##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended July 31, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from _________ to _________
 Commission File No. 0-24015
 STEELCLOUD, INC.
  VIRGINIA
(State or other jurisdiction of incorporation or 
organization)
    
    54-1890464
(I.R.S. Employer Identification No.)
 14040 Park Center Road, Herndon, VA
(Address of principal executive offices)
    
    20171
(Zip code)
 
   þ o
  o o þ
  o þ




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##### 



Description
    
    PagePart I. Financial InformationItem 1. Financial Statements
    
    
    1Consolidated Balance Sheets as of October 31, 2005 and July 31, 2006
    
    
    1Consolidated Statements of Operations for the three and nine month periods ended July 31, 2005 and 2006
    
    
    2Consolidated Statements of Cash Flows for the nine month periods ended July 31, 2005 and 2006
    
    
    3Notes to the Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3. Quantitative and Qualitative Disclosures About Market Risks
    
    
    21Item 4. Controls and Procedures
    
    
    21Part II. Other Information
    
    
    22Item 1. Legal Proceedings
    
    
    22Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    22Item 3. Defaults Upon Senior Securities
    
    
    22Item 4. Submission of Matters to a Vote of Security Holders
    
    
    22Item 5. Other Information
    
    
    23Item 6. Exhibits
    
    
    23




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##### 



PART I. FINANCIAL INFORMATION
 ITEM 1. FINANCIAL STATEMENTS
 STEELCLOUD, INC.
CONSOLIDATED BALANCE SHEET
 October 31,
    
    
    July 31,2005
    
    
    2006(unaudited)ASSETSCurrent assetsCash and cash equivalents
    
    $
    6,657,367
    
    
    $
    3,406,060Accounts receivable, net
    
    
    5,777,154
    
    
    
    4,526,928Inventory, net
    
    
    1,218,596
    
    
    
    857,337Prepaid expenses and other current assets
    
    
    264,968
    
    
    
    361,711Deferred contract cost
    
    
    94,549
    
    
    
    226,416Total current assets
    
    
    14,012,634
    
    
    
    9,378,452Property and equipment, net
    
    
    1,255,666
    
    
    
    1,134,114Equipment on lease, net
    
    
    698,285
    
    
    
    459,060Goodwill and other intangible assets, net
    
    
    4,571,992
    
    
    
    Deferred tax asset
    
    
    400,000
    
    
    
    Other assets
    
    
    114,060
    
    
    
    61,967Total assets
    
    $
    21,052,637
    
    
    $
    11,033,593LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilitiesAccounts payable
    
    $
    3,467,028
    
    
    $
    2,126,115Accrued expenses
    
    
    982,149
    
    
    
    1,143,795Notes payable, current
    
    
    70,952
    
    
    
    47,631Unearned revenue
    
    
    310,940
    
    
    
    277,025Total current liabilities
    
    
    4,831,069
    
    
    
    3,594,566Notes payable, long-term
    
    
    63,088
    
    
    
    32,855Other,
including severance obligations
    
    
    161,166
    
    
    
    461,964Total long-term liabilities
    
    
    224,254
    
    
    
    494,819Stockholders equityPreferred stock, $.001 par value: 2,000,000 shares authorized, no shares
issued and outstanding at October 31,
2005 and July 31, 2006
    
    
    
    
    
    
    Common stock, $.001 par value: 50,000,000 shares authorized,
14,449,271 and 14,609,274 shares issued
at October 31, 2005 and July 31, 2006,
respectively
    
    
    14,449
    
    
    
    14,609Additional paid in capital
    
    
    49,579,868
    
    
    
    49,781,987Treasury stock, 400,000 shares at
October 31, 2005 and July 31, 2006,
respectively
    
    
    (3,432,500
    )
    
    
    (3,432,500
    )Accumulated deficit
    
    
    (30,164,503
    )
    
    
    (39,419,888
    )Total stockholders equity
    
    
    15,997,314
    
    
    
