362,532 | ) | $ | (1,351,944 | ) |
| Year Ended December 31, 2003:                                              |       |                  |       |                         |       |                      |       |        |       |   |   |
| Cancellation of stock repurchase agreement                                 |       | 450,000               |       | 450                          |       | 669,907                   |       | 402,803     |       | 1,073,160 |   |
| Issuance of shares - private offerings                                     |       | 236,668               |       | 237                          |       | 959,764                   |       | —      |       | 960,001 |   |
| Exercise of warrants                                                       |       | 80,000                |       | 80                           |       | 239,920                   |       | —      |       | 240,000 |   |
| Issuance of shares to employees and  directors for services rendered (SIP) |       | 18,200                |       | 18                           |       | 55,441                    |       | —      |       | 55,459 |   |
| Issuance of shares - public offering                                       |       | 250,000               |       | 250                          |       | 1,292,250                 |       | —      |       | 1,292,500 |   |
| Issuance of shares - officer’s  performance-based stock options       |       | —                |       | —                       |       | 666,667                   |       | —      |       | 666,667 |   |
| Net loss                                                                   |       | —                |       | —                       |       | —                    |       | (1,865,317  | )          | (1,865,317 | ) |
| 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 |   |
|                                                                       |       |                  |       |                         |       |                      |       |        |       |   |   |
| 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 | ) |

 

See Notes to Consolidated Financial Statements

 

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**IWT TESORO CORPORATION AND SUBSIDIARIES**

CONSOLIDATED STATEMENTS OFCASH FLOWS

YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003

 
| ** **                                                                   | ** ** | **2005**    | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
|                                                                         |       |        |       |        |       |        |       |
| Cash flows from operating activities:                                        |       |        |       |        |       |        |       |
| Net loss                                                                     |       | $           | (4,343,457 | )           | $          | (1,209,396  | )          | $ | (1,865,317 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |        |       |        |       |        |       |
| Depreciation and amortization                                                |       | 443,030     |       | 297,324     |       | 341,073     |       |
| Amortization of loan discount                                                |       | 555,552     |       | —      |       | —      |       |
| Change in fair value of embedded  derivatives                                |       | 954,462     |       | —      |       | —      |       |
| Deferred income taxes                                                        |       | —      |       | —      |       | 597,196     |       |
| Common stock issued for services and  compensation                           |       | 10,600      |       | 147,050     |       | 722,128     |       |
| Provision for doubtful accounts and  allowance for returns                   |       | 22,649      |       | 226,089     |       | 259,581     |       |
| (Gain) loss on disposal of property and  equipment                           |       | 8,691       |       | (21,532     | )          | 18,757      |       |
| Changes in operating assets and  liabilities:                                |       |        |       |        |       |        |       |
| (Increase) Decrease in:                                                      |       |        |       |        |       |        |       |
| Accounts receivable                                                          |       | (2,049,444  | )          | (3,257,140  | )          | (2,236,753  | )          |
| Inventories                                                                  |       | (10,583,515 | )          | (8,569,653  | )          | (7,010,963  | )          |
| Deposit on purchase of inventories                                           |       | (361,222    | )          | (409,375    | )          | —      |       |
| Prepaid expenses and other assets                                            |       | (239,468    | )          | 210,670     |       | (513,560    | )          |
| Increase in:                                                                 |       |        |       |        |       |        |       |
| Accounts payable                                                             |       | 4,874,099   |       | 5,432,046   |       | 4,455,345   |       |
| Accrued expenses and other liabilities                                       |       | 520,226     |       | 503,930     |       | 182,120     |       |
| Net cash used in operating activities                                        |       | (10,187,797 | )          | (6,649,987  | )          | (5,050,393  | )          |
|                                                                         |       |        |       |        |       |        |       |
| Cash flows from investing activities:                                        |       |        |       |        |       |        |       |
| Acquisitions of property and equipment                                       |       | (621,654    | )          | (656,464    | )          | (1,029,310  | )          |
| Proceeds from sale of equipment                                              |       | 10,500      |       | 25,000      |       | 20,000      |       |
| Net cash used in investing activities                                        |       | (611,154    | )          | (631,464    | )          | (1,009,310  | )          |
|                                                                         |       |        |       |        |       |        |       |
| Cash flows from financing activities:                                        |       |        |       |        |       |        |       |
| Proceeds from revolving line of credit                                       |       | 65,641,124  |       | 48,766,998  |       | 42,239,607  |       |
| Payments on revolving line of credit                                         |       | (58,989,215 | )          | (42,392,747 | )          | (37,662,341 | )          |
| Collection on notes receivable arising from  sale of stock                   |       | —      |       | 550,000     |       | —      |       |
| Proceeds from issuance of stock                                              |       | —      |       | 147,875     |       | 1,942,500   |       |
| Payments of long-term debt and capital  lease obligations                    |       | (126,796    | )          | (126,860    | )          | (128,994    | )          |
| Loan financing costs                                                         |       | (76,135     | )          | (23,499     | )          | (85,000     | )          |
| Proceed from issuance of convertible debt,  options and warrants             |       | 5,000,000   |       | —      |       | 157,296     |       |
| Debt issuance costs                                                          |       | (267,000    | )          | —      |       | —      |       |
| Repayment of notes payable, subordinated  debt                               |       | (338,662    | )          | —      |       | (110,050    | )          |
| Net cash provided by financing activities                                    |       | 10,843,316  |       | 6,921,767   |       | 6,353,018   |       |
|                                                                         |       |        |       |        |       |        |       |
| Net Increase (Decrease) in Cash                                              |       | 44,365      |       | (359,684    | )          | 293,315     |       |
|                                                                         |       |        |       |        |       |        |       |
| Cash, Beginning                                                              |       | 507,677     |       | 867,361     |       | 574,046     |       |
| Cash, Ending                                                                 |       | $           | 552,042    |        | $          | 507,677     |       | $ | 867,361 |   |
| Cash Paid (Received) During the Period for:                                  |       |        |       |        |       |        |       |
| Interest                                                                     |       | $           | 1,430,004  |        | $          | 627,439     |       | $ | 473,056 |   |
| Income tax                                                                   |       | $           | 45,682     |        | $          | (359,400    | )          | $ | — |   |
| Non-Cash Operating Activities:                                               |       |        |       |        |       |        |       |
| Inventory acquired through deposit with  vendor                              |       | $           | 82,350     |        | $          | 93,318      |       | $ | — |   |
| Non-Cash Investing and Financing  Activities:                                |       |        |       |        |       |        |       |
| Acquisition of property and equipment  financed through long-term debt       |       | $           | 97,155     |        | $          | 136,319     |       | $ | 172,667 |   |
| Reclassification of note payable to  embedded derivative liability           |       | $           | 5,000,000  |        | $          | —      |       | $ | — |   |

 

See Notes to Consolidated Financial Statements

 

35

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

###### ** **

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

#### ** **

Theconsolidated financial statements include IWT Tesoro Corporation and its whollyowned subsidiaries (collectively the “Company”).

 

IWTTesoro Corporation was incorporated in the state of Nevada on May 3, 2000 asPonca Acquisition Corporation. On September 23, 2002, the Company changed thename from Ponca Acquisition Corporation to IWT Tesoro Corporation. On October1, 2002, IWT Tesoro Corporation (an inactive publicly held company) acquired100% of the outstanding stock of International Wholesale Tile, Inc. (IWT) inexchange for 83% of its outstanding common stock in a transaction accounted foras a recapitalization of IWT. A total of 9,000,000 shares of common stock wereissued for the acquisition. For accounting purposes, the acquisition has beentreated as a capital transaction and as a recapitalization of InternationalWholesale Tile, Inc. The financial statements became those of InternationalWholesale Tile, Inc., with adjustments to reflect the changes in equitystructure.

 

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 three additional wholly owned subsidiaries. These include IWTTesoro Transport, a USDOT licensed common carrier, organized to act as ourfreight carrier outside of Florida and to back haul non household goods toFlorida; IWT Tesoro International, LTD., a Bermuda corporation to act as aholding company for activities and assets such as agency agreements andinvestments in foreign operations; The Tile Club, Inc., formed in 2004,organized to acquire licensing, manufacturing and distribution rights forhigh-end designer and artistic based decorative tiles and to also act as anagent for foreign manufacturers from whom IWT has acquired excusivedistribution rights. Import Flooring Group, Inc., a wholly owned subsidiary ofThe Tile Club was formed in June 2005 to develop an agency business to brokerin the floor covering market.

 

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

#### ** **

Theconsolidated financial statements include IWT Tesoro Corporation and its whollyowned subsidiaries International Wholesale Tile, Inc., IWT TesoroInternational, Ltd, IWT Tesoro Transport, Inc. and The Tile Club, Inc and TheTile Club, Inc.’s wholly owned subsidiary Import Flooring Group, Inc. Allsignificant inter-company balances and transactions have been eliminated inconsolidation.

 

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

#### ** **

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.

 

36

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#### ***Cash***

#### ** **

Cashequivalents include short-term, highly liquid investments that are readilyconvertible to known amounts of cash and are of an original maturity of threemonths or less.

 

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

#### ** **

Accountsreceivable are carried at the amount billed to a customer, net of the allowancefor     doubtful receivables and anallowance for returns. The allowance for doubtful accounts is an estimate forcredit losses based on a review of all outstanding amounts on a monthly basis. Managementdetermines the allowance for doubtful accounts by regularly evaluatingindividual customer receivables and considering a customer’s financialcondition, credit history and current economic conditions. Accounts receivableare written off when deemed uncollectible. Recoveries of accounts receivablepreviously written off are recorded when received. The allowance for returns isan estimate for material returns based on a review of all credits issued on amonthly basis. Management determines the allowance for returns by regularlyevaluating merchandise returns and their corresponding reason.

 

***Concentration of Credit Risk***

 

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

 

**Cash**

 

Atvarious times during the year, the Company had deposits in financialinstitutions in excess of the federally insured limits. At December 31, 2005,the Company had deposits in excess of federally insured limits of approximately$622,000. The Company maintains its cash with high quality financialinstitutions which the Company believes limits these risks. The Company has notsustained any losses as a result of this concentration.

 

**AccountsReceivable**

 

TheCompany does business and extends credit based on an evaluation of thecustomers’ financial condition, generally without requiring collateral.Exposure to losses on receivables is expected to vary by customer due to thefinancial condition of each customer. The Company monitors exposure to creditlosses and maintains allowances for anticipated losses considered necessaryunder the circumstances. Additionally, the Company maintains credit insurancefor certain customer accounts, which mitigates the credit risk. Allowance fordoubtful accounts and returns on accounts receivable balances wereapproximately $293,000 and $270,000 as of December 31, 2005 and 2004,respectively.

 

37

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#### ***Inventories***

#### ** **

Inventoriesare valued at the lower of cost or market, with cost determined on the firstin, first out (FIFO) method and include freight in, duty and handling costs.Inventories consist of finished goods and merchandise in transit from overseasfactories. The Company performs periodic assessments to determine the existenceof obsolete, slow-moving and non-salable inventories, and records necessaryprovisions to reduce such inventories to net realizable value.

 

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

#### ** **

Propertyand equipment are stated at cost. Equipment under capital leases is stated atthe present 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, are capitalized, whereas maintenance andrepairs and small renewals are expensed as incurred.

 

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

#### ** **

TheCompany recognizes income taxes under the asset and liability method. Underthis method, deferred tax assets and liabilities are recognized for the futuretax consequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases, and loss carryforwards. Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered or settled. Theeffect on deferred tax assets and liabilities of a change in tax rates isrecognized in income in the period that includes the enactment date. Deferredtax assets are reduced by a valuation allowance when, in the opinion ofmanagement, it is more likely than not that some portion or all of the deferredtax assets will not be realized.

 

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

#### ** **

***Merchandise***

 

Revenueis recognized when goods are shipped. Allowances for product returns arerecorded as a reduction of sales at the time revenue is recognized based onhistorical data. These allowances are adjusted to reflect actual returns.

 

***Membership Fees***

 

Revenuesare derived from annual membership contracts sold to our customers and arerecognized over the terms of the contracts. The membership provides productexclusivity within a territory.

 

38

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***Agency Fees***

 

Revenuesare derived from annual sales agreements sold to our vendors and are recognizedover the term of the contract. The agency agreement provides the vendor with aportion of our showroom to display select merchandise and participation rightsto the annual convention. Commission revenue is generated on merchandisepurchased from the vendor and are recognized as earned.

 

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

#### ** **

TheCompany reviews the recoverability of our long-lived assets to determinewhether events or changes in circumstances occurred that indicate the carryingvalue of the asset may not be recoverable. The assessment of possibleimpairment is based on its ability to recover the carrying value of the assetfrom the expected future cash flows of the related operations. If these cashflows are less than the carrying value of such asset, an impairment loss isrecognized for the difference between the estimated fair value and carryingvalue. The measurement of impairment requires management to make estimates ofthese cash flows related to long-lived assets, as well as other fair valuedeterminations.

 

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

#### ** **

Shipping and handling costs,included in warehouse and distribution expense in the consolidated statementsof operations, were approximately $3,097,000, $2,357,000 and $1,775,000 for theyears ended December 31, 2005, 2004 and 2003, respectively.

 

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

#### ** **

Advertising and promotionexpenses are charged to expense during the period in which they are incurred.Promotional merchandise, which includes boards and sample packs, are held inother inventories until they are shipped to the customer at which point theyare expensed. Advertising and promotion expenses, included in sales and marketingexpenses in the consolidated statement of operations, was approximately$2,462,000, $1,990,000 and $1,429,000 for the years ended December 31, 2005,2004 and 2003, respectively.

 

#### ***Stock-Based Compensation***

#### ** **

The Company has elected tofollow Accounting Principles Board Opinion No. 25, “*Accounting forStock Issued to Employees*” (APB No. 25), and relatedinterpretations, in accounting for its employee and board of director stockoptions rather than the alternative fair value accounting allowed by SFAS No. 123,“*Accounting for Stock-Based Compensation*”.As amended by SFAS 148 “Accounting for Stock-Based Compensation Transition andDisclosure” APB No. 25 provides that the compensation expense relative to theCompany’s employee and director stock options is measured based on theintrinsic value of the stock option.

