##### 



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 April 30, 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
  Large Accelerated filer o
    
    Accelerated filer o
    
    Non-accelerated filer þ
  o þ




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Description
    
    
    
    PagePart I.
    
    Financial InformationItem 1.
    
    Financial Statements
    
    
    1Consolidated Balance Sheets as of October 31, 2005 and April 30, 2006
    
    
    1Consolidated Statements of Operations for the three and six month periods ended April 30, 2005 and 2006
    
    
    2Consolidated Statements of Cash Flows for the six month periods ended April 30, 2005 and 2006
    
    
    3Notes to the Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    10Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risks
    
    
    18Item 4.
    
    Controls and Procedures
    
    
    18Part II.
    
    Other Information
    
    
    19Item 1.
    
    Legal Proceedings
    
    
    19Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    19Item 3.
    
    Defaults Upon Senior Securities
    
    
    19Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    19Item 5.
    
    Other Information
    
    
    19Item 6.
    
    Exhibits
    
    
    19




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##### 



PART I. FINANCIAL INFORMATION
 ITEM 1. FINANCIAL STATEMENTS
 STEELCLOUD, INC.
 CONSOLIDATED BALANCE SHEET
 October 31,
    
    
    April 30,2005
    
    
    2006(unaudited)ASSETSCurrent assetsCash and cash equivalents
    
    $
    6,657,367
    
    
    $
    3,853,791Accounts receivable, net
    
    
    5,777,154
    
    
    
    6,472,956Inventory, net
    
    
    1,218,596
    
    
    
    1,686,917Prepaid expenses and other current assets
    
    
    264,968
    
    
    
    271,777Deferred contract cost
    
    
    94,549
    
    
    
    289,882Total current assets
    
    
    14,012,634
    
    
    
    12,575,323Property and equipment, net
    
    
    1,255,666
    
    
    
    1,182,356Equipment on lease, net
    
    
    698,285
    
    
    
    538,623Goodwill and other intangible assets, net
    
    
    4,571,992
    
    
    
    4,514,435Deferred tax asset
    
    
    400,000
    
    
    
    Other assets
    
    
    114,060
    
    
    
    105,462Total assets
    
    $
    21,052,637
    
    
    $
    18,916,199LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilitiesAccounts payable
    
    $
    3,467,028
    
    
    $
    3,221,404Accrued expenses
    
    
    953,552
    
    
    
    1,665,700Notes payable, current
    
    
    70,952
    
    
    
    61,730Unearned revenue
    
    
    339,537
    
    
    
    349,041Total current liabilities
    
    
    4,831,069
    
    
    
    5,297,875Notes payable, long-term
    
    
    63,088
    
    
    
    36,699Other
    
    
    161,166
    
    
    
    164,663Total long-term liabilities
    
    
    224,254
    
    
    
    201,362Stockholders equityPreferred stock, $.001 par value: 2,000,000
shares authorized, no shares issued and
outstanding at October 31, 2005 and April
30, 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 April
30, 2006, respectively
    
    
    14,449
    
    
    
    14,609Additional paid in capital
    
    
    49,579,868
    
    
    
    49,758,553Treasury stock, 400,000 shares at October 31,
2005 and April 30, 2006, respectively
    
    
    (3,432,500
    )
    
    
    (3,432,500
    )Accumulated deficit
    
    
    (30,164,503
    )
    
    
    (32,923,700
    )Total stockholders equity
    
    
    15,997,314
    
    
    
    13,416,962Total liabilities and stockholders equity
    
    $
    21,052,637
    
    
    $
    18,916,199
 .
 1




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##### 



STEELCLOUD, INC.
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (unaudited)
 Three Months Ended
    
    
    Six Months EndedApril 30,
    
    
    April 30,2005
    
    
    2006
    
    
    2005
    
    
    2006RevenuesProducts
    
    $
    8,924,494
    
    
    $
    6,618,262
    
    
    $
    17,147,952
    
    
    $
    12,606,300Services
    
    
    759,544
    
    
    
    674,607
    
    
    
    1,599,679
    
    
    
    1,349,224Total revenues
    
    
    9,684,038
    
    
    
    7,292,869
    
    
    
    18,747,631
    
    
    