    6,944,208Total liabilities and stockholders equity
    
    $
    21,052,637
    
    
    $
    11,033,593
  1




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##### 



STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
 Three Months Ended
    
    
    Nine Months EndedJuly 31,
    
    
    July 31,2005
    
    
    2006
    
    
    2005
    
    
    2006RevenuesProducts
    
    $
    7,970,288
    
    
    $
    5,374,379
    
    
    $
    24,282,772
    
    
    $
    16,865,230Services
    
    
    751,878
    
    
    
    611,839
    
    
    
    2,351,557
    
    
    
    1,961,063Total revenues
    
    
    8,722,166
    
    
    
    5,986,218
    
    
    
    26,634,329
    
    
    
    18,826,293Cost of revenuesProducts
    
    
    6,019,563
    
    
    
    4,265,321
    
    
    
    17,815,640
    
    
    
    13,652,289Services
    
    
    553,451
    
    
    
    509,672
    
    
    
    1,615,767
    
    
    
    1,567,320Total cost of revenues
    
    
    6,573,014
    
    
    
    4,774,993
    
    
    
    19,431,407
    
    
    
    15,219,609Gross profit
    
    
    2,149,152
    
    
    
    1,211,225
    
    
    
    7,202,922
    
    
    
    3,606,684Selling and marketing
    
    
    450,061
    
    
    
    701,856
    
    
    
    1,259,654
    
    
    
    1,914,008Research and product development
    
    
    208,405
    
    
    
    151,346
    
    
    
    599,700
    
    
    
    457,152General and administrative
    
    
    1,451,026
    
    
    
    1,338,523
    
    
    
    4,475,820
    
    
    
    4,546,921Amortization of other intangible
assets
    
    
    28,778
    
    
    
    28,778
    
    
    
    86,335
    
    
    
    86,335Severance and restructuring costs
    
    
    
    
    
    
    839,642
    
    
    
    
    
    
    
    839,642Impairment of goodwill and other
intangibles
    
    
    
    
    
    
    4,485,657
    
    
    
    
    
    
    
    4,485,657Income (loss) from operations
    
    
    10,882
    
    
    
    (6,334,577
    )
    
    
    781,413
    
    
    
    (8,723,031
    )Other (income) expenseInterest (income), net
    
    
    (10,205
    )
    
    
    (12,750
    )
    
    
    (22,276
    )
    
    
    (42,007
    )Other expense
    
    
    
    
    
    
    174,361
    
    
    
    
    
    
    
    174,361Total other (income) expense
    
    
    (10,205
    )
    
    
    161,611
    
    
    
    (22,276
    )
    
    
    132,354Income (loss) before income taxes
    
    
    21,087
    
    
    
    (6,496,188
    )
    
    
    803,689
    
    
    
    (8,855,385
    )Provision for income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    400,000Net income (loss)
    
    
    21,087
    
    
    
    (6,496,188
    )
    
    
    803,689
    
    
    
    (9,255,385
    )Earnings (loss) per share:Basic earnings (loss) per share
    
    $
    0.01
    
    
    $
    (0.46
    )
    
    $
    0.06
    
    
    $
    (0.66
    )Diluted earnings (loss) per share
    
    $
    0.01
    
    
    $
    (0.46
    )
    
    $
    0.06
    
    
    $
    (0.66
    )Weighted-average shares outstanding,
basic
    
    
    13,981,101
    
    
    
    14,209,274
    
    
    
    13,899,857
    
    
    
    14,119,089Weighted-average shares outstanding,
diluted
    
    
    14,581,143
    
    
    
    14,209,274
    
    
    
    14,481,124
    
    
    
    14,119,089
  2




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##### 



STEELCLOUD, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
 Nine Months EndedJuly 31,2005
    
    
    2006Operating activitiesNet income (loss)
    
    $
    803,689
    
    
    $
    (9,255,385
    )Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    661,378
    
    
    
    494,909Stock-based compensation
    
    
    
    
    
    
    85,811Impairment of goodwill and other intangibles
    
    
    
    
    
    
    4,485,657Provision for income taxes
    
    
    
    
    