 

39

----

 

SFAS No. 123 requirescompanies that continue to follow APB No. 25 to provide pro forma disclosure ofthe impact of applying the fair value method of SFAS No. 123. The Companyfollows SFAS No. 123 in accounting for stock options issued to non-employees.Pro forma information regarding net loss and loss per share is required by SFASNo. 123, “*Accounting for Stock-Based Compensation*,”and has been determined as if the Company had accounted for its stock optionsunder the fair value method of that Statement. The fair value for these optionswas estimated at the grant date using the Black-Scholes option-pricing modelusing the following weighted average assumptions for 2005 and 2004,respectively: risk-free interest rates of 4.29%, and 3.47%, dividend yields of0% and 0%, volatility factors of the expected market price of the Company’scommon stock of 75.60% and 57.46% and a weighted average expected life of theoptions of 10 years. There were no stock options issued during 2003.

 

The Black-Scholes optionvaluation model was developed for use in estimating the fair value of tradedoptions, which have no vesting restrictions and are fully transferable. In addition,option valuation models require the input of highly subjective assumptionsincluding the expected stock price volatility. Because the Company’s employeestock options have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of itsemployee stock options. For purposes of pro forma disclosures, the estimatedfair value of the options is amortized to expense over the options’ vestingperiods.

 

No stock option-basedemployee compensation cost is reflected in net loss for the years endedDecember 31, 2005 and 2004, as all options granted under those plans had anexercise price equal to the market value of the underlying common stock on thedate of the grant. The net loss for the year ended December 31, 2003 includes$666,667 of stock option-based compensation cost because of performance-basedvesting criteria that were met during 2003 when the market price of theunderlying stock was greater than the exercise price of the options.

 

40

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The following tableillustrates the effect on net loss and loss per share if the Company hadapplied the fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation”, to stock option-based employee compensation.

 
| ** **                                                                                                                        | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                                                              |       |                                        |       |   |   |   |   |
| Net loss                                                                                                                          |       | $                                           | (4,343,457 | ) | $ | (1,209,396 | ) | $ | (1,865,317 | ) |
|                                                                                                                              |       |                                        |       |   |   |   |   |
| Add: total stock-based compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | (67,444                                     | )          | (6,334 | ) | (2,281 | ) |
|                                                                                                                              |       |                                        |       |   |   |   |   |
| Pro forma net loss                                                                                                                |       | $                                           | (4,410,901 | ) | $ | (1,215,730 | ) | $ | (1,867,598 | ) |
|                                                                                                                              |       |                                        |       |   |   |   |   |
| Loss per share - Basic and Diluted:                                                                                               |       |                                        |       |   |   |   |   |
| As reported                                                                                                                       |       | $                                           | (0.37      | ) | $ | (0.10 | ) | $ | (0.17 | ) |
| Pro forma                                                                                                                         |       | $                                           | (0.38      | ) | $ | (0.10 | ) | $ | (0.17 | ) |

 

#### ***Earnings (Loss) Per Share***

#### ** **

The Company has adopted SFASStatement No. 128, “*Earnings per Share*”.The statement establishes standards for computing and presenting earnings pershare (EPS). It requires dual presentation of basic and diluted EPS on the faceof the income statement. There is no presentation of diluted loss per share in2005, 2004 or 2003 as the effect of common stock options and warrants amountswere antidilutive.

 

Note 12 discusses thewarrants issued in connection with equity transactions.

Note 13 discusses optionsissued through the Company’s stock option plans.

 

#### ***Fair Value of Financial Instruments***

#### ** **

The carrying amount of cashand cash equivalents, accounts receivable, accounts payable and accruedexpenses approximate fair value due to short-term maturities of theseinstruments. The carrying value of the Company’s line of credit approximatesfair value because the interest rate used with this instrument fluctuates withthe market rate. The fair values of subordinated long-term debt are estimatedbased on current rates offered to the Company for debt with comparablematurities and similar collateral requirements (see Note 8). The fair value ofall other long-term debt approximates their carrying value. The fair value of theembedded derivative liability is determined using the Black-Scholes option valuationmodel.

 

***DerivativeFinancial Instruments***

 

The Company occasionallyenters into a financial instrument that contains a derivative instrument thatis embedded in the financial instrument. Upon entering into the instrument, theCompany assesses whether the economic characteristics of the embeddedderivative are clearly and closely related to the economic characteristics ofthe remaining component of the financial instrument (i.e. the host contract)and whether a separate instrument with the same terms as the embeddedinstrument would meet the definition of a derivative instrument. When it isdetermined that (1) the embedded derivative possesses economic characteristicsthat are not clearly and closely related to the economic characteristics of thehost contract, and (2) a separate instrument with the same terms would qualifyas a derivative instrument, the embedded derivative is separated from the hostcontract and carried at fair value. In cases where (1) host contract ismeasured at fair value, with changes in fair value reported in current earningsor (2) the Company is unable to reliably identify and measure an embeddedderivative for separation from the host contract, the entire contract iscarried on the balance sheet at fair value. The fair value is determined usingthe Black-Scholes option valuation model using the weighted-average assumptionsas described in Note 6.

 

41

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#### ***Segment Information***

#### ** **

The Company has adopted SFASNo. 131, “Disclosures about Segments of an Enterprise and RelatedInformation.” SFAS No. 131 establishes standards for the way that publicbusiness enterprises report information about operating segments in annualfinancial statements and requires those enterprises to report selected informationabout operating segments in interim financial reports issued to stockholders.The Company’s operating segments offer similar products to the same type ofcustomers using similar distribution methods. The Company’s management reviewsresults, allocates resources and makes decisions as a single operating entity.

 

#### ***Recent Accounting Pronouncements***

#### ** **

In November, 2004, the FASBissued SFAS No. 151 “Inventory Costs” an  amendment to Accounting Research        Bulletin No. 43, “Inventory Pricing,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial. This Statement requires that those items be recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal.”  Additionally this statementrequires that allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. Theprovisions of SFAS No. 151 are effective for fiscal years beginning afterJune 15, 2005. The adoption of SFAS 151 is not expected to have an impacton our consolidated results of operations, financial position or cash flows.

 

In December 2004, theFASB issued SFAS No. 153, *“Exchanges ofNonmonetary Assets”* an amendment to Accounting Principles BoardOpinion No. 29, “*Accounting forNonmonetary Transactions,”* which is based on the principle thatexchanges of nonmonetary assets should be measured based on the fair value ofthe assets exchanged. The guidance in that Opinion, however, included certainexceptions to that principle. This Statement amends Opinion 29 to eliminate theexception for nonmonetary exchanges of similar productive assets and replacesit with a general exception for exchanges in which the future cash flows of theentity are not expected to change significantly as a result of the exchange. Theprovisions of SFAS No. 153 are effective for nonmonetary asset exchangesin fiscal periods beginning after June 15, 2005. The adoption of SFAS 153is not expected to have an impact on our consolidated results of operations,financial position or cash flows.

 

In December 2004, theFASB issued SFAS No. 123 (revised 2004)(“SFAS No. 123R”), “*Share-Based Payment*,” which requires that the compensationcost relating to share-based payment transactions be recognized in thefinancial statements. SFAS No. 123R replaces SFAS No. 123, “Accountingfor Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” Share-based compensation arrangements includeshare options, restricted share plans, performance-based awards, shareappreciation rights and employee share purchase plans. SFAS No. 123R requiresall share-based payments to employees be valued using a fair value method onthe date of grant and expensed based on that fair value generally over theapplicable vesting period. SFAS No. 123R also amends SFAS No. 95 “statement ofCash Flows,” requiring the benefits of tax deductions in excess of recognizedcompensation cost be reported as

 

42

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financing cash inflow ratherthan as a reduction of taxes paid. In March 2005, the Securities and ExchangeCommission (“SEC”) issued Staff Accounting Bulletin No. 107, (“SAB No. 107”)which expresses the SEC’s views regarding the interaction between SFAS No. 123Rand certain SEC rules and regulations and, accordingly, provides guidancerelated to share-based payment transactions for public companies. The Companywill be required to apply SFAS No. 123R as of January 1, 2006. The Company’s estimatedcompensation expense upon adoption of SFAS No. 123R will be approximately $39,000.The financial impact of any stock options granted in the future will bedetermined using an appropriate option-pricing model.

 

InMarch 2005, the FASB issued FIN 47 as an interpretation of FASBStatement 143, *Accounting for AssetRetirement Obligations*(FASB 143). This interpretation clarifiesthat the term conditional asset retirement obligation as used in FASB 143 andrefers to a legal obligation to perform an asset retirement activity in whichthe timing and/or method of settlement are conditional on a future event thatmay or may not be within the control of the entity. The obligation to performthe asset retirement activity is unconditional even though uncertainly existsabout the timing and/or method of settlement. Accordingly, an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value of the liability can be reasonably estimated.This interpretation also clarifies when an entity would have sufficientinformation to reasonably estimate the fair value of an asset retirementobligation. FIN 47 is effective no later than the end of fiscal yearsending after December 15, 2005. The Company adopted FIN 47 for the fiscalyear ended December 31, 2005, which did not have a material impact on itsfinancial statements.

 

OnJune 1, 2005, the FASB issued Statement No. 154, *Accounting Changes and Error Corrections, areplacement of APB Opinion No. 20 and FASB Statement No. 3(SFAS 154)*. The Statement applies to all voluntary changes inaccounting principle, and changes the requirements for accounting for andreporting of a change in accounting principle. As of December 31, 2005, we didnot have any changes in accounting principles and, accordingly, SFAS 154 had noimpact on our financial statements.

 

***Reclassifications***

 

Certain amounts in the 2004and 2003 financial statements have been reclassified for comparative purposesto conform to the 2005 presentation.

 

43

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**NOTE 2**.**                LIQUIDITY AND PROFITABILITYCONSIDERATIONS**

 

TheCompany has suffered net losses of approximately $4,344,000, $1,209,000 and$1,865,000 for the years ended December 31, 2005, 2004 and 2003, respectively.As reflected in the consolidated balance sheet as of December 31, 2005, theCompany had a working capital deficit of approximately $625,000 and its totalliabilities exceed its total assets.

 

*Management’splans with regard to these matters encompass the following actions:*

 

***Profitability***

 

InJanuary 2006 management reduced projected operating costs by approximately $3.6million. These reductions included sales and marketing and administrativeoverhead. In February 2006 International Wholesale Tile, Inc. implemented a3.5% price increase. As part of the Company’s plan to increase sales theCompany opened a small warehouse in Ohio in February 2006 to service existingand new customers from Chicago to Philadelphia (see Note 16). As a result ofopening this warehouse to support the Midwest customer base, the Company beganselling products to two additional home center companies.

 

***Liquidity***

 

InFebruary 2006, as more fully described in Note 16 herein, the Company obtained$2.0 million through the issuance of a three year subordinated term note. Thesefunds will generally be used for the Company’s working capital requirements.

 

TheCompany hired a consultant to review purchasing and inventory managementprocedures. The goal of the study is to determine the optimum inventorynecessary to maintain the high levels of customer satisfaction while improvingworking capital. Management expanded its business model to include more directshipments of product from the manufacturer. This expansion will reduce theamount of inventory the Company needs to carry to support sales and to improvethe use of its working capital.

 

InDecember 2005 the Company signed an agreement with a company to provide marketcapitalization support services. Additionally, in February 2006 the Companysigned an agreement with an investment banking firm to provide generalfinancial advisory services to develop and implement a plan to restructure theCompany’s financial structure and raise new debt and /or equity capital.

 

***Summary***

 

Management believes the implementation of the plans described abovewill provide adequate improvements in the Company’s profitability, cash flowand liquidity to ensure its viability and to sustain its operations. Managementalso believes that the additional working capital provided by financial institutionscoupled with improved financial performance, will allow the Company to continueits growth and expansion plans.

 

44

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###### **NOTE3.                INVENTORIES**

###### ** **

Inventories consisted of thefollowing:

 
| ** **           | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                 |       |                        |       |                        |       |
| Tiles                |       | $                           | 28,858,620 |                        | $          | 17,034,540 |   |
| Inventory in transit |       | 3,353,387                   |       | 4,593,952                   |       |
| Total inventories    |       | $                           | 32,212,007 |                        | $          | 21,628,492 |   |

 

Inventory in transitconsists of merchandise purchased overseas, which has not yet been received inthe warehouse. The Company obtains legal title at the shipping point.

 

###### **NOTE4.                PROPERTY AND EQUIPMENT**

###### ** **

Property and equipmentconsisted of the following:

 
| ** **                    | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
|                          |       |                        |       |                        |       |
| Furniture and fixtures        |       | $                           | 423,806    |                        | $          | 295,920 |   |
| Machinery and equipment       |       | 859,996                     |       | 658,292                     |       |
| Vehicles                      |       | 307,195                     |       | 258,273                     |       |
| Office and computer equipment |       | 676,304                     |       | 526,703                     |       |
| Leasehold improvements        |       | 676,094                     |       | 719,560                     |       |
|                          |       | 2,943,395                   |       | 2,458,748                   |       |
| Less accumulated depreciation |       | 822,973                     |       | 696,683                     |       |
|                          |       | $                           | 2,120,422  |                        | $          | 1,762,065 |   |

 

 

Depreciation expense for theyears ended December 31, 2005, 2004 and 2003 was approximately $341,000,$264,000 and $267,000, respectively.

 

###### **NOTE5.                NOTE PAYABLE, REVOLVINGLINE OF CREDIT**

###### ** **

On December 31, 2004, theCompany amended and restated the existing revolving line of credit agreementproviding up to $25,000,000 with interest rates of either (1) LIBOR plus 3.00%or (2) the base rate plus 0.50% (interest rates ranging from 6.85% to 7.45% atDecember 31, 2005) payable monthly. The line of credit is limited by aborrowing base which is comprised of a percentage of eligible accountsreceivable and eligible inventories, as defined, and is collateralized bysubstantially all the assets of the Company. The balance due at December 31,2005 and 2004 was $22,625,500 and $15,973,591, respectively. The line maturesSeptember 10, 2006 and contains certain covenants requiring the Company tomaintain a certain leverage ratio, a required minimum fixed charge coverageratio, and certain inventory turnover ratio.

 

45

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At December 31, 2005 theCompany was not in compliance with the leverage, fixed charge coverage or theinventory turnover ratio requirements. See Note 16.

 

For the years ended December31, 2005, 2004 and 2003, interest expense related to the revolving line ofcredit amounted to $1,344,000, $578,000 and $413,000 respectively.

 

**NOTE 6                 NOTEPAYABLE – CONVERTIBLE DEBT**

 

On August 25, 2005, theCompany issued a secured revolving note in the aggregate amount of $5,000,000resulting in net proceeds of $4,733,000 after debt issuance costs of $267,000. Interestaccrues on the principal balance of the note at an annual interest rate equalto prime plus 1.5%. On December 31, 2005, the interest rate was 8.75%. The notematures on August 25, 2008. The note is convertible into common stock of theCompany at an initial conversion rate of $2.74 per share. Because the agreementcontains certain non-standard anti-dilution provisions and requirements tosettle any conversion option with registered shares, the Company is required toaccount for the conversion option as an embedded derivative requiring separateaccounting treatment in accordance with *SFAS No. 133 Accountingfor Derivative Instruments and Hedging Activities*. Based upon theclosing price per share of the Company’s common stock on the date of issuance,the Company estimated the fair value of the embedded conversion option andclassified $2,068,317 as a derivative liability that is adjusted to fair valueat each reporting date with changes in fair value reported in earnings. Inconnection with the convertible notes, the Company issued to the holder of thenote a five-year warrant to purchase 511,883 shares of the Company’s commonstock at an exercise price of $3.15 per share and an option to purchase1,170,110 shares of the Company’s common stock at an exercise price of $0.001per share. Based upon the closing price per share of the Company’s common stockon the date of issuance, the Company estimated the fair value of the warrantand option and classified $3,099,835 and $692,334, respectively, as aderivative liabilities that are adjusted to fair value at each reporting datewith changes in fair value reflected in operations. The fair values of theoptions, warrants, and embedded conversion option was estimated at the date ofissuance using the Black-Scholes option-pricing model using the followingweighted average assumptions: risk-free rate of 4.06%, dividend yields of 0%,and volatility factors of the expected market price of the Company’s commonstock of 60.79%.

 

The excess of the fair valueof the derivative liabilities over the principal amount of the notes of$860,486 was recorded as an expense in the period of issuance and the remainingfair value of $5,000,000 was recorded as a discount to the convertible debt tobe amortized into expense over the three-year terms of the notes.

 

The balance of the note, netof unamortized discounts and the embedded derivative as of December 31, 2005 isas follows:

 
| Derivative liability at date of issuance                       |   | $          | 5,000,000 |   |
|----------------------------------------------------------------|--------|------------|-----------|--------|
| Change in fair value                                           |   | 954,462    |      |
| Derivative liability as of December 31,  2005                  |   | $          | 5,954,462 |   |
|                                                           |   |       |      |
| 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 to interest expense                      |   | 555,552    |      |
| Balance as of December 31, 2005, net of  unamortized discounts |   | $          | 555,552   |   |

 

The Company expects the debtto be held to maturity.

 

Interest expense related tothe note amounted to $148,576 during the period of August 25, 2005 to December31, 2005.

 

Amortization of discountsfor the warrant and option resulted in charges to interest expense totaling $555,552during the year ended December 31, 2005.

 

46

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The increase in the fairvalue of the embedded conversion option resulted in charges to expense totaling$954,462 during the year ended December 31, 2005

 

The note is secured by alien on substantially all the assets of the Company, subject to a firstpriority lien of the Company’s primary financial lender.

 

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

 

###### **NOTE7.                CAPITAL LEASEOBLIGATIONS**

###### ** **

The Company leases certainmachinery and equipment under capital leases which expire at various datesthrough 2009. The future minimum lease payments required are as follows:

 
| 2006                                    |   | $       | 82,423 |   |
|-----------------------------------------|--------|---------|--------|--------|
| 2007                                    |   | 65,055  |   |
| 2008                                    |   | 32,509  |   |
| 2009                                    |   | 16,350  |   |
|                                    |   | 196,337 |   |
| Less amount representing interest       |   | 26,707  |   |
| Present value of minimum lease payments |   | 169,630 |   |
| Less current portion                    |   | 71,770  |   |
|                                    |   | $       | 97,860 |   |

 

Assets acquired undercapital leases are presented in property and equipment in the accompanyingbalance sheet. Balances of assets under capital leases at December 31, 2005 and2004 were as follows:

 
| ** **                    | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
|                          |       |     |       |     |       |
| Property and equipment        |       | $        | 437,716    |     | $          | 437,716 |   |
| Less accumulated depreciation |       | 148,989  |       | 98,639   |       |
|                          |       | $        | 288,726    |     | $          | 339,077 |   |

 

###### **NOTE8.                SUBORDINATED NOTES PAYABLE,STOCKHOLDERS**

###### ** **

The fair value of theCompany’s Subordinated long-term debt is based on the available marketinformation and management’s estimate of current market conditions of similarinstruments.

 
| ** **                                | ** ** | **Carrying Amount** | ** ** | **Fair Value** | ** ** |
|-------------------------------------------|------------|--------------------------|------------|---------------------|------------|
| ** **                                | ** ** | **2005**                 | ** ** | **2004**            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                      |       |                     |       |                |       |   |   |   |   |
| Subordinated Notes Payable - Stockholders |       | $                        | —     |                | $          | 338,662 |   | $ | — |   | $ | 519,589 |   |
|                                           |            |                          |            |                     |            |  |  |  |  |  |  |  |  |

 

Interest expense related tothe subordinated notes payable was approximately $23,000 for the year endedDecember 31, 2005, and approximately $34,000 for the years ended December 31,2004 and 2003.

 

47

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###### **NOTE9.                NOTES PAYABLE, OTHER**

 
| ** **                                                                                                                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Various equipment notes, payable in monthly  installments ranging from $521 to $889; maturing at various dates through July  2010. |       | $        | 107,802    |     | $          | 55,705 |   |
|                                                                                                                               |       |     |       |     |       |
| Less current portion                                                                                                               |       | 29,645   |       | 18,218   |       |
|                                                                                                                               |       | $        | 78,157     |     | $          | 37,487 |   |

 
| Year ending December 31: |   |   |    |   |   |
|--------------------------|--------|--------|---------|--------|--------|
| 2006                     |   | $      | 29,645  |   |   |   |
| 2007                     |   | 30,888 |    |   |   |
| 2008                     |   | 22,171 |    |   |   |
| 2009                     |   | 19,765 |    |   |   |
| 2010                     |   | 5,333  |    |   |   |
|                     |   | $      | 107,802 |   |   |   |

 

48

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###### **NOTE10.              COMMITMENTS ANDCONTINGENCIES**

###### ** **

***Operating Leases***

 

The Company leases officeand warehouse facilities in various locations under operating leases expiringthrough March 31, 2020.

 

Future minimum leasepayments under non-cancelable operating leases are estimated as follows:

 
| 2006           |   | $          | 2,144,000  |   |
|----------------|--------|------------|------------|--------|
| 2007           |   | 2,263,000  |       |
| 2008           |   | 2,230,000  |       |
| 2009           |   | 2,131,000  |       |
| 2010           |   | 1,833,000  |       |
| Thereafter     |   | 15,249,000 |       |
| Total payments |   | $          | 25,850,000 |   |

 

Rent expense wasapproximately $2,308,000, $1,435,000 and $1,032,000 for the years endedDecember 31, 2005, 2004 and 2003, respectively.

 

***Purchase Commitments***

 

On December 29, 2003, theCompany entered into an agreement to purchase tile from a vendor, who is also astockholder of the Company and paid a deposit of $550,000 on this purchasecommitment during 2004, which is reduced by 20% of each purchase throughout theterm of the agreement. The agreement is for a term of 18 months from the dateof the initial delivery and commits the Company to purchase a total of$2,750,000 of tile. As of December 31, 2005, the Company had a remainingpurchase commitment under the agreement of approximately $1,872,000 and theremaining balance of deposits on future purchases is approximately $374,000which is included in the deposits on purchases of inventories on theaccompanying consolidated balance sheet. This commitment previously due toexpire March 2006 has been extended until the entire deposit is utilized.

 

***401K Employee Benefit Plan***

 

The Company sponsors a401(k) plan known as the International Wholesale Tile, Inc. 401(k) ProfitSharing Plan & Trust (the “401K Plan”). The 401K Plan provides tax deferredsalary reductions for eligible employees. Employees become eligible sixty daysafter the date hired, as defined in the 401K Plan. The Company providesmatching contributions equal to 100% of the employee’s contributions up to amaximum of 3% of eligible pay. The contribution expense related to the 401KPlan was approximately $169,000, $121,000 and $76,000 for the years endedDecember 31, 2005, 2004 and 2003, respectively.

 

49

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###### **NOTE11.**              STOCKHOLDERS’ EQUITY

###### ** **

***Public Offering***

 

OnApril 11, 2003, the Company filed a registration statement with the Securitiesand Exchange Commission that was declared effective on June 17, 2003. Twoofferings were included in the registration statement. The first was the offerand sale of 250,000 units at $5.50 per unit. Each unit consisted of one shareof the Company’s common stock and a warrant to purchase one common share at $7per share through June 17, 2006. These units were offered initially to thencurrent stockholders of the Company. The second offering was to register onbehalf of certain of the Company’s stockholders, an aggregate of 1,243,502shares for resale. Of this total, 443,500 were not subject to any lock-upperiod, 699,002 shares were subject to a six-month lock-up period commencing asof the effective date of the registration statement, and the remaining 101,000shares were subject to a 12 month lock-up period through June 17, 2004. Allcontractual lockup periods have expired.

 

Underthis offering, the Company raised $1,292,500, net of offering costs of $82,500.

 

### ***Private Offering***

### ** **

DuringMarch 2003, the Company completed a private placement of its securities, whichwas initiated in 2002. The offering resulted in the Company issuing anaggregate of 220,002 shares of common stock at $3 per share or $660,000. Underthe offering, the Company issued 83,334 shares for $250,000 during 2002 and136,668 shares for $410,000 during 2003.

 

Additionally,as part of this offering, the Company issued 330,000 warrants at an initialprice of $3 per share. The price of the warrants will increase by $.25 pershare each at the beginning of each calendar quarter. These warrants expire 5years from the date of issuance. During the years ended December 31, 2003 and2002, 80,000 and 5,000 shares of common stock were issued pursuant to warrantsexercised, respectively.

 

***Note Receivable Arising from Sale of Stock***

 

InDecember 2003, the Company completed a private placement of securities andsigned an agreement with an investor to purchase 100,000 units at $5.50 perunit. Each unit consisted of one share of common stock and one warrant topurchase one additional share at $7 per share. In addition, the investor signeda stock pledge agreement and a promissory note for $550,000, at 3% interest peryear, with a maturity date of March 31, 2004. In March 2004, the Companyreceived full payment for the promissory note.

 

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### ***Common Stock***

### ** **

Duringthe year ended December 31, 2004, the Company issued 45,500 shares of commonstock pursuant to warrants exercised at $3.25 per share, for a total of$147,875.

 

Duringthe year ended December 31, 2004, the Company issued 17,000 shares of commonstock to consultants for services rendered, based on the trading price at thedate of issuance, for a total of $98,350, resulting in an equivalent charge tooperations.

 

OnMay 26, 2004, the Company issued 10,000 shares of common stock to a directorunder the Stock Incentive Plan for services rendered, based on thecontemporaneous trading price, for a total of $42,500, resulting in anequivalent charge to operations.

 

OnApril 15th, 2004, the Company cancelled 100 shares of common stockissued to an employee, based on the trading price at the date of issuance, fora total of $550, resulting in an equivalent reduction in charge to operations.

 

OnJuly 20th, 2004, the Company issued 500 shares of common stock to anemployee under the original terms of an employment agreement, based on thetrading price at the date of issuance, resulting in an equivalent charge tooperations of $2,125.

 

Duringthe year ended December 31, 2004, the Company issued 1,500 shares of commonstock to existing customers as a promotional project, based on the tradingprice at the dates of issuance for a total of $4,625, resulting in anequivalent charge to operations.

 

OnJune 2nd, 2005, the Company issued 4,000 shares of common stock toemployees, based on the trading price at the date of issuance for a total of$10,600, resulting in an equivalent charge to operations.

 

51

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###### **NOTE 12.**              COMMON STOCK WARRANTS

###### ** **

Asummary of warrants issued and outstanding in connection with equitytransactions as discussed above is presented below. Upon exercise, warrants areconvertible into an equal number of the Company’s common stock. The warrantsare exercisable immediately.

 

###### ** **

| ** **                               | ** ** | **Year Ended Decemebr 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                               | ** ** | ** **                                 | ** ** | **Weighted  Average  Exercise** | ** ** | ** ** | ** ** | **Weighted  Average  Exercise** | ** ** | ** ** | ** ** | **Weighted  Average  Exercise** | ** ** |
| ** **                               | ** ** | **Warrants**                               | ** ** | **Price** | ** ** | **Warrants** | ** ** | **Price** | ** ** | **Warrants** | ** ** | **Price** | ** ** |
|                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at the beginning of the year |       | 549,500                                    |       | $ | 5.91 |   | 595,000 |   | $ | 5.35 |   | 120,000 |   | $ | 3.00 |   |
|                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Granted                                  |       | 511,883                                    |       | $ | 3.15 |   | — |   | $ | — |   | 555,000 |   | $ | 5.52 |   |
|                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Exercised                                |       | —                                     |       | $ | — |   | (45,500 | ) | $ | 3.25 |   | (80,000 | ) | $ | 3.00 |   |
|                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at the end of the year       |       | 1,061,383                                  |       | $ | 4.77 |   | 549,500 |   | $ | 5.91 |   | 595,000 |   | $ | 5.35 |   |
|                                     |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Warrants exercisable at year-end         |       | 1,061,383                                  |       | $ | 4.77 |   | 549,500 |   | $ | 5.91 |   | 595,000 |   | $ | 5.35 |   |

 

The following tables summarize informationfor warrants outstanding at December 31, 2005 and 2004:

 

| ** **                          | ** **  | **Warrants Outstanding at December 31, 2005** | ** ** |
|-------------------------------------|-------------|------------------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** **  | **Number  Outstanding  at 12/31/05**                              | ** ** | **Weighted  Average  Remaining  Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** **  | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                   | 3.15 - 5.00 |                                                                   | 711,383    |   | 3.9 |   | $ | 3.67 |   |
| $                                   | 7.00        |                                                                   | 350,000    |   | 0.9 |   | $ | 7.00 |   |
|                                |        | 1,061,383                                                              |       |   |   |   |   |

 

| ** **                          | ** ** | **Warrants Outstanding at December 31, 2004** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding  at 12/31/04**                              | ** ** | **Weighted  Average  Remaining  Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                   | 4.00       | ** **                                                             | 199,500    | ** ** | 3.0 | ** ** | $ | 4.00 | ** ** |
| $                                   | 7.00       | ** **                                                             | 350,000    | ** ** | 1.9 | ** ** | $ | 7.00 | ** ** |
| ** **                          | ** ** | 549,500                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |

 

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###### **NOTE 13.**              COMMON STOCK OPTIONS

###### ** **

***Stock Option Plan***

 

TheCompany entered into a Stock Incentive Plan on December 27, 2001. The planprovides that eligible employees, consultants, and affiliates may be grantedshares of common stock. Under the plan, the options granted are non-qualifiedstock options, incentive stock options and restricted stock. The aggregatetotal common stock that may be issued under the plan is 4,000,000 shares. Theshares issued to employees were recorded at the fair value on the grant date.

 

Underthe Plan, a total of 4,000, 28,900 and 18,200 restricted shares were issued toemployees, directors and consultants for services rendered for the years endedDecember 31, 2005, 2004 and 2003, respectively and these shares were recordedat fair value at the date of issuance.

 

Asummary of the Company’s stock option plan is presented below:

 
| ** **                                 | ** ** | **Year Ended Decemebr 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **Shares**                                 | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at the beginning of the period |       | 517,749                                    |       | $ | 3.14 |   | 306,667 |   | $ | 3.00 |   | 440,000 |   | $ | 3.00 |   |
|                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Granted at fair value                      |       | 50,000                                     |       | $ | 2.55 |   | 216,082 |   | $ | 3.42 |   | — |   | $ | — |   |
|                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Forfeited                                  |       | —                                     |       | $ | — |   | (5,000 | ) | $ | 6.00 |   | (133,333 | ) | $ | 3.00 |   |
|                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Outstanding at the end of the period       |       | 567,749                                    |       | $ | 3.21 |   | 517,749 |   | $ | 3.14 |   | 306,667 |   | $ | 3.00 |   |

 
| ** **                                      | ** ** | **Year Ended Decemebr 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **Shares**                                 | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Options Exercisable at the end of the  period   |       | 409,883                                    |       | $ | 3.31 |   | 331,667 |   | $ | 3.03 |   | 306,667 |   | $ | 3.00 |   |
|                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Weighted average fair value of options  granted |       |                                       |       | $ | 1.66 |   |   |   | $ | 1.01 |   |   |   | $ | — |   |

 

53

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The following table summarizesinformation for stock options outstanding at December 31, 2005:

 

| ** **                          | ** ** | **Options Outstanding**              | ** ** | **Options Exercisable**            | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding  at 12/31/05** | ** ** | **Weighted  Average  Remaining  Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at 12/31/05** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                                | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2.55 - 3.00                         |       | 517,749                                   |       | 3.88                                    |       | $ | 2.95 |   | 363,883 |   | $ | 2.97 |   |
| 6.00                                |       | 50,000                                    |       | 8.04                                    |       | $ | 6.00 |   | 46,000 |   | $ | 6.00 |   |
|                                |       | 567,749                                   |       |                                    |       |   |   | 409,883 |   |   |   |

 

Thefollowing table summarizes information for stock options outstanding atDecember 31, 2004:

 

| ** **                          | ** ** | **Options Outstanding**              | ** ** | **Options Exercisable**            | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| **Range of  Exercise  Prices** | ** ** | **Number  Outstanding  at 12/31/05** | ** ** | **Weighted  Average  Remaining  Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at 12/31/04** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                                | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 2.55 - 3.00                         |       | 467,749                                   |       | 4.33                                    |       | $ | 2.84 |   | 306,667 |   | $ | 3.00 |   |
| 6.00                                |       | 50,000                                    |       | 9.04                                    |       | $ | 6.00 |   | 25,000 |   | $ | 6.00 |   |
|                                |       | 517,749                                   |       |                                    |       |   |   | 331,667 |   |   |   |

 

***Common Stock Options***

 

DuringAugust 2005, the Company granted a five-year option to purchase up to 1,170,110shares of common stock at an exercise price of $0.001 per share in connectionwith the secured convertible revolving note (see Note 6).

 

54

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**NOTE14.****             ****INCOME TAXES**

 

Thefollowing is a reconciliation of income tax computed at the Federal Statutoryrate to the provision for income taxes:

 
| ** **                            | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | **Amount** | ** ** | **%**      | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income tax(benefit) at statutory rate |       | $          | (1,461,244 | )          | (34.0      | )          | $          | (411,193 | ) | (34.0 | ) | $ | (431,162 | ) | (34.0 | ) |
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Permanent items                       |       | 14,588     |       | (0.3       | )          | 29,925     |       | 2.5 |   | 34,981 |   | 2.8 |   |
|                                  |       |       |       |       |       |       |       |   |   |   |   |   |   |
| Change in valuation allowance         |       | 1,436,385  |       | 33.4       |       | 421,974    |       | 34.9 |   | 1,035,675 |   | 81.7 |   |
|                                  |       |       |       |       |       |       |       |   |   |   |   |   |   |
| State taxes, net of federal benefit   |       | (108,771   | )          | (2.5       | )          | (40,706    | )          | (3.4 | ) | (42,298 | ) | (3.3 | ) |
|                                  |       |       |       |       |       |       |       |   |   |   |   |   |   |
| Changes in deferred items             |       | 164,724    |       | 3.9        |       | —     |       | — |   | — |   | — |   |
|                                  |       |       |       |       |       |       |       |   |   |   |   |   |   |
| Income tax provision                  |       | $          | 45,682     |       | 0.3        |       | $          | — |   | — |   | $ | 597,196 |   | 47.2 |   |

 

Deferredtax assets and liabilities are determined based on the estimated future taxeffects of temporary differences between the financial statement and tax basesof assets and liabilities, as measured by the current enacted tax rates.Deferred tax expense (benefit) is the result of changes in the deferred taxasset and liability. A valuation allowance is recorded to reduce the carryingamounts of deferred tax assets if there is uncertainty regarding theirrealization.

 

Significant components of the provision for income taxes are asfollows:

 
| ** **            | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------|------------|-----------------------------|------------|
| ** **            | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income Tax  Provision |       |                        |       |   |   |   |   |
| Current               |       | $                           | 45,682     |   | $ | — |   | $ | — |   |
| Deferred              |       | —                      |       | — |   | $ | 597,196 |   |
| Total                 |       | $                           | 45,682     |   | $ | — |   | $ | 597,196 |   |

 

55

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Thetax effects of temporary differences that give rise to significant componentsof deferred tax assets and deferred tax liabilities at December 31, 2005 and2004 are presented below:

 
| ** **                            | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Deferred tax asset:                   |       |                        |       |                        |       |
| Net operating loss carry forward      |       | $                           | 1,302,015  |                        | $          | 571,649 |   |
| Accounts receivable                   |       | 52,630                      |       | 56,450                      |       |
| Accrued expense                       |       | 25,355                      |       | 72,956                      |       |
| Deferred compensation - stock options |       | 250,867                     |       | 250,867                     |       |
| Property and Equipment                |       | 822,168                     |       | 499,195                     |       |
| Return Reserve                        |       | 57,499                      |       | 0                           |       |
| Derivative liability                  |       | 359,164                     |       | 0                           |       |
| Other                                 |       | 24,336                      |       | 6,532                       |       |
|                                  |       | 2,894,034                   |       | 1,457,649                   |       |
| Less: Valuation allowance             |       | (2,894,034                  | )          | (1,457,649                  | )          |
|                                  |       | $                           | —     |                        | $          | — |   |

 

The following table summarizes the classification ofthe deferred tax asset as of December 31, 2005 and 2004.

 
| ** **              | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------|------------|------------|------------|------------|------------|
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current                 | ** ** | $          | 140,998    | ** ** | $          | 129,406 | ** ** |
| Non-current             | ** ** | 2,753,036  | ** ** | 1,328,243  | ** ** |
| Total                   | ** ** | 2,894,034  | ** ** | 1,457,649  | ** ** |
| Valuation  allowance    | ** ** | (2,894,034 | )          | (1,457,649 | )          |
| Net  deferred tax asset | ** ** | $          | —     | ** ** | $          | — | ** ** |

 

AtDecember 31, 2005, the Company had net operating loss carryforwards for federalincome tax purposes of approximately $3,264,000, which are available to offsetfuture federal taxable income through 2025.

 

56

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**NOTE 15.****             ****QUARTERLY FINANCIAL INFORMATION(UNAUDITED)**

 
| ** **                                    | ** ** | **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 | ) |

 
| ** **                                  | ** ** | **Quarter Ended** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| ** **                                  | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| 2003                                        |       |                   |       |   |   |   |   |   |   |
| Net sales                                   |       | $                      | 6,713,810  |   | $ | 8,477,575 |   | $ | 8,955,693 |   | $ | 8,457,468 |   |
| Gross profit                                |       | 2,634,202              |       | 3,465,576 |   | 3,582,445 |   | 3,107,809 |   |
| Net income (loss)                           |       | $                      | (51,988    | ) | $ | 337,512 |   | $ | (108,921 | ) | $ | (2,041,920 | ) |
|                                        |       |                   |       |   |   |   |   |   |   |
| Basic and diluted earnings (loss) per share |       | $                      | (0.00      | ) | $ | 0.03 |   | $ | (0.01 | ) | $ | (0.18 | ) |

 

57

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**NOTE16.****             ****SUBSEQUENT EVENT**

 

***Financing***

 

OnFebruary 10th, 2006, the Company issued a $2,000,000 securedconvertible term note payable. This note, which matures on February 10th,2009, is convertible into common stock at $2.17 per share, subject to the sameconversion limitation as described in Note 6. As a part of the financingarrangement the Company issued the Purchaser a three-year warrant to purchaseup to 460,829 shares of the Company’s Common Stock at $2.39 per share andissued 221,198 shares of Common Stock to the Purchaser at closing. Interestaccrues on the principal balance of the note at an annual interest rate equalto prime plus 2.0%, payable monthly, commencing on March 1st, 2006.Amortizing payments of $66,666 plus accrued interest commence on August 1,2006, payable on the first business day of each succeeding month through andincluding the Maturity Date.

 

At December 31, 2005, the Company was not in compliance with theleverage, fixed coverage or the inventory turnover ratio requirements. On March29th, 2006 the Company obtained a waiver of these covenantsfrom its commercial lender.

 

OnMarch 31st, 2006, the Company issued Amendment #2 to the SecurityAgreement and the Convertible Minimum Borrowing Note with Laurus Master Fund,LTD, as more fully described in Note 6 to the consolidated financialstatements. As a result of the Amendment, the Company is no longer required tomake any modifications to the fixed conversion price, or issue any additionalsecurities in the event the Company issues common stock at a price less than$2.74 per share.

 

OnMay 3rd, 2006, the Company issued a $2,000,000 secured term notewith Laurus Master Fund, LTD which matures on May 3rd, 2007. As apart of the financing arrangement, the Company issued the Purchaser a ten-yearwarrant to purchase up to 333,333 shares of the Company’s Common Stock at $.001per share. Interest accrues on the principal balance of the note at an annualinterest rate equal to 15.0% per annum, payable monthly, commencing on June 1st,2006.

 

AtMarch 31, 2006, the Company was not in compliance with the leverage and fixedcharge coverage ratio requirements. On May 12, 2006, the Company obtained awaiver of these covenants from its commercial lender.

 

***Operations***

 

OnFebruary 17th, 2006, the Company purchased from JPMorgan Chase Bank,NA substantially all the assets from their debtor Versatile/Master Tile ofCanton, Ohio. Consideration was given in the amount of $279,365 to purchase thedebtors inventory and receivables.

 

58

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

 

None

 

**ITEM 9A.****    ****CONTROLS AND PROCEDURES**

* *

*Disclosure Controls and Procedures*

 

As of December 31, 2005, the end of theperiod covered by this report, our Chief Executive Officer andChief Financial Officer, reviewed and evaluated the effectiveness of theCompany’s disclosure controls and procedures, (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (“Exchange Act”) to ensure that material informationrequired to be disclosed in the reports filed or submitted under the ExchangeAct is recorded, processed, summarized, and reported within the periodspecified by the SEC’s rules and forms.

 

Based on that evaluation,Tesoro’s principal executive officer and principal financial officer haveconcluded that its disclosure controls and procedures are effective in ensuringthat information required to be disclosed by the Company in the reports that itfiles or submits under the Exchange Act is recorded, processed, summarized, andreported within the time periods specified by the SEC’s rules and forms.At this time, management has determined that the Company’s current system ofdisclosure controls and procedures may not be sufficient i) to ensure that dataerrors, control problems, or acts of fraud are detected and ii) to confirm thatappropriate corrective action, including process improvements, is undertaken ina timely manner.

 

Attached as Exhibits 31.1and 31.2 to this Annual Report are certifications of the CEO and the CFO, whichare required in accordance with Rule 13a-14 of the Securities Exchange Act of1934 (the Exchange Act). This Controls and Procedures section includes theinformation concerning the controls evaluation referred to in thecertifications and it should be read in conjunction with the certifications.

 

We are in the process ofimplementing the requirements of Section 404 of the Sarbanes-Oxley Act of2002 which requires our management to assess the effectiveness of our internalcontrol over financial reporting and include an assertion in our 2007 annualreport as to the effectiveness of our internal controls over financialreporting. Subsequently, our independent registered public accounting firm,McGladrey & Pullen LLP, will be required to attest to whether ourassessment of the effectiveness of our internal controls over financialreporting is fairly stated in all material respects and separately report onwhether it believes we maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2007. We are in theprocess of performing the system and process documentation, evaluation andtesting required for management to make this assessment and for the registeredpublic accounting firm to provide its attestation report. We have not completedthis process or its assessment, and this process will require significantamounts of management time and resources. In the course of evaluation andtesting, management may identify deficiencies that would need to be addressedand remediated.