    13,955,524Cost of revenuesProducts
    
    
    6,696,927
    
    
    
    5,676,713
    
    
    
    12,631,545
    
    
    
    10,502,417Services
    
    
    471,014
    
    
    
    583,734
    
    
    
    1,062,316
    
    
    
    1,057,648Total cost of revenues
    
    
    7,167,941
    
    
    
    6,260,447
    
    
    
    13,693,861
    
    
    
    11,560,065Gross profit
    
    
    2,516,097
    
    
    
    1,032,422
    
    
    
    5,053,770
    
    
    
    2,395,459Selling and marketing
    
    
    367,608
    
    
    
    711,978
    
    
    
    809,593
    
    
    
    1,212,152Research and product development
    
    
    177,813
    
    
    
    127,443
    
    
    
    391,295
    
    
    
    305,806General and administrative
    
    
    1,578,450
    
    
    
    1,704,362
    
    
    
    3,024,794
    
    
    
    3,208,398Amortization of other intangible
assets
    
    
    28,779
    
    
    
    28,779
    
    
    
    57,557
    
    
    
    57,557Income (loss) from operations
    
    
    363,447
    
    
    
    (1,540,140
    )
    
    
    770,531
    
    
    
    (2,388,454
    )Interest (income), net
    
    
    (4,362
    )
    
    
    (11,827
    )
    
    
    (12,071
    )
    
    
    (29,257
    )Income (loss) before income taxes
    
    
    367,809
    
    
    
    (1,528,313
    )
    
    
    782,602
    
    
    
    (2,359,197
    )Provision for income taxes
    
    
    
    
    
    
    400,000
    
    
    
    
    
    
    
    400,000Net income (loss)
    
    
    367,809
    
    
    
    (1,928,313
    )
    
    
    782,602
    
    
    
    (2,759,197
    )Earnings (loss) per share:Basic earnings (loss) per
share
    
    $
    0.03
    
    
    $
    (0.14
    )
    
    $
    0.06
    
    
    $
    (0.20
    )Diluted earnings (loss) per
share
    
    $
    0.03
    
    
    $
    (0.14
    )
    
    $
    0.05
    
    
    $
    (0.20
    )Weighted-average shares
outstanding, basic
    
    
    13,882,019
    
    
    
    14,098,542
    
    
    
    13,858,562
    
    
    
    14,073,747Weighted-average shares
outstanding, diluted
    
    
    14,633,702
    
    
    
    14,098,542
    
    
    
    14,482,490
    
    
    
    14,073,747
  2




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##### 



STEELCLOUD, INC.
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (unaudited)
 
 Six Months EndedApril 30,2005
    
    2006Operating activitiesNet income (loss)
    
    $
    782,602
    
    
    $
    (2,759,197
    )Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    393,956
    
    
    
    381,426Stock-based compensation
    
    
    
    
    
    
    62,378Provision for income taxes
    
    
    
    
    
    
    400,000Changes in operating assets and liabilities:Accounts receivable
    
    
    3,604,958
    
    
    
    (695,802
    )Inventory
    
    
    333,478
    
    
    
    (468,321
    )Prepaid expenses and other assets
    
    
    509
    
    
    
    1,789Deferred contract costs
    
    
    (301,270
    )
    
    
    (195,333
    )Accounts payable
    
    
    (3,158,987
    )
    
    
    (245,624
    )Accrued expenses
    
    
    73,089
    
    
    
    715,645Unearned revenue and other liabilities
    
    
    337,731
    
    
    
    9,504Net cash provided by (used in) operating activities
    
    
    2,066,066
    
    
    
    (2,793,535
    )Investing activitiesPurchase of property and equipment
    
    
    (1,319,392
    )
    
    
    (90,897
    )Financing activitiesProceeds from exercise of common stock options
    
    
    160,370
    
    
    
    116,467Payments on notes payable
    
    
    (36,090
    )
    
    
    (35,611
    )Proceeds on line of credit
    
    
    2,000,000
    
    
    
    Net cash provided by financing activities
    
    
    2,124,280
    
    
    
    80,856Net increase (decrease) in cash and cash equivalents
    
    
    2,870,954
    
    
    