    
    400,000Changes in operating assets and liabilities:Accounts receivable
    
    
    4,700,018
    
    
    
    1,250,226Inventory
    
    
    2,597,866
    
    
    
    361,259Prepaid expenses and other assets
    
    
    74,126
    
    
    
    (44,650
    )Deferred contract costs
    
    
    (25,422
    )
    
    
    (131,867
    )Accounts payable
    
    
    (2,574,797
    )
    
    
    (1,340,913
    )Unearned revenue
    
    
    (49,064
    )
    
    
    16,003Accrued expenses and other liabilities
    
    
    158,356
    
    
    
    412,526Net cash provided by (used in) operating activities
    
    
    6,346,150
    
    
    
    (3,266,424
    )Investing activitiesPurchase of property and equipment
    
    
    (1,542,172
    )
    
    
    (47,797
    )Financing activitiesProceeds from exercise of common stock options
    
    
    237,870
    
    
    
    116,468Payments on notes payable
    
    
    (53,987
    )
    
    
    (53,554
    )Net cash provided by financing activities
    
    
    183,883
    
    
    
    62,914Net increase (decrease) in cash and cash equivalents
    
    
    4,987,861
    
    
    
    (3,251,307
    )Cash and cash equivalents at beginning of period
    
    
    3,108,941
    
    
    
    6,657,367Cash and cash equivalents at end of period
    
    $
    8,096,802
    
    
    $
    3,406,060Supplemental cash flow informationInterest paid
    
    $
    5,457
    
    
    $
    866Income taxes paid
    
    $
    
    
    
    $
    
  3




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##### 



STEELCLOUD, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Nature of Business and Basis of Presentation
    TM TM TM
   2. Reclassification
 Reporting
Revenue Gross as a Principal versus Net as an Agent.
 4




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Fiscal Year ended
    
    Fiscal Year endedOctober 31, 2004
    
    October 31, 2005Total revenue as reported
    
    $
    28,169,205
    
    
    $
    36,474,657Total revenue (resale of software
maintenance and support contracts
reported as net revenue)
    
    $
    26,900,254
    
    
    $
    34,525,138Total cost of goods sold as reported
    
    $
    21,996,481
    
    
    $
    27,863,509Total cost of goods sold (resale of
software maintenance and support
contracts reported as net revenue)
    
    $
    20,727,530
    
    
    $
    25,913,990
   3. Management Change and Restructuring
    5




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##### 



4. Goodwill
  5. Significant Accounting Policies
 Deferred Tax Assets
 Accounting for Income Taxes
 6. Employee Stock Options
 Share-Based Payment
 6




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##### 



Accounting
for Stock Issued to Employees Accounting for Stock Based
Compensation Accounting for Stock-Based CompensationTransition and
Disclosure
 Three Months Ended
    
    Nine Months EndedJuly 31, 2005
    
    July 31, 2005Net income   as reported
    
    $
    21,087
    
    
    $
    803,689Add: compensation expense recorded
under APB No. 25
    
    
    
    
    
    
    Deduct: SFAS 123R compensation expense
    
    
    720,965
    
    
    
    1,420,267Net loss  pro forma
    
    $
    (699,878
    )
    
    $
    (616,578
    )Net earnings (loss) per share:Basic  as reported
    
    $
    0.01
    
    
    $
    0.06Basic  pro forma
    
    $
    (0.05
    )
    
    $
    (0.04
    )Diluted  as reported
    
    $
    0.01
    
    
    $
    0.06Diluted  pro forma
    
    $
    (0.05
    )
    
    $
    (0.04
    )
  Three months ended
    
    Nine months endedOptions
    
    ESPP
    
    Options
    
    ESPPJuly 31, 2005
    
    July 31, 2005
    
    July 31, 2005
    
    July 31, 2005Expected term (years)
    
    
    5
    
    
    
    
    
    
    
    5
    
    
    
    0.50Expected stock price volatility
    
    
    87.5
    %
    
    
    
    
    
    
    87.5
    %
    
    
    45.4
    %Risk-free interest rate
    
    
    3.69
    %
    
    
    
    
    
    
    3.69
    %
    
    
    3.13
    %
 Incentive Stock Option Plans
  7




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##### 



Weighted-Weighted-
    
    
    AverageAverage
    
    
    RemainingExercise
    
    
    ContractualShares
    
    
    Price
    
    
    Term (in years)Outstanding at October 31, 2005
    
    
    2,448,910
    
    
    $
    1.99Options granted
    
    
    
    
    
    
    Options exercised
    
    
    (135,000
    )
    
    
    0.59Options canceled or expired
    
    
    (1,665,360
    )
    
    
    2.18Outstanding at July 31, 2006
    
    
    648,550
    
    
    $
    1.81
    
    
    
    2.31Exercisable at July 31, 2006
    
    
    570,800
    
    
    $
    1.73
    
    
    
    2.20
    Options Outstanding
    
    Options ExercisableWeighted-
    
    Average
    
    
    
    
    
    Weighted-Average
    
    Remaining
    
    
    
    
    
    AverageNumber
    
    Exercise
    
    Contractual
    
    Number
    
    ExerciseRange of Exercise Prices
    
    Outstanding
    
    Price
    
    Life
    
    Outstanding
    
    Price$0.55-$1.75
    
    
    281,050
    
    
    $
    1.06
    
    
    
    1.05
    
    
    
    277,050
    
    
    $
    1.06$1.76-$4.50
    
    
    367,500
    
    
    
    2.38
    
    
    
    3.28
    
    
    
    293,750
    
    
    
    2.37$0.55-$4.50
    
    
    648,550
    
    
    $
    1.81
    
    
    
    2.31
    
    
    
    570,800
    
    
    $
    1.73
  8




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Employee Stock Purchase Plan
  Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option
 Three MonthsEnded
    
    Nine Months EndedJuly 31, 2006
    
    July 31, 2006Expected term (years)1
    
    
    
    
    
    
    0.50Expected stock price volatility2
    
    
    
    
    
    
    42.6
    %Risk-free interest rate3
    
    
    
    
    
    
    4.81
    %
 
 1
    
    - Expected term.Expected term for ESPP awards is equal to the vesting period of
the award.2
    
    - Expected stock price volatility.Expected stock price volatility for ESPP
awards is calculated using the weighted average of the Companys historical volatility over
the expected term of the award.3
    
    - Risk-free interest rate.The risk-free interest rate is calculated based on
the U.S Treasury yield curve on the grant date and the expected term of the award.  7. Operating Leases
   8. Debt
  9




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9. Deferred Revenue
  10. Earnings Per Share
  11. Segment Reporting
 Disclosures about Segments of an Enterprise and Related Information
 12. Significant Customer
  10




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
   11




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OVERVIEW
    TM TM TM
  Recent Developments
      
    
    Strategic Alliances  The Company continues to strengthen its partnerships with
industry leaders such as Intel and Microsoft. Management believes both of these firms
desire to leverage SteelClouds access and presence in the federal market space and the
Company, in turn, needs Intels and Microsofts latest technology and marketing
strength.
 12




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
    
    Product Leadership  SteelCloud is collaborating with Intel to develop and market a
new line of server solutions targeted for the Department of Defense. The products are
based on ATCA. On June 12, 2006 the Company and Intel unveiled these products at its
new Solutions Center located at Steelcloud headquarters in Herndon, VA. Intel Business
Development and other ATCA industry participants attended the grand opening. Federal
Integrators from all over the country are being encouraged by Intel, other ATCA vendors
and national distributors to use this Center and more importantly, SteelCloud, to
capture new government business.
    
    Loyal Customers  SteelCloud is working on creating deep and lasting relationships
with new integrators and ISVs. Over the last five years, the Company has done business
with hundreds of customers. The Company will focus on further developing and nurturing
these customers in order to promote new sales and broaden the repeat customer base. In
the past, the Company had a strong dependence on a few customers. In the future, the
Company will strive to reduce this dependence through the addition of new customers.
    
    Sales & Marketing  In June 2006, the Company hired David FitzHugh, who has over 25
years of significant IT industry experience, as Vice President of Marketing. Mr.
FitzHugh is spearheading the Companys marketing thrust into the Federal marketplace.
In August 2006, Mitch Turpyn, an experienced sales and business development executive
in the federal market space, was named SteelCloud Vice President of Sales. Mr. Turpyn
is reshaping the sales organization to focus on its core federal integrator and ISV
businesses. The Company believes a solid sales and marketing infrastructure is
mandatory for building market share and attracting new customers. Resources will
continue to be added in this organization as this is a very critical initiative.
    
    Market Focus  In light of the Company direction to concentrate on Federal
integrators and ISVs, the Company closed its Fort Lauderdale, FL sales office and
ceased sales and marketing operations on July 31, 2006. The Florida operation was
focused on selling third-party products and consulting services to commercial end users
which are not priorities in Companys strategic direction. All
research and development
activities that were being conducted in the Florida office have been
transferred to the Companys research and development department at corporate
headquarters in Herndon, VA.
  Federal Integrator and ISV Business
    13




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TM
   End User Solutions
  Research and Development
 TM TM TM TM
   Significant Customer Contracts
  14




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Notices from Nasdaq
    CRITICAL ACCOUNTING POLICIES
  Revenue Recognition
 Revenue
Recognition in Financial Statements, corrected copy
    15




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##### 



Reporting Revenue
Gross as a Principal versus Net as an Agent
   Deferred Tax Assets
 Accounting for Income Taxes
 Goodwill and Other Intangible Assets
 Accounting for Goodwill and Other Intangible Assets,
  16




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RESULTS OF OPERATIONS
 For the three and nine months ended July 31, 2006 compared to the three and nine months ended July
31, 2005
     17




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##### 



18




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19




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##### 



LIQUIDITY AND CAPITAL RESOURCES
        Contractual Obligations and Commercial Commitments:
  Payments Due by PeriodLess than 1
    
    
    
    
    
    
    
    
    
    
    More than 5Contractual Obligations
    
    Total
    
    
    year
    
    
    1-3 years
    
    
    4-5 years
    
    
    yearsOperating Leases
    
    $
    3,044,826
    
    
    $
    564,196
    
    
    $
    1,101,986
    
    
    $
    549,255
    
    
    $
    829,389
  20




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##### 



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  ITEM 4. CONTROLS AND PROCEDURES
 Evaluation of SteelClouds Disclosure Controls and Internal Controls
  Limitations
  Changes in Internal Control Over Financial Reporting
  21




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##### 



PART II. OTHER INFORMATION
 ITEM 1. LEGAL PROCEEDINGS
   ITEM 1A. RISK FACTORS
  ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  ITEM 3. DEFAULTS UPON SENIOR SECURITIES
  ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
   FOR
    
    WITHHELDVADM E.A. Burkhalter
    
    
    12,276,660
    
    
    
    693,702James Bruno
    
    
    12,276,660
    
    
    
    693,702
   FOR
    
    AGAINST
    
    ABSTAIN12,699,636
    
    
    188,325
    
    
    
    82,401
  FOR
    
    AGAINST
    
    ABSTAIN12,659,863
    
    
    181,954
    
    
    
    128,545
 22




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##### 



ITEM 5. OTHER INFORMATION
  ITEM 6. EXHIBITS
 Exhibit 11.1
    
    Statement of computation of earnings per share.Exhibit 31.1
    
    Certification of Chief Executive Officer and President
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.Exhibit 31.2
    
    Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.Exhibit 32.1
    
    Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes  Oxley Act of 2002.Exhibit 32.2
    
    Certification Pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes  Oxley Act of 2002.
 23




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##### 



SIGNATURES
  September 14, 2006
    
    STEELCLOUD, INC.By:
    
    /s/ Clifton W. Sink, Jr.Name: Clifton W. Sink, Jr.Title: Chief Executive Officer and PresidentBy:
    
    /s/ Kevin MurphyName: Kevin MurphyTitle: Chief Financial Officer
 24