 

59

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

 

None

 

**PART III.**

 

**ITEM 10.****     ****DIRECTORS, EXECUTIVEOFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH 16(a).**

 

The names and ages, business experience and year in which each nomineewas first elected to the Board are shown below.

 
| **Name**                         | ** ** | **Age** | ** ** | **Principal Occupation and Business Experience**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **Year First  Elected Director** |
|----------------------------------|------------|---------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|
| •  *Insider Directors* |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| Henry J.  Boucher, Jr.           |       | 58      |       | •  Tesoro’s President since December 2001 and Chairman, Director, and Chief  Executive Officer since November 2002.•** **Tesoro’s subsidiaries: IWT Tesoro International  (International) Director since 2003, IWT Tesoro Transport President and  Director since 2003, and President and Director of The Tile Club since 2004.•** **Principal, Mentus Consulting LLC, a consulting firm since  January 2001.                                                                                                                                                                                                                                                                                                                                                       |       | 2001                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| Forrest P.  Jordan               |       | 59      |       | •Tesoro’s  Senior Vice President and Director since 2002 and Chief Financial Officer  since 2003.•** **Tesoro’s subsidiaries: International Wholesale Tile’s  Vice-President, Secretary, Treasurer, Director and Sales Manager since  April 1994, International Director since 2003, Transport Director since  2003, The Tile Club Director since 2004.                                                                                                                                                                                                                                                                                                                                                                                                                            |       | 2002                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| Paul F.  Boucher                 |       | 48      |       | •** **Tesoro’s Senior Vice President and Director since 2002.•** **Tesoro’s subsidiaries: President and Director of IWT  since 1994, International Director since 2003, The Tile Club Director since  2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | 2002                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| Grey Perna                       |       | 50      |       | •** **Tesoro’s Senior Vice President and Director since 2002.•** **Tesoro’s subsidiaries: Vice President and Director of IWT  since 1997, President and Director of International since 2003, Director of  The Tile Club since 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       | 2002                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| •  *Outside Directors* |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| James R.  Edwards                |       | 55      |       | •  Senior Vice President, General Counsel and Secretary of Wireless Facilities,  Inc. (NASDAQ: WFII), a telecommunications services and engineering company,  April 2004 to present.• Senior Legal  Counsel, Qualcomm Incorporated, a telecommunications company, from May 2003  to April 2004• Vice President,  General Counsel and Secretary of Wireless Knowledge, Inc., a  telecommunications company from March 2002 to May 2003• Vice President, General Counsel, Secretary  and Vice President of Finance & Administration for Vapotronics, a medical  device company from April 2000 to March 2002.• Tesoro – Board Member; Chairman,  Compensation Committee, Member, Nominating Committee, and Chairman of the  Independent Directors Committee. |       | 2002                                       |
|                             |       |    |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       |                                       |
| Carl G.  Anderson, Jr.           |       | 61      |       | •  Chairman of the Board, Chief Executive Officer and President of Arrow  International, Inc. (NMS:ARRO) a $450 million critical care medical device  company since 2002, Audit Committee Member and Board Member of Carpenter  Technology (NYSE: CRS) since August 2003.• President and CEO  of ABC School Supply between 1997 and 2002.• Tesoro – Board Member, Audit Committee  Member and Chairman of                                                                                                                                                                                                                                                                                                                                                                                         |       | 2002                                       |

 

60

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|                |   |   |   | Nominating and Governance Committee.                                                                                                                                                                                                                                                                                                                                                                                             |   |   |
|---------------------|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                             |   |   |
| Joseph A.  Equale   |   | 61     |   | •  Managing Partner of Equale & Cirone, LLP, a Connecticut CPA firm founded  in 1999.• Audit Committee Chair and Board Member and  Compensation Committee Member of Startech Environmental Corporation  (OTCBB:STHK), which provides waste management services.  Tesoro – Board Member and Chairman of Audit Committee                                                                                        |   | 2004   |
|                |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                             |   |   |
| Robert B.  Rogers   |   | 70     |   | • Chairman  Emeritus of Ewing Marion Kauffman Foundation since March 1999.  Tesoro- Board Member and Committee Member of the Audit Committee                                                                                                                                                                                                                                                                           |   | 2003   |
|                |   |   |   |                                                                                                                                                                                                                                                                                                                                                                                                                             |   |   |
| Allen G.  Rosenberg |   | 59     |   | •  Executive Vice President of Market Communications, a direct response agency  which he co-founded, since November 2004 and from 1979 to  January 2004, and January 2005 to the present.• Vice President of Marketing for Panolanm  Industries, a laminate manufacturing company, between February and  October 2004.• Tesoro – Board Member and member of the  Compensation Committee. |   | 2002   |

 

Paul Boucher and Henry J. Boucher, Jr. are brothers.

 

STOCKHOLDER COMMUNICATION WITH OUR BOARD

 

Stockholders interested in communicating with our Directors may writeto the Board of Directors c/o Henry J. Boucher, Jr., IWT Tesoro Corporation 191Post Road West, Suite 10, Westport, CT 06880. Management will forward allcorrespondence to the respective Board members, with the exception ofcommercial solicitations, advertisements or obvious “junk” mail. Concernsrelating to accounting, internal controls or auditing matters are to beimmediately brought to the attention of our Audit Committee, which will handlesuch matters with all procedures established by our Audit Committee and ourNominating and Governance Committee.

 

CORPORATE GOVERNANCE

 

**Code of Ethics**

 

In November 2002, Tesoro’s Board of Directors adopted a Code ofEthics for its executive officers, including its CEO and CFO and other personsperforming similar functions. The Code of Ethics are written standards that aredesigned to deter wrongdoing and promote

 

•      honest andethical conduct, including the ethical handling of actual and apparentconflicts of interest between personal and professional relationships;

 

•      full, fair,accurate, timely, and understandable disclosure in reports and documents that aregistrant files with, or submits to, the Commission and in other publics madeby us;

 

•      our complyingwith applicable governmental laws, rules and regulations;

 

•      our promptinternal reporting of violations of the code to appropriate persons; and

 

•      accountabilityfor adhering to the code.

 

In January 2005, the Code of Ethics was also incorporated into IWT’sEmployee Handbook, which was distributed to all employees. All new employeesreceive the Employee Handbook upon being hired.

 

In March 2003, our Board has also adopted “Principles of CorporateGovernance,” the full text of which can be found on our website atwww.iwttesoro.com. These principles include the standards for our Board andmanagement, which, include other things:

 

•****Requires an ethical Board, Chief Executive Officer andmanagement;

•****Sets forthour Directors’ and committee members’ qualification standards andresponsibilities;

•****Describes our management’s responsibilities to new Boardmembers;

 

61

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•****Enumerates the guidelines for our Board’s compensation;

•****Provide for access to our management and independentadvisors; and

•****Address succession planning for senior management.

 

**A COPY OF THE CODE OF ETHICS IS AVAILABLE ONTESORO’S WEBSITE AT** www.iwttesoro.com. We will alsoprovide, at no charge, a copy of its Code of Ethics, which can be obtained bycontacting Investor Relations, IWT Tesoro Corporation, 191 Post Road West,Suite 10, Westport, CT 06880, or call (203) 221-2770

 

**BOARD ANDCOMMITTEE MEETINGS**

 

*Board Meetings*

 

During fiscal year 2005, the Board of Directors held four meetings andall Directors attended at least 75% of all meetings. Our policy is to expecteach of our Board members or nominees to attend each of our Annual StockholdersMeetings, barring any reasonable conflicts. Seven of our nine Directors (eachof whom was also a nominee) attended our 2005 Annual Stockholders Meeting heldon May 7, 2005.

 

*Standing Committees*

 

In 2002, our Board formed an Audit Committee, a Compensation Committeeand a Nominating and Governance Committee. In January 2003, upon therecommendation of each of the Committees, our Board adopted separate chartersfor our Audit Committee, our Compensation Committee and our Nominating andGovernance Committee. Copies of each of the standing committee charters areavailable on our website at www.iwttesoro.com. All members of our standingcommittees are “independent”, as we described above.

 

*-Audit Committee*

 

As of the date of this Information Statement, our Audit Committeemembers are Joe Equale, Chair, Carl Anderson, and Bob Rogers. During fiscal2005, the Audit Committee held ten meetings.

 

Each of the members of the Audit Committee possess the required levelof financial literacy and currently, each member of the Committee meets thecurrent standards of requisite financial management expertise required byapplicable rules and regulations. The Audit Committee was established accordingto the definition of “audit committee” as described in the Exchange Act. Noneof the members of the Audit Committee have any relationship to Tesoro or any ofits subsidiaries or affiliates that may interfere with the exercise of theirindependence from management and the Company.

 

The Committee’s Chair, Joe Equale, Managing Partner of the CPA firm ofEquale & Cirone, LLP, and Immediate Past President and member of the Boardof Governors of the Connecticut Society of CPAs, meets the current standards ofthe “audit committee financial expert” required by applicable rules andregulations.

 

The Committee assists the Board of Directors in fulfilling itsoversight responsibility relating to (i) the integrity of Tesoro’s financialstatements, the financial reporting process, and the systems of internalaccounting and financial controls; (ii) the performance of Tesoro’s internalaudit function; (iii) the appointment, engagement and performance of theIndependent Public Accountants and the evaluation of their qualifications andindependence; and (iv) Tesoro’s compliance with ethics and confidentialinformation, policies and legal and regulatory requirements, including Tesoro’sdisclosure controls and procedures. Additionally, the Committee, consistentwith the Sarbanes-Oxley Act of 2002 and the related rules, as amended, meetswith management and the auditors prior to the filing of the Officers’certification with the SEC to receive information concerning, among otherthings, significant deficiencies in the design or operation of internalcontrols. The Independent Public Accountants report directly to the AuditCommittee.

 

The Audit Committee acts in accordance with a written charter adoptedby the Board of Directors. The Committee reviews this charter annually. ItsReport for 2005 follows the descriptions of Tesoro’s committees.

 

*-Compensation Committee*

 

The current Compensation Committee members are Jim Edwards, Chairman,and Allen Rosenberg, and four meetings were held in 2005.

 

The purpose of the Committee is discharge the Board’s responsibilitiesrelating to (1) compensating our executives, (2) approving and evaluating ourequity-based compensation plans, including our Stock Incentive Plan, and (3)making arrangements with executives Officers relating to their employmentrelationships.

 

The Committee is also responsible for producing an annual report onexecutive compensation, which is included in this Information 

 

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Statement, as well as assisting in the preparation of certaininformation to be included in other periodic reports filed with the SEC.

 

The Compensation Committee has overall responsibility for approving andevaluating our executive officer compensation plans, policies and programs. Inaddition, the Committee oversees, views and approves all of our ERISA and otheremployee plans.

 

*-Nominating and Governance Committee*

 

The current members of our Nominating and Governance Committee includeCarl Anderson, Chairman and Jim Edwards and three meetings of the Committeewere held during 2005.

 

The Committee is charged with reviewing the appropriate skills andcharacteristics required of Directors in the context of the then currentmake-up of the Board. Its assessment generally includes issues of judgment,diversity, age and skills (such as understanding of relevant technologies,business background, etc.) in the context of an assessment of the perceivedneeds of the Board at that time. The Committee makes an annual report of itsfindings to our Board. It also develops and recommends to the Board a set ofCorporate Governance guidelines.

 

The Committee is responsible for selecting individuals who stand forelection to our Board of Directors and to consider all reasonable comments fromour stockholders regarding proposed nominees for Directors, as well asnominations for Board members recommended by Stockholders.

 

The Board has adopted the following series of minimum qualificationsand specific qualities and skills for the Company’s directors, which will serveas the basis upon which potential director the Nominating Committee evaluatescandidates:

 

•      Integrity;

•      Commitment todevoting necessary time and attention to his or her duties to the Corporation;

•      Independence;

•      Businessexperience;

•      Specializedskills or experience;

•      Diversity ofbackground and experience (including race, ethnicity, international, gender andage);

•      Possibleconflicts of interest; and

•      Other criteriaappropriate to the character of the expertise or other director characteristicneeded on the Board in any specific situation.

 

This Committee considers recommendations for Board candidates submittedby stockholders using the same criteria it applies to recommendations fromdirectors and members of management. Subject to limitations our Amended andRestated Certificate of Incorporation, Amended and Restated By-Laws andapplicable law, stockholders may submit recommendations by writing to thisCommittee in care of IWT Tesoro Corporation, to the attention of the CorporateSecretary at 191 Post Road West, Suite 10, Westport, CT 06880.

 

To be considered by the Nominating and Corporate Governance Committeefor the 2005 annual meeting, recommendations for nominees must comply with thenotice requirements. The notice shall contain the following information:

 

•      The name of thenominating stockholders and the address, phone number and e-mail address atwhich the nominating stockholders can be contacted.

 

•      Evidence of thenumber of the Company’s Common Stock held by the nominating stockholders,  a statement of long the nominatingstockholder has held those shares,  and astatement that the nominating stockholders will continue to hold those sharesat least through our next annual meeting of stockholders.

 

•      The candidate’sfull name, together with the address, phone number and e-mail address at whichthe candidate can be contacted.

 

•      A statement ofthe candidate’s qualifications and experiences, and any other qualities thatthe nominating stockholders believe that the candidate would bring to the Board.

 

•      A description ofall arrangements or understandings, if any, between the stockholders and the candidateand any other person or persons with respect to the candidate’s proposedservice on the Board.

 

•      The candidate’sresume,  which must include at a minimuma detailed description of the candidate’s business,

 

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professional or other appropriate experiencefor a least the last ten (10) years, a list of other boards of directors ofpublic companies on which the candidate currently serves or on which he or sheserved in the last ten years, and undergraduate and post-graduate educationalinformation.

 

•      A written statement,signed by the candidate, agreeing that if he or she is selected by theCommittee and the board, he or she will (i) be a nominee for election to theboard, (ii) provide all information necessary for us to include in ourinformation statement or proxy statement under applicable SEC or OTCBBrules,  and (iii)  serve as a director if he or she is electedby stockholders.

 

•      Any additional informationthat the nominating stockholders believe is relevant to the Committee’sconsideration of the candidate.

 

The Nominating Committee did not receive any recommendations fromstockholders regarding candidates to serve on the Board for the 2005 AnnualStockholder Meeting.

 

**AUDITCOMMITTEE REPORT**

 

The role of the Audit Committee is to oversee management’s preparing,presenting and integrity of its financial statements. Management is alsoresponsible for our accounting and financial reporting principles and internalcontrols and procedures designed to assure that it is complying with accountingstandards and applicable laws and regulations. The independent auditors areresponsible for auditing Tesoro’s financial statements and expressing an opinionas to their conformity with accounting principles generally accepted in theUnited States. The purpose of the Audit Committee is to monitor theseactivities.

 

The Audit Committee meets with the independent auditors, with andwithout management present, to discuss the results of their examinations, theirevaluations of the Company’s systems of internal control, and the overallquality of the Company’s financial reporting. The Audit Committee reviewed theCompany’s internal controls with the Company’s independent auditors and,consistent with Section 302 of the Sarbanes-Oxley Act of 2002, as amendedand the rules adopted thereunder, met with management and the auditors prior tothe filing of officers’ certifications required by that statute to receive anyinformation concerning (a) significant deficiencies in the design or operationof internal controls which could adversely affect the Company’s ability torecord, process, summarize and report financial data and (b) any fraud, whetheror not material, that involves management or other employees who have asignificant role in the Company’s internal controls.

 

It is not the Audit Committee’s duty or responsibility to conductauditing or accounting reviews or procedures. Audit Committee members are notemployees of the Company and may not be, and may not represent themselves tobe, or to serve as, accountants or auditors by profession. Members of the AuditCommittee rely, without independent verification, on the information providedto them and on the representations made by management and the independentauditors.

 

In performing its oversight function, the Audit Committee hasconsidered and discussed the audited financial statements and unauditedquarterly financial statements with management and the independent auditors,including a discussion of the quality, not just the acceptability, ofaccounting principles, the reasonableness of significant judgments and theclarity of disclosures in the financial statements. The Audit Committee hasalso discussed with the independent auditors the matters required to bediscussed by Statement on Auditing Standards No. 61 (Communication with AuditCommittees) as currently in effect. The Committee has received the writtendisclosures and the letter from the independent auditors required byIndependence Standard No. 1, *Independence Discussionswith Audit Committees*, currently in effect, and has discussed withthe auditors the auditors’ independence from Tesoro and its management, andreviewed and approved the compatibility of non-audit services provided by theindependent accountants and approved the fees paid to them for the 2005 fiscalyear. These fees are listed below under Proposal No. 3 – To Ratify McGladrey& Pullen as Tesoro’s Independent Public Accountants.

 

The Audit Committee has adopted a policy regarding the pre-approval ofaudit and permitted non-audit services to be performed by Tesoro’s independentregistered public accounting firm, McGladrey & Pullen, LLP. The AuditCommittee will, on an annual basis, consider and, if appropriate, approve theprovision of audit and non-audit services provided by McGladrey. Thereafter,the Audit Committee will, as necessary, consider and, if appropriate, approvethe provision of additional audit and non-audit services by McGladrey, whichare not encompassed by the Audit Committee’s annual pre-approval and are notprohibited by law. The Audit Committee has delegated to the Chair of the AuditCommittee the authority to pre-approve, on a case-by-case basis, non-auditservices to be performed by McGladrey that are not encompassed by the AuditCommittee’s pre-approval and not prohibited by law, provided that the Chairshall report any decisions to pre-approve such services to the Audit Committeeat its next regular meeting. None of the engagements pre-approved by the AuditCommittee during 2005 made use of the de minimus exception to pre-approvalcontained in the applicable rules of the Securities and Exchange Commission.

 

Based upon the reports and discussions described in this report, and subjectto the limitations on the role and responsibilities of the Audit Committeereferred to above, the Audit Committee recommended to the Board that theaudited financial statements be included in the Company’s Annual Report on Form10-K for the year ended December 31, 2005 to be filed with the Securitiesand Exchange

 

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Commission. The Committee has also recommended to the Company’sshareholders to appoint McGladrey & Pullen LLP as Tesoro’s Independent RegisteredPublic Accounting Firm (auditors) for the 2006 fiscal year and to ratify themas Tesoro’s independent auditors for 2005.

 

The foregoing Audit Committee Report does not constitute solicitingmaterial and shall not be deemed to be filed or incorporated by reference intoany other Company filing under the Securities Act of 1933, as amended or theSecurities Exchange Act of 1934, as amended, except to the extent the Companyspecifically incorporates this Audit Committee Report by reference therein.

 

**Joseph A.Equale, Chairman**

**Carl G.Anderson Jr.**

**RobertRogers**

 

**SECTION 16(a) BENEFICIAL OWNERSHIPREPORTING COMPLIANCE**

 

Section 16(a) of the Securities Exchange Act of 1934, as amended,requires our Executive Officers, Directors and 10% Shareholders to file reportsregarding initial ownership and changes in ownership with the SEC. ExecutiveOfficers, Directors, and 10% shareholders are required by SEC regulations tofurnish us with copies of all Section 16(a) forms they file. Ourinformation regarding compliance with Section 16 is based solely on areview of the copies of such reports furnished to us by our Executive Officers,Directors and 10% shareholders. These forms include (i) Form 3, which is theInitial Statement of Beneficial Ownership of Securities, (ii) Form 4, which isa Statement of Changes in Beneficial Ownership, and (iii) Form 5, which is anAnnual Statement of Changes in Beneficial Ownership.

 

Based on information provided to the Company, all required filings forfiscal year 2005 have been made.

 

**ITEM 11.****     ****EXECUTIVE COMPENSATION**

 

The information described in our discussion concerning “ExecutiveOfficers” includes Henry J. Boucher, Jr., Paul Boucher, Forrest Jordan and GreyPerna.

 

**Summary Compensation Table**

 

 
| ** **                                     | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                         | ** ** | ** **                                    | ** ** | **Long-Term Compensation** | ** ** | ** **                       | ** ** |
|------------------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------------|------------|-----------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
|                                           |       |       |       |                         |       |                               |       |                                          |       | **Awards**                      |       | **Payouts**                      |       |   |   |
| ** **                                     | ** ** | ** ** | ** ** | **Annual Compensation** | ** ** | **Restricted  Stock  Awards  ($)** | ** ** | **Securities  Underlying  Options/  SARs(A)** | ** ** | **LTP  Payouts ($)**       | ** ** | **All Other  Compensation** | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** **                   | ** ** | **Bonus  ($)**                     | ** ** | **Other Annual  Compensation  ($)**      | ** ** | ** **                      | ** ** | ** **                       | ** ** |
| ** **                                     | ** ** | ** ** | ** ** | ** **                   | ** ** | ** **                         | ** ** | ** **                                    | ** ** | ** **                      | ** ** |
| **Name and Principal Position** | ** ** | **Year**   | ** ** | **Salary**                   | ** ** | ** **                         | ** ** | ** **                                    | ** ** | ** **                      | ** ** |
|                                           |       |       |       |                         |       |                               |       |                                          |       |                            |       |                             |       |   |   |   |   |
| Henry J. Boucher,  Jr.,                        |       | 2005       |       | $                            | 240,000    |                               | -0-        |                                          | $          | 18,450                          | (1)        |                             |       | -0- |   |   |   |   |   |
| Chairman,  Director, President                 |       | 2004       |       | $                            | 240,000    |                               | -0-        |                                          | $          | 18,292                          | (2)        | —                           |       | 33,334 | (13) | 0 |   |   |   |
| Chief Executive  Officer                       |       | 2003       |       | $                            | 240,000    |                               | $          | 25,000                                        |       | $                               | 18,000     | (3)                              | —     |   | 66,667 | (14) | 0 |   | 0 |   |
|                                           |       |       |       |                         |       |                               |       |                                          |       |                            |       |                             |       |   |   |   |   |
| Paul F. Boucher,                               |       | 2005       |       | $                            | 263,066    |                               | -0-        |                                          | $          | 37,033                          | (4)        |                             |       | -0- |   |   |   |   |   |
| Director, Senior  Vice President               |       | 2004       |       | $                            | 263,066    |                               | -0-        |                                          | $          | 37,719                          | (5)        | —                           |       | 33,334 | (13) | 0 |   |   |   |
|                                           |       | 2003       |       | $                            | 263,066    |                               | $          | 25,000                                        |       | $                               | 40,150     | (6)                              | —     |   | 66,667 | (14)  | 0 |   | — |   |
|                                           |       |       |       |                         |       |                               |       |                                          |       |                            |       |                             |       |   |   |   |   |
| Forrest Jordan,                                |       | 2005       |       | $                            | 253,067    |                               | -0-        |                                          | $          | 43,995                          | (7)        |                             |       | -0- |   |   |   |   |   |
| Director, Senior  Vice President               |       | 2004       |       | $                            | 253,067    |                               | -0-        |                                          | $          | 43,407                          | (8)        | —                           |       | 33,334 | (13) | 0 |   |   |   |
|                                           |       | 2003       |       | $                            | 253,067    |                               | $          | 25,000                                        |       | $                               | 42,374     | (9)                              | —     |   | 66,667 | (14)  | 0 |   | — |   |
|                                           |       |       |       |                         |       |                               |       |                                          |       |                            |       |                             |       |   |   |   |   |
| Grey Perna, ,                                  |       | 2005       |       | $                            | 253,067    |                               | -0-        |                                          | $          | 45,108                          | (10)       |                             |       | -0- |   |   |   |   |   |
| Director, Senior  Vice President               |       | 2004       |       | $                            | 253,097    |                               | -0-        |                                          | $          | 46,258                          | (11)       | —                           |       | 33,334 | (13) | 0 |   |   |   |
|                                           |       | 2003       |       | $                            | 253,067    |                               | $          | 25,000                                        |       | $                               | 49,558     | (12)                             | —     |   | 66,667 | (14)  | 0 |   | — |   |

 

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(1)           Includes an automobileallowance of $18,000 and automobile fringe benefit of $450.00

 

(2)           Includes an automobileallowance of $18,000 and an automobile fringe benefit of $292.

 

(3)           Includes an automobileallowance of $18,000.

 

(4)           Includes an automobileallowance of $9,105, an automobile fringe benefit of $2,611 and payment of$25,317 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(5)           Includes an automobileallowance of $10,372, an automobile fringe benefit of $2,030 and payment of$25,317 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(6)           Includes an automobileallowance of $12,914, an automobile fringe benefit of $1,919 and payment of$25,317 for an Executive Life Insurance policy with his spouse as beneficiary.

 

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(7)           Includes an automobileallowance of $7,412, an automobile fringe benefit of $2,972 and payment of$33,610 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(8)           Includes an automobileallowance of $7,415, automobile fringe benefits of $2,382 and payment of$33,610 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(9)           Includes an automobileallowance of $7,413, automobile fringe benefits of $1,351 and payment of$33,610 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(10)         Includes an automobileallowance of $15,051 and payment of $30,056 for an Executive Life Insurancepolicy with his spouse as beneficiary.

 

(11)         Includes an automobileallowance of $9,552, an automobile fringe benefit of $6,650 and payment of$30,056 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(12)         Includes an automobileallowance of $9,551, an automobile fringe benefit of $9,949 and payment of$30,058 for an Executive Life Insurance policy with his spouse as beneficiary.

 

(13)         These represent incentivestock options grated on December 18th, 2004 pursuant to our StockIncentive Plan. The options are for five years and have an exercise price of$2.48 per share. Twenty percent of the options will vest on the firstanniversary of the grant date and an additional 20% will vest thereafter oneach anniversary date thereafter, subject to forfeiture in the event thatTesoro no longer employs the executive. .

 

(14)         These represent incentivestock options granted as of November 23, 2002 pursuant to our StockIncentive Plan. The options are for five years and have an exercise price of$3.00 per share.

 

**Option/SAR Grants in Last Fiscal Year**

 

No options were granted to any of the four named executives.

 

**Aggregated Option/SAR Exercises in LastFiscal Year and FY-End Option/SAR Values**

 

No options were exercised in 2005 by any person, including any of thefour named executives, each of whom hold options to acquire up to 100,000shares ranging from $3.00 per share to $2.48 per share. None of the optionswere in-the-money at December 31, 2005.

 
| ** **            | ** ** | **Shares  Acquired on   Exercise** | ** **              | ** ** | ** **                      | **Number of  Securities  Underlying  Unexercised  Options/SARs at  Fiscal year end** | ** **                      | **Value of  Unexercised  In-the-money  Options/SARs at  Fiscal year end (1)** | ** ** |
|-----------------------|------------|-----------------------------------------|-------------------------|------------|---------------------------------|----------------------------------------------------------------------------------------------------------|---------------------------------|--------------------------------------------------------------------------------------------------------|------------|
| **Name**              | ** ** | ** **                              | **Value Realized** | ** ** | **Exercisable/  Unexercisable** | ** **                                                                                               | **Exercisable/  Unexercisable** | ** **                                                                                             |
| Henry J. Boucher, Jr. |       | -0-                                     |                    | -0-        |                            | 73,333/26,667                                                                                            |                            | 0/0                                                                                                    |       |
| Paul F. Boucher       |       | -0-                                     |                    | -0-        |                            | 73,333/26,667                                                                                            |                            | 0/0                                                                                                    |       |
| Forrest Jordan        |       | -0-                                     |                    | -0-        |                            | 73,333/26,667                                                                                            |                            | 0/0                                                                                                    |       |
| Grey Perna            |       | -0-                                     |                    | -0-        |                            | 73,333/26,667                                                                                            |                            | 0/0                                                                                                    |       |

 

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(1)           At December 31,2005, none of the options held by the Named Executive Officers werein-the-money.

 

The Company sponsors a 401(k) plan known as the International WholesaleTile 401(k) Profit Sharing Plan & Trust. The Profit Sharing Plan providestax deferred salary deductions for eligible employees. Employees may contributefrom 1% to 12% of their annual compensation to the Plan, limited to an annualmaximum amount as set periodically by the Internal Revenue Service. The Companyprovides matching contributions equal to 100% of the employee’s contributionsup to a maximum of 3% of eligible pay. The contribution expense related to thePlan amounted to $168,901 and $120,492 for the years ended December 31,2005 and 2004, respectively.

 

**Tesoro Stock Incentive Plan.**

 

In 2001, the then Director and Stockholder recommended and adopted the2001 Tesoro Stock Incentive Plan (the “Plan”). Below is a summary of the Plan:

 

Under the Plan, we may grant “non-qualified” and incentive stockoptions to purchase, as well as restricted stock (Awards). The

 

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aggregate maximum number of shares for which Awards may be issued underthe Plan is 4.0 million shares.

 

Our Compensation Committee currently controls and manages the Plan’soperation and administration. The Committee has discretion to:

 

•      Determine thetypes, terms and conditions of all Awards, including exercise price or purchaseprice (if any), performance goals, and other earn-out and/or vestingcontingencies and acceleration provisions,

•      Adopt, alter orrepeal administrative rules, guidelines and practices (including specialguidelines for non-U.S. employees),

•      Delegateadministrative responsibilities,

•      Construe andinterpret the Plan’s terms and any agreements evidencing Awards granted.

 

Our Board has authority to grant stock options to Non-EmployeeDirectors according to the Plan. All awards are subject to the terms of awritten agreement between the participant and us.

 

In January 2004, all the shares underlying the Plan wereregistered and those shares already issued were registered for resale, pursuantto a Form S-8.

 

Through December 31, 2005, 1,876,192 options were granted, ofwhich 145,133 have expired or been forfeited and 409,883 were vested. Theseoptions have exercise prices ranging from $2.55 to $6.00 per share and areexercisable for periods between five to ten years. Additionally, 184,900restricted shares were issued under the Plan.

 

**Directors’ Compensation**

 

Currently, Outside Board Members receive the following:

 

•      10,000 sharesupon accepting the Board appointment;

•      A stipend of$1,000 per Director per meeting attended;

•      A stipend of$1,000 per Director per committee meeting attended (with the exception of theChair of the Audit Committee, who willreceive a stipend of $1,500 per meeting);

•      A stipend of $500 per Director per committeemeeting attended telephonically.

•      Reimbursement of out of pocket expensesincurred by each Director in order to attend a meeting (spouse costs includedfor annual stockholder/ Board meeting only); and

•      10,000 optionsto acquire shares of common stock at the fair market value per each fullcalendar year of service, of which 50% vest on the grant date and the remaining50% vest on the anniversary of the grant date, providing that the Director isstill serving in that capacity.

 

Insider Directors do not receive any compensation for their services assuch.

 

**Compensation Committee Interlocks and InsiderParticipation**

 

No member of our compensation committee has ever been an executiveofficer or employee of Tesoro or any of its subsidiaries. None of our executiveofficers currently serve, or has served during the last completed fiscal year,on any Standing Committee or as board of directors of any other entity that hasone or more executive officers serving as a member of our board of directors orcompensation committee.

 

**BOARD COMPENSATION COMMITTEE REPORT ONEXECUTIVE COMPENSATION**

 

General Compensation Policy.

 

The Compensation Committee administers the Corporation’s executivecompensation program, which is intended to provide incentives to executiveofficers to achieve both current and long-term strategic management goals ofthe Corporation, with the ultimate objective of achieving a superior return onthe shareholders’ investment. To this end, the program is comprised of cash andequity-based components, which recognize performance as measured against theCorporation’s annual and long-term goals as well as performance evaluated incomparison to industry peers.

 

Equity-based compensation, including the Stock Incentive Plan,encourages ownership and retention of the Corporation’s common stock by keyemployees, assuring that they have a meaningful stake in the Corporation’scontinued success and thereby aligning the interests of these employees andshareholders.

 

The executive compensation program is designed to assist theCorporation in achieving its business objectives by: maintaining a 

 

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competitive compensation program to attract and retain qualifiedexecutives; providing performance-based incentive compensation that is directlyrelated to the Corporation’s financial performance and individual contributionsto that performance; and linking compensation to factors, which affectshort-term and long-term stock performance.

 

The manner in which the Committee establishes the compensation andincentives of each of Tesoro’s executive officers listed in the SummaryCompensation Table is described below.

 

Cash Compensation.

 

The Compensation Committee determined the annual cash compensation paidto the Corporation’s executive officers for 2004, consisting of salary andincentive compensation. The salaries paid to the executive officers named inthe Summary Compensation Table for 2004 are shown in the “Salary” column ofthat Table. These salaries were subjectively determined after consideration ofthe executive officer’s individual responsibilities, performance, experience,the chief executive officer’s evaluation of the other executive officers, areview of several measurements of the Corporation’s short-term and long-termfinancial results compared with industry peers, and other factors such asbudgetary considerations and inflation rates.

 

The incentive compensation in the form of stock option were granted andvested pursuant to the Stock Incentive Plan, which incorporates modernincentive plan techniques and executive retention features for the purpose ofclosely aligning the interests of executives with those of shareholders. Typically,the Committee may assign to certain or all executive officers a target bonus. Theparticipant’s incentive compensation is based on accomplishment of specificperformance levels set forth in stock option or incentive agreements.

 

On November 23, 2002, the Committee granted incentive stock optionspursuant to the Plan to purchase up to 100,000 shares at $3.00 per to each ofthe four executive officers. The options are for ten years and have an exerciseprice is $3.00 per share. The options vested as follows: (a) 33% at such timeas our Common Stock begins trading on the OTCBB (or equivalent), (b) 33% atsuch time as Tesoro attains no less than a $50.0 million market cap for tenconsecutive trading days, and (c) 34% when Tesoro achieves its 2003 revenue andprofit targets, as approved by Tesoro’s Board of Directors. Of the threecriteria, all four executive officers achieved (a) and (b), but not (c). Assuch, options to purchase up to 66,667 shares vested on December 31, 2003to each of the executive officers.

 

On December 18, 2004, the Committee also granted 33,333 options toeach of the four executive officers at an exercise price of $3.00 per share. Twentypercent of the options will vest on the first anniversary of the grant date andan additional 20% will vest thereafter on each anniversary date thereafter,subject to forfeiture in the event that Tesoro no longer employs the executive...

 

Other Compensation.

 

The executive officers are also covered by medical plans that aregenerally applicable to full-time employees of the Corporation and its subsidiaries.They also receive automobile allowances and payment of life insurance policies.

 

The above report is submitted by:

 

**JamesEdwards, Chairman**

**AllenRosenberg**

 

**Employment and Consulting Agreements**

 

**Henry J. Boucher, Jr.**OnDecember 29, 2001, Tesoro entered into an employment agreement with Henryto serve as Tesoro’s President. In consideration for his services, and underthe terms of his employment agreement, Henry received an annual salary of$120,000. He had signed a Salary Deferral Agreement that was later terminatedby Tesoro’s Board, with Henry abstaining. All his deferred salary was paid toHenry Boucher in December 2002. He also received a monthly car allowanceof $1,500. Henry Boucher’s employment may be terminated for cause at any timeand within 30 days without cause. He is subject to non-disclosure andnon-compete provisions.

 

On March 27, 2003, the Board of Directors voted to increase theterm of Henry Boucher’s employment agreement from one year to three years andto increase his salary to $240,000 per year at such time as a registrationstatement to register certain securities became effective, which occurred onJune 17, 2003. At that time, the salary became retroactive as ofJanuary 1, 2003. The Board also voted to issue Mr. Boucher a $25,000 bonusfor 2002.

 

**Forrest Jordan.**EffectiveOctober 2, 2002, IWT entered into an employment agreement with Forrest forone year, renewed automatically unless terminated by IWT not less than ninetydays prior to the expiration of the term. In consideration for his services,Forrest Jordan receives a salary of $253,000 per year. He also receives amonthly car allowance of $1,500. Forrest Jordan also receives a life insurancepolicy whose beneficiary is his family and such other compensation as determinedby the Compensation Committee. He is subject to non-disclosure and non-competeprovisions. On March 27, 2003, the Board of Directors voted to increase 

 

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the term of his employment agreement from one year to three years andto issue Forrest Jordan a $25,000 bonus for 2002.

 

**Paul F. Boucher.**PaulBoucher’s employment agreement is substantially the same as that of ForrestJordan’s, with the exception that he receives an annual salary of $263,000. OnMarch 27, 2003, the Board of Directors voted to increase the term of hisemployment agreement from one year to three years and to issue Paul Boucher a$25,000 bonus for 2002.

 

**Grey Perna.**GreyPerna’s employment agreement is substantially the same as that of ForrestJordan’s. On March 27, 2003, the Board of Directors voted to increase theterm of his employment agreement from one year to three years and to issue GreyPerna a $25,000 bonus for 2002.

 

**Performance Graph**

 

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

 
| ** **                      | ** ** | **FISCAL YEAR ENDING** | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| **COMPANY/INDEX/MARKET**        | ** ** | **12/23/2003**                   | ** ** | **12/31/2003** | ** ** | **12/31/2004** | ** ** | **12/30/2005** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **IWT  Tesoro Group**           | ** ** | **100.00**                       | ** ** | **100.00** | ** ** | **41.67** | ** ** | **45.00** | ** ** |
| **General  Building Materials** | ** ** | **100.00**                       | ** ** | **100.00** | ** ** | **123.60** | ** ** | **132.25** | ** ** |
| **NASDAQ  Market Index**        | ** ** | **100.00**                       | ** ** | **100.00** | ** ** | **100.60** | ** ** | **110.79** | ** ** |

 

ASSUMES $100 INVESTED ON DEC.23, 2003ASSUMES DIVIDEND REINVESTEDFISCAL YEAR ENDING DEC. 31, 2005

 

**ITEM 12.****     ****SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The following table sets forth information with respect to thebeneficial ownership of our Common Stock as of April 24, 2006 for:

 

•      Each person whowe know beneficially owns more than 5% of our Common Stock;

•      Each of ourDirectors and nominees for election to the Board;

•      Each of thenamed Executive Directors; and

•      All of ourDirectors and Executive Officers as a group.

 

“Beneficial Ownership” is a technical term broadly defined by theSecurities and Exchange Commission to mean more than ownership in the usualsense. For example, you “beneficially” own Common Stock not only if you hold itdirectly, but also if you hold it indirectly (though a relationship, a positionas a director or trustee, or a contract or understanding), or have (or share thepower to vote the stock or sell it) the right to acquire it within 60 days.Except as disclosed in the footnotes below, each of the Executive Officers,Directors and Nominees for Directors listed have sole voting and investmentpower over his or its shares. As of April 24, 2006, there were 11,926,900shares of Company Stock issued and outstanding (no shares of Preferred Stockwere issued and outstanding) and approximately 278 holders of record.

 
| **Name(1)**                  | ** ** | **Current Title**                                                                                                                                                                                                            | ** ** | **Shares  Beneficially  Owned** | ** ** | **Percent  of  Class** | ** ** |
|------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------------|------------|
| Henry J.  Boucher, Jr.       |       | •  Tesoro: Chairman, President, Chief Executive Officer,• IWT Tesoro  International Ltd.: Director• IWT Tesoro  Transport, Inc.: President and Director• The Tile Club,  Inc., President, Director, Secretary |       | 832,434                         | (2)(3)     | 6.9                    | %          |
|                         |       |                                                                                                                                                                                                                              |       |                            |       |                   |       |
| James R.  Edwards(4)(5)      |       | Tesoro: Director                                                                                                                                                                                                                  |       | 70,000                          | (6)(7)     |                   | *          |
|                         |       |                                                                                                                                                                                                                              |       |                            |       |                   |       |
| Joseph A.  Equale (8)        |       | Tesoro: Director                                                                                                                                                                                                                  |       | 20,000                          | (9)        |                   | *          |
|                         |       |                                                                                                                                                                                                                              |       |                            |       |                   |       |
| Carl G.  Anderson, Jr.(5)(8) |       | Tesoro: Director                                                                                                                                                                                                                  |       | 95,000                          | (6)(10)    |                   | *          |
|                         |       |                                                                                                                                                                                                                              |       |                            |       |                   |       |
| Robert B.  Rogers(8)         |       | Tesoro: Director                                                                                                                                                                                                                  |       | 42,000                          | (6)(11)    |                   | *          |
|                         |       |                                                                                                                                                                                                                              |       |                            |       |                   |       |
| Allen G.  Rosenberg(4)       |       | Tesoro: Director                                                                                                                                                                                                                  |       | 45,000                          | (6)        |                   | *          |

 

69

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| Paul F.  Boucher                                                                          |   | •  Tesoro: Director, Senior Vice President• IWT: President,  Director• IWT Tesoro International  Ltd.: Director• IWT Tesoro  Transport: Director• The Tile Club,  Inc.: Director |   | 3,104,334 | (2)(12)(13) | 25.9   | %      |
|-------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|-------------|--------|--------|
|                                                                                      |   |                                                                                                                                                                                                      |   |      |        |   |   |
| Forrest P.  Jordan                                                                        |   | •  Tesoro: Senior Vice President, Director• IWT: Senior Vice  President, Treasurer, Secretary, Director• IWT Tesoro  International Ltd.: Director• The Tile Club,  Inc.: Director     |   | 3,073,334 | (2)(12)     | 25.6   | %      |
|                                                                                      |   |                                                                                                                                                                                                      |   |      |        |   |   |
| Grey Perna                                                                                |   | •  Tesoro: Director, Senior Vice President• IWT: Senior Vice  President, Director• IWT Tesoro  International Ltd.: President, Director• The Tile Club:  Director                      |   | 3,073,334 | (2)(12)     | 25.6   |   |
|                                                                                      |   |                                                                                                                                                                                                      |   |      |        |   |   |
| All Current  Officers, Directors and Nominees for Director; as a Group (nine persons)(14) |   |                                                                                                                                                                                                      |   | 9,896,100 |        | 82.35  | %      |
|                                                                                      |   |                                                                                                                                                                                                      |   |      |        |   |   |
| Laurus  Master Fund, Ltd.                                                                 |   |                                                                                                                                                                                                      |   | 2,364,018 | (15)        | 16.8   | %      |

 

----

*Less than 1%.

 

(1)           Theaddress for each of Tesoro’s Directors, Nominees for Directors and ExecutiveOfficers is 191 Post Road West, Suite 10, Westport, CT 06880.

 

(2)           Includesoptions to purchase up to 73,334 shares at $3.00 per share.

 

(3)           Includes3,000 shares held in IWT’s 401(k) Plan.

 

(4)           Memberof the Compensation Committee.

 

(5)           Memberof the Nominating and Governing Committee.

 

(6)           Includes35,000 incentive stock options, of which (a) 10,000 are vested and which areexercisable at $3.00 per share through December 31, 2012, (b) 10,000 optionsare vested and exercisable at $6.00 per share through January 10, 2014, (c)10,000 are vested and which are exercisable at $2.55 per share through January11, 2015, and (d) 5,000 are vested and which are exercisable at $2.50 per sharethrough January 6, 2016.

 

(7)           Alsoincludes (i) warrants to purchase up to 7,500 shares at $5.25 per share throughJanuary 7, 2008 and (ii) 17,500 shares of which Mr. Edwards is trustee.

 

(8)           Memberof the Audit Committee.

 

(9)           Includes15,000 incentive options, of which (a) 10,000 are vested and which areexercisable at $2.55 per share through January 11, 2015, and (b) 5,000 arevested and which are exercisable at $2.50 per share through January 6, 2016.

 

(10)         Includes warrants to purchase up to10,000 shares at $5.25 per share through March 10, 2008.

 

(11)         Includes25,000 incentive stock options, of which (a) 10,000 options are vested andexercisable at $6.00 per share through January 10, 2014, (b) 10,000 are vestedand which are exercisable at $2.55 per share through January 11, 2015, and (c)5,000 are vested and which are exercisable at $2.50 per share through January6, 2016. Also includes warrants to purchase up to 3,500 shares at $7.00 pershare. .

 

(12)         IWT’sinstitutional lender requires that during the term of its loan, Paul Boucher,Grey Perna and Forrest P. Jordan will not allow their aggregate beneficiallyownership interest in Tesoro to be less than 51%.

 

(13)         Includes30,000 shares held by Mr. Boucher’s minor children.

 

(14)         Includesonly stockholdings as of the record date and does not give include anyderivative securities.

 

(15)         Includesoptions to purchase up to 1,170,110 shares at $.001 per share, warrants topurchase up to 511,881 shares at $3.15 per

 

70

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share, and warrants to purchase up to 460,829shares at $2.39 per share.

 

**ITEM 13.****     ****CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS**

 

Each of the three principal stockholders ofthe Company, Forrest P. Jordan, Grey Perna and Paul F. Boucher as payees, heldpromissory notes from IWT in the principal amounts of $ 88,712, $119.975 and$129,975, respectively, for a total of $338,662. On August 20, 2005, allobligations due to each of these stockholders were satisfied in full.

 

**ITEM 14.****               ****PRINCIPAL ACCOUNTANT FEES AND SERVICES.**

 

**Audit Fees**

 

Total audit fees for audit services rendered during 2005 by McGladreywere $349,837.

 

McGladrey was our principal accountant and reported on and audited thefinancial statements prepared by us for the period commencingSeptember 10, 2004 and for the fiscal year ended 2004. Total audit feesfor audit services rendered during 2004 were $241,694, which includes thereview of the financial information included in our Form 10Q for the periodended September 30, 2004.

 

For purposes of the following disclosure, fees paid to KSO and itspredecessor Sewell have been combined and noted only as KSO.

 

The aggregate fees for professional services rendered by KSO for itsquarter reviews from January 1, 2004 through September 13, 2004 andfor the fiscal year ended December 2003 was $72,250 and for taxpreparation was $4,450, for a total of $76,700.

 

KSO was our principal accountant and reported on and audited thefinancial statements prepared by Tesoro for the fiscal year 2003 and continuingthrough September 14, 2004. Total fees paid to KSO and Sewell for auditservices rendered during 2004 and 2003 were $72,250 and $175,325 and,respectively and tax preparation for 2004 through September 14, 2004 andfor 2003 was $4,450 and $6,500, respectively. These amounts total $76,700 and$178,825, respectively.

 

**Audit-Related Fees**

 

Fees for audit-related services during 2005 and 2004 provided byMcGladrey were $0 and $0, respectively.

 

Fees paid to KSO for audit-related services rendered for 2004 and 2003were $0 and $0, respectively.

 

**Tax Fees.**

 

Fees for tax services provided by McGladrey in fiscal year 2005 andfrom September 14, 2004 through December 31, 2004 was $191,643 and $0,respectively.

 

Fees paid to KSO for tax services rendered through September 14,2004 and for 2004 were $4,450 and $6,550, respectively. These fees relatedprimarily to preparing federal and state tax returns and other tax consultingservices.

 

**All Other Fees.**

 

Fees for all other services rendered by McGladrey for fiscal year endedDecember 31, 2005 and from September 14 through December 31, 2004 was $0 and$0, respectively.

 

Total fees paid to KSO all other services rendered throughSeptember 14, 2004 and during 2003 were $12,000 and $6,386, primarilyrelated to business review of controls surrounding systems implementation,audit committee meetings and other similar services.

 

**Audit Committee Pre-Approval Policies andProcedures**

 

Our Audit Committee has considered whether the provision of the abovedescribed services is compatible with maintaining with both McGLADREY and KSO’sindependence for the periods described and believes the providing services isnot incompatible with maintaining such independence. Our Audit Committee hasapproved all fees described above. Additionally, the Audit Committee hasapproved appointing McGladrey as our independent auditors for fiscal year 2005according to the Audit Committee’s pre-approval policies and procedures.

 

**Financial Information Systems Design andImplementation Fees**

 

The Company has not engaged either KSO or McGladrey to provide adviceto the Company regarding financial information systems design andimplementation.

 

71

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**ITEM15.****      EXHIBITS and FINANCIAL STATEMENT SCHEDULES**

 

**(a)**           **Documents filed as part ofthis report:**

 

(1)   Financial Statements

 

Referenceis made to the Index to Consolidated Financial Statements of IWT TesoroCorporation under Item 8 of Part II hereof.

 

(2)   Consolidated Financial Statement Schedules

 

        (i)            Report Of Independent RegisteredPublic Accounting Firm on Financial Statement Schedule:

 

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

 

                                                Kantor,Sewell and Oppenheimer - as of December 31, 2003 and each of the years inthe two year period then ended.

 

        (ii)           Schedule II - Consolidated Valuationand 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)                                     |
| 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,                                                     |

 

72

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|   |   | 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, and on  May 10, 2006). |
| 10.32  |   | Amended and Restated Registration Rights Agreement dated May 3,  2006 between IWT Tesoro Corporation and Laurus Master Funds, Ltd. (filed as  an exhibit to the Company’s periodic report on Form 8-K, filed with the  Securities and Exchange Commission on May 8, 2006).                                                                                                                                  |
| 10.33  |   | Form of Securities Purchase Agreement dated May 3, 2006  between Tesoro and Laurus Master Fund dated May 3, 2006 (filed as an  exhibit to the Company’s periodic report on Form 8-K, filed with the  Securities and Exchange Commission on May 9, 2006).                                                                                                                                          |
| 10.34  |   | Form of Common Stock Purchase Warrant by Tesoro in favor of  Laurus Master Funds., Ltd. (filed as an exhibit to the Company’s periodic  report on Form 8-K, filed with the Securities and Exchange Commission on  May 9, 2006).                                                                                                                                                                             |
| 10.35  |   | Amended and Restated Registration Rights Agreement dated May 3,  2006 between IWT Tesoro Corporation and Laurus Master Funds, Ltd. (filed as  an exhibit to the Company’s periodic report on Form 8-K, filed with the  Securities and Exchange Commission on May 9, 2006).                                                                                                                                  |
| 10.36  |   | Reaffirmation and Ratification Agreement dated May 3, 2006 by  Tesoro and its subsidiaries (filed as an exhibit to the Company’s periodic  report on Form 8-K, filed with the Securities and Exchange Commission on  May 9, 2006).                                                                                                                                                                          |
| 10.37  |   | Second Amended and Restated Senior Subordination Agreement between  Laurus Master Fund, Ltd. and Bank of                                                                                                                                                                                                                                                                                                                        |

 

73

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|   |   | 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).                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 13     |   | Annual report to security holders*                                                                                                                                                                                                                             |
| 16     |   | Letter  from Kantor Sewell & Oppenheimer, P.A., concurring with statements  concerning their resignation (filed as an exhibit to the Company Report on Form 8-K  filed with the Securities and Exchange Commission on September 14,  2004). |
| 21     |   | Subsidiaries of Registrant (filed as an Exhibit to  the Company registration statement on Form S-1, filed with the  Securities and Exchange Commission on September 21, 2005                                                                    |
| 31.1   |   | Certification of Henry J. Boucher, Jr., Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act.*                                                                                                                                 |
| 31.2   |   | Certification of Forrest Jordan, Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act.*                                                                                                                                             |
| 32.1   |   | Certification of Henry J. Boucher, Jr., Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                 |
| 32.2   |   | Certification of Forrest Jordan, Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act.*                                                                                                                                             |

 

----

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

 

74

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SIGNATURES

 

Inaccordance with Section 13 or 15(d) of the Exchange Act of 1934, theCompany caused this Registration Statement to be signed on its behalf by theundersigned thereunto duly authorized.

 

IWTTESORO CORPORATION

 

 
| By:                                                                                                                                                                          | /s/ Henry J. Boucher, Jr.        |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|--------|
|                                                                                                                                                                         | Henry J. Boucher, Jr., President |
|                                                                                                                                                                         |
| Date: May 19, 2006                                                                                                                                                           |
|                                                                                                                                                                         |
| 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.                                                                                                                                               | May 19, 2006                          |
| Henry J. Boucher, Jr., Principal Executive Officer                                                                                                                      |
|                                                                                                                                                                         |
| /s/ Forrest Jordan                                                                                                                                                           | May 19, 2006                          |
| Forrest Jordan, Principal Financial Officer                                                                                                                                  |
|                                                                                                                                                                         |
| /s/ Henry J. Boucher, Jr.                                                                                                                                               | May 19, 2006                          |
| Henry J. Boucher, Jr., Director                                                                                                                                         |
|                                                                                                                                                                         |
| /s/ James R. Edwards, Director                                                                                                                                               | May 19, 2006                          |
| James Edwards, Director                                                                                                                                                      |
|                                                                                                                                                                         |
| /s/ Paul F. Boucher                                                                                                                                                          | May 19, 2006                          |
| Paul F. Boucher, Director                                                                                                                                                    |
|                                                                                                                                                                         |
| /s/ Forrest Jordan                                                                                                                                                           | May 19, 2006                          |
| Forrest Jordan, Director                                                                                                                                                     |
|                                                                                                                                                                         |
| /s/ Grey Perna                                                                                                                                                               | May 19, 2006                          |
| Grey Perna, Director                                                                                                                                                         |
|                                                                                                                                                                         |
| /s/ Joseph Equale                                                                                                                                                            | May 19, 2006                          |
| Joseph Equale, Director                                                                                                                                                      |
|                                                                                                                                                                         |
| /s/ Allen Rosenberg                                                                                                                                                          | May 19, 2006                          |
| Allen Rosenberg, Director                                                                                                                                                    |
|                                                                                                                                                                         |
| /s/ Carl G. Anderson, Jr.                                                                                                                                               | May 19, 2006                          |
| Carl G. Anderson, Jr., Director                                                                                                                                         |
|                                                                                                                                                                         |
| /s/ Robert Rogers                                                                                                                                                            | May 19, 2006                          |
| Robert Rogers, Director                                                                                                                                                      |
|                                                                                                                                                                              |                                       |        |  |

 

75

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## **REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

## **ONFINANCIAL STATEMENT SCHEDULE**

 

 

To the Board of Directors

IWT Tesoro Corporation and Subsidiaries

Westport, Connecticut

 

Our audits of the consolidated financial statements referred to in ourreport dated March 1, 2006, except for Note 16, as to which the date is May 12,2006, (included elsewhere in this Annual Report on Form 10K) also includedthe consolidated financial statement Schedule II for the years ended December 31,2005 and 2004.  This Schedule is theresponsibility of IWT Tesoro’s management. Our responsibility is to express an opinion based on our audits of theconsolidated financial statements.

 

In our opinion, the financial statement schedule, when considered inrelation to the basic consolidated financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.

 
| **/S/McGLADREY & PULLEN,  LLP** | ** ** |
|------------------------------------------|------------|

 

 

New Haven, Connecticut

March 1, 2006, except for Note 16,

  as to which the date is May 12,2006

 

 

McGladrey &Pullen, LLP is a member firm of RSM International,

an affiliationof separate and independent legal entities.

 

S-1

----

 

Schedule II

 

**IWT TESORO CORPORATION AND SUBSIDIARIES**

**CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS**

**YEARS ENDED DECEMBER 31, 2005 , 2004 AND 2003**

 

 
| ** **                                           | ** ** | **Balance**      | ** ** | **Additions**  | ** ** | ** **         | ** ** | **Balance** | ** ** |
|------------------------------------------------------|------------|------------------|------------|----------------|------------|--------------------|------------|-------------|------------|
| ** **                                           | ** ** | **at Beginning** | ** ** | **Charged**    | ** ** | ** **         | ** ** | **at End**  | ** ** |
| **Description**                                      | ** ** | **of Year**      | ** ** | **to Expense** | ** ** | **Deductions (1)** | ** ** | **of Year** | ** ** |
|                                                 |       |             |       |           |       |               |       |        |       |
| Year ended  December 31, 2003 (as restated):    |       |             |       |           |       |               |       |        |       |
| Allowance for returns, claims and doubtful  accounts |       | $                | 83,245     |           | 259,581    |               | 167,826    |        | $          | 175,000 |   |
|                                                 |       |             |       |           |       |               |       |        |       |
| 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 |   |

 

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(1)Represents charge offs, net of recoveries,to the valuation account

 

S-2

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