    (2,803,576
    )Cash and cash equivalents at beginning of period
    
    
    3,108,941
    
    
    
    6,657,367Cash and cash equivalents at end of period
    
    $
    5,979,895
    
    
    $
    3,853,791Supplemental cash flow informationInterest paid
    
    $
    6,076
    
    
    $
    2,137Income taxes paid
    
    $
    
    
    
    $
    
 
  3




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STEELCLOUD, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 1. Nature of Business and Basis of Presentation
   TM TM
  2. Significant Accounting Policies
 Deferred Tax Assets
 Accounting for Income Taxes
 4




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3. Employee Stock Options
 Share-Based Payment
  Accounting
for Stock Issued to Employees Accounting for Stock Based
Compensatio Accounting for Stock-Based CompensationTransition and
Disclosure
 Three Months Ended
    
    Six Months EndedApril 30, 2005
    
    April 30, 2005Net income  as reported
    
    $
    367,809
    
    
    $
    782,602Add: compensation expense recorded under APB No. 25
    
    
    
    
    
    
    Deduct: SFAS 123R compensation expense
    
    
    349,651
    
    
    
    699,302Net income  pro forma
    
    $
    18,158
    
    
    $
    83,300Net earnings per share:Basic  as reported
    
    $
    0.03
    
    
    $
    0.06Basic  pro forma
    
    $
    0.01
    
    
    $
    0.01Diluted  as reported
    
    $
    0.03
    
    
    $
    0.05Diluted  pro forma
    
    $
    0.01
    
    
    $
    0.01
  Three months ended
    
    Six months endedOptions
    
    ESPP
    
    Options
    
    ESPPApril 30, 2005
    
    April 30, 2005
    
    April 30, 2005
    
    April 30, 2005Expected term (years)
    
    
    
    
    
    
    0.50
    
    
    
    
    
    
    
    0.50Expected stock price volatility
    
    
    
    
    
    
    45.4
    %
    
    
    
    
    
    
    45.4
    %Risk-free interest rate
    
    
    
    
    
    
    3.13
    %
    
    
    
    
    
    
    3.13
    %
 5




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Incentive Stock Option Plans
     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
    
    
    (466,626
    )
    
    
    1.60Outstanding at April 30, 2006
    
    
    1,847,284
    
    
    $
    2.20
    
    
    
    2.29Exercisable at April 30, 2006
    
    
    1,727,534
    
    
    $
    2.19
    
    
    
    2.21
   6




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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
    
    
    494,050
    
    
    $
    1.13
    
    
    
    0.84
    
    
    
    486,800
    
    
    $
    1.12$1.76-$4.50
    
    
    1,353,234
    
    
    
    2.59
    
    
    
    2.82
    
    
    
    1,240,734
    
    
    
    2.61$0.55-$4.50
    
    
    1,847,284
    
    
    $
    2.20
    
    
    
    2.29
    
    
    
    1,727,534
    
    
    $
    2.19
  Employee Stock Purchase Plan
  Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option
 Three MonthsEnded
    
    
    Six Months EndedApril 30, 2006
    
    
    April 30, 2006Expected term (years)1
    
    
    0.50
    
    
    
    0.50Expected stock price volatility2
    
    
    42.6
    %
    
    
    42.6
    %Risk-free interest rate3
    
    
    4.81
    %
    
    
    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




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4. Operating Leases
  5. Debt
   6. Deferred Revenue
  7. Earnings Per Share
  8. Segment Reporting
 Disclosures about Segments of an Enterprise and Related Information
 8




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9. Significant Customer
  
 10. Subsequent Event
    9




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
   10




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OVERVIEW
   
 TM TM
 
 Recent Developments Subsequent to Balance Sheet Date
  
  
 
    
    Strategic Alliances  The Company will strengthen its partnerships with industry
leaders such as Intel and Microsoft. Management believes both of these firms
desire to leverage the Companys access and presence in the federal market space
and the Company, in turn, needs their latest technology and marketing strength.
    
    Product Leadership  The Company needs market leading products in order to grow.
Presently, SteelCloud is collaborating with Intel to develop and brand a new line
of server solutions targeted for the Department of Defense. Based on Advanced
Telecom Computