HUMBL, INC. - Quarter Report: 2006 June (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

o                                 TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

Commission File No. 0-31267

IWT TESORO CORPORATION

(Exact name of registrant as specified in its charter)

 

101 Post Road West, Suite 10, Westport, CT  06880

(Address of principal executive offices)

(203) 221-2770

(Registrant’s telephone number, including area code)

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

x Yes  oNo

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

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

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

 

IWT TESORO CORPORATION AND SUBSIDIARIES
FORM 10-Q
For the Six months ended June 30, 2006
INDEX

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

 

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PART 1 — FINANCIAL INFORMATION

ITEM 1:                   FINANCIAL STATEMENTS

IWT TESORO CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)

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

 

See notes to the consolidated interim financial statements.

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IWT TESORO CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

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

 

See notes to the consolidated interim financial statements.

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IWT TESORO CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
(Unaudited)

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

 

See notes to the consolidated interim financial statements.

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IWT TESORO CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

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

 

See notes to the consolidated interim financial statements.

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IWT TESORO CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
SIX MONTHS ENDED JUNE 30, 2006

NOTE 1.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include IWT Tesoro Corporation and its wholly owned subsidiaries International Wholesale Tile, Inc., IWT Tesoro International, Ltd, IWT Tesoro Transport, Inc. and The Tile Club, Inc and The Tile Club, Inc.’s wholly owned subsidiary Import Flooring Group, Inc. All significant inter-company balances and transactions have been eliminated in consolidation.

Basis of Presentation

The interim financial information included herein is unaudited; however, such information reflects all adjustments, which are, in the opinion of management, necessary for a fair presentation of the Company’s financial position, results of operations, changes in stockholders’ equity and cash flows for the interim periods. All such adjustments are of a normal, recurring nature. The results of operations for the first six months of the year are not necessarily indicative of the results of operations which might be expected for the entire year.

The accompanying consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Rule 10-10 of Regulation S-X of the Securities and Exchange Commission. Accordingly certain information and footnote disclosure required by accounting principles generally accepted in the United States of America for complete financial statements have been omitted. These condensed financial statements should be read in conjunction with the Company’s financial statements and notes thereto included in the Company’s audited financial statements on Form 10-K, for the fiscal year ended December 31, 2005.

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

Earnings per Share

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

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The following table reflects the calculation of basic and diluted earnings per share:

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

 

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

 

Income Taxes

The Company recognizes income taxes under the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and loss carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Segment Information

The Company has adopted SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires those enterprises to report selected information about operating segments in interim financial reports issued to stockholders. The Company’s revenues are all from floor covering products and services sold throughout the United States with no single customer accounting for more than 10% of net sales. There fore the Company operates in one segment for management reporting purposes.

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Reclassifications

Certain amounts in the 2005 financial statements have been reclassified for comparative purposes to conform to the 2006 presentation. These reclassifications had no effect on net income.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004) (“SFAS No. 123R”), “Share-Based Payment,” which requires that the compensation cost relating to share-based payment transactions be recognized in the financial statements. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123R requires all share-based payments to employees be valued using a fair value method on the date of grant and expensed based on that fair value generally over the applicable vesting period. SFAS No. 123R also amends SFAS No. 95 “Statement of Cash Flows,” requiring the benefits of tax deductions in excess of recognized compensation cost be reported as financing cash inflow rather than as a reduction of taxes paid. In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107, (“SAB No. 107”) which expresses the SEC’s views regarding the interaction between SFAS No. 123R and certain SEC rules and regulations and, accordingly, provides guidance related to share-based payment transactions for public companies. The Company adopted SFAS 123R on January 1, 2006 and its adoption did not have a material effect on our consolidated results of operations, financial position or cash flows. The Company’s compensation expense for the three and six months ended June 30, 2006 was approximately $30,400 and $60,100, respectively, as further described in Note 11. The financial impact of any stock options granted is determined using the Black-Scholes option-pricing model with the following assumptions: option price, dividend yield, expected volatility, risk free interest rate and the expected life.

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

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NOTE 2   LIQUIDITY AND PROFITABILITY CONSIDERATIONS

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

Profitability

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

Liquidity

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

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

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

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

Summary

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

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NOTE 3   RESTRUCTURING

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

In connection with this restructuring plan IFG incurred the following costs:

1.               One-Time Termination Benefits of $30,400 as severance pay to satisfy the employment contract of a former IFG sales person.

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

3.               Other Associated Costs of approximately $493,000, of which $357,035 is the difference between the value of the assets and liabilities surrendered in the agreement with the former IFG salesperson.to purchase certain assets and liabilities of Import Flooring Group, Inc. The Company also incurred attorney’s fees of approximately $22,000 and $113,000 related to the write off on a non-refundable deposit for inventory.

The Company accounted for restructuring costs pursuant to Statement of Financial Accounting Standards (SFAS” No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, as opposed to when there is a commitment to a restructuring plan. Through the second quarter of 2006, the Company recorded a restructuring charge in the amount of approximately $585,700 in connection with the restructuring activities which includes the recognition of a liability of $11,450 for other associated costs incurred, however unpaid as of June 30, 2006. The Company does not anticipate incurring any additional costs with respect to this restructure. Restructuring charges are reflected in a separate line item in the accompanying consolidated statements of operations.

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NOTE 4   INVENTORIES

Inventories consisted of the following:

 

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

NOTE 5   PROPERTY AND EQUIPMENT

Property and equipment consisted of the following:

 

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

NOTE 6   NOTES PAYABLE, REVOLVING LINE OF CREDIT

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

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

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NOTE 7   NOTES PAYABLE — CONVERTIBLE DEBT

On February 10, 2006, the Company issued a secured convertible term note in the amount of $2,000,000 resulting in net proceeds of $1,919,500. Interest accrues on the principal balance of the note at an annual interest rate equal to prime plus 2.0%, payable monthly in arrears commencing on March 1, 2006. On June 30, 2006, the interest rate was 10.25%. The note requires monthly principal payments of $66,667 commencing on August 1, 2006 and continuing until maturity. The note matures on February 10, 2009. The note is convertible into common stock of the Company at a fixed conversion rate of $2.17 per share. Based upon the closing price per share of the Company’s common stock on the date of issuance, there was a beneficial conversion feature with an estimated intrinsic value of $553,593, which is presented as a discount on the note to be amortized into expense over the three year term of the loan using the effective interest method. In connection with the convertible note, the Company issued to the holder of the note a seven-year warrant to purchase 460,829 shares of the Company’s common stock at an exercise price of $2.39 per share. The Company estimated the fair value of the warrant and allocated $455,943 of the proceeds of the debt to the warrant which is presented as a discount on the note to be amortized into interest expense over the three-year term of the note using the effective interest method. The aggregate discount allocated to the beneficial conversion feature and the options and warrants was recorded as additional paid in capital at June 30, 2006. The fair value of the warrant was estimated at the date of issuance using the Black-Scholes option-pricing model using the following assumptions: risk-free rate of 4.59%, dividend yields of 0%, and a volatility factor of the expected market price of the Company’s common stock of 58.2%. The Company also issued to the holder, 221,198 shares of the Company’s common stock as prepayment of interest in the amount of $486,636, which was calculated based upon the closing price per share of the Company’s common stock on the date of issuance of $2.20 per share. The prepaid interest is presented as a discount on the note to be amortized into interest expense over the three year term using the effective interest method.

On August 25, 2005, the Company issued a secured convertible revolving note in the aggregate amount of $5,000,000 resulting in net proceeds of $4,733,000 after debt issuance costs of $267,000. Interest accrues on the principal balance of the note at an annual interest rate equal to prime plus 1.5%. On June 30, 2006, the interest rate was 9.75%. The note matures on August 25, 2008. The note is convertible into common stock of the Company at an initial conversion rate of $2.74 per share. Because the agreement contains certain non-standard anti-dilution provisions and requirements to settle any conversion option with registered shares, the Company is required to account for the conversion option as an embedded derivative requiring separate accounting treatment in accordance with SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities. Based upon the closing 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 and classified $2,068,317 as a derivative liability that is adjusted to fair value at each reporting date with changes in fair value reported in earnings. In connection with the convertible notes, the Company issued to the holder of the note a five-year warrant to purchase 511,883 shares of the Company’s common stock at an exercise price of $3.15 per share and an option to purchase 1,170,110 shares of the Company’s common stock at an exercise price of $0.001 per share. Based upon the closing price per share of the Company’s common stock on the date of issuance, the Company estimated the fair value of the warrant and option and classified $3,099,835 and $692,334, respectively, as derivative liabilities that are adjusted to fair value at each reporting date with changes in fair value reflected in operations. The estimated fair value of the derivative liabilities as of June 30, 2006 is $1,607,229. This is a decrease in fair value of $4,347,233 from the value as of December 31, 2005. This decrease is primarily due to the decrease in the Company’s closing stock prices as of June 30, 2006 compared to the closing stock price as of December 31, 2005. The Company has recognized this change in fair value as other income in the Consolidated Statement of Operations for the six months ended June 30, 2006. The fair values of the options, warrants, and embedded conversion option was estimated at the date of issuance using the Black-Scholes option-pricing model using the following weighted average assumptions: risk-free rate of 4.06%, dividend yields of 0%, and volatility factors of the expected market price of the Company’s common stock of 60.79%.

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

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

 

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

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

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

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

The holder of the note has agreed 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 beneficial ownership of the Company’s common stock to exceed 4.99%, without 120 days prior notice, or 19.199%, without stockholder approval.

NOTE 8   NOTES PAYABLE – OTHER

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

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

 

NOTE 9   STOCKHOLDERS’ EQUITY

Common Stock

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

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

NOTE 10   INCOME TAXES

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

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

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

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

 

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

 

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

NOTE 11   STOCK-BASED COMPENSATION

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

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

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

As a result of adopting SFAS No. 123R on January 1, 2006, during the three and six month periods ended June 30, 2006, the Company recognized additional compensation costs of $30,437 and $29,715, respectively. The adoption of SFAS No. 123R had no impact on basic and diluted earnings per share for the six months ended June 30, 2006.

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

 

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

 

The assumptions above are based on multiple factors, including historical exercise patterns of employees in relative homogeneous groups with respect to exercise and post-vesting employment termination behaviors, expected future exercising patterns for these same homogenous groups and the implied volatility of our stock price.

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

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

 

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

 

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

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

 

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

 

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NOTE 12   SUBSEQUENT EVENT

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

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

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

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

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

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

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

·                  The Tile Club, Inc., formed in 2004, was organized to acquire licensing, manufacturing and distribution rights for high-end designer and artistic based decorative tiles and to also act as an agent for foreign manufacturers from whom IWT has acquired exclusive distribution rights.

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

Our principal 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 be found at http://www.iwttesoro.com.  Information contained on our web site is not part of this report.

RESTRUCTURING

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

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

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

Results of Operations for the three months ended June 30, 2006, 2005 and 2004.

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto that appear elsewhere in this document. The table below sets forth certain operating data for the periods indicated. Percentages are relative to total revenue for the periods indicated.

 

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

Net sales for the three months ended June 30, 2006 increased $2,623,354 or approximately 18.3% over the reported net sales for the three months ended June 30, 2005. This growth follows a 23.6% increase in net sales for the three months ended June 30, 2005 over the three months ended June 30, 2004. Management believes that the lower growth for the three months ended June 30, 2006 was due to a general softening in the new home construction and remodeling activity in the United States. A trend the Company expected. Standard and Poor’s July 6, 2006 survey of the home building industry reports that “Data through April 2006 suggests that new home sales, though still close to record levels, have begun to trend downward”. However, the report goes on to say “We do not view the United States home building industry as operating with a bubble that is now expected to burst”. The Company is continuing to increase its market share of the $2.86 billion wholesale hard surfaces market by expanding geographical operations and expects to maintain a strong growth rate.

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

 

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

Results of Operations for the Six Months ended June 30, 2006, 2005 and 2004

The following discussion and analysis should be read in conjunction with the financial statements and notes thereto that appear elsewhere in this document. The table below sets forth certain operating data for the periods indicated. Percentages are relative to total revenue for the periods indicated.

 

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

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

Gross margin for the six months ended June 30, 2006 decrease to 36.4% of net sales compared to 38.5% of net sales for the six months ended June 30, 2005. Gross profit was impacted by higher than expected cost of goods sold relating to the start up of the Company’s agency based subsidiary, Import Flooring Group Inc. and a larger percentage of truckload sales. The Company has restructured the operations of Import Flooring Group and expects to return to an approximate 38 % gross profit sales ratio.

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

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

Changes in Financial Position for the six months ended June 30, 2006 from the year ended December 31, 2005

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

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

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

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

Liquidity and Capital Resources

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

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

Net cash used in investing activities during the six months ended June 30, 2006 was approximately $406,400 compared to $107,600 for the six months ended June 30, 2005. Capital expenditures consisted of tile finishing equipment to enhance our breadth of products offered.

Net cash provided by financing activities during the six months ended June 30, 2006 was approximately $4.5 million, provided through the issuance of convertible debt of $2.0 million and the issuance of term debt of $2.0. This compared to $5.6 million during the six months ended June 30, 2005. The decrease is primarily attributable to a slightly slower growth rate. The cash provided by these financing activities was used to fund our continued sales growth and our geographical expansion.

During the six months ended June 30, 2006, we issued a $2,000,000 convertible term note to an institutional investor as more fully described in Note 7 to the consolidated financial statements and a $2,000,000 term note to an institutional investor as more fully described in Note 8 to the consolidated financial statements. The notes are subordinate to a revolving credit line with our commercial lender. The combination of these notes and our revolving credit facilities provides us with up to $34 million of working capital. We expect that this debt will be sufficient to support our normal growth in accounts receivable and inventory through 2006. However, our growth through geographical expansion and acquisition is expected to continue to require us to seek additional outside capital to supplement earnings and to strengthen our balance sheet. We expect to raise additional equity through both the public and private debt and equity markets during 2006. However, we cannot assure anyone that we will be able to obtain outside capital, or if we do, that it will be on terms beneficial to us.

The balance due at June 30, 2006 for our subordinated debt was $9 million. The balance due at June 30, 2006 to our commercial lender for the use of the revolving line of credit was approximately $23.2 million. The loan and security agreement contains certain covenants, which include financial covenants that require us to maintain a certain leverage ratio, limit our unfunded capital expenditures, a required minimum fixed charge coverage ratio, and a certain inventory turnover ratio. At June 30, 2006 the Company was not in compliance with two of these covenants and obtained a waiver from its commercial lender.

Critical Accounting Policies

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

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We believe that our application of accounting policies, and the estimates that are inherently required by these policies, are reasonable. We believe that significant accounting policies are described in Note 1 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K, for the year ended December 31, 2005 and the stock-based compensation expense policy adopted January 1, 2006 may involve a higher degree of judgment and complexity.

Stock-based compensation expense

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

Forward-Looking Information

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

ITEM 3 — QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Quantitative and Qualitative Disclosures about Market Risk

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

ITEM 4 — CONTROLS AND PROCEDURES

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

Based on that evaluation, Tesoro’s principal executive officer and principal financial officer have concluded that its disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified by the SEC’s rules and forms. At this time, management has determined that the Company’s current system of disclosure controls and procedures are sufficient i) to ensure that data errors, control problems, or acts of fraud are detected and ii) to confirm that appropriate corrective action, including process improvements, is undertaken in a timely manner.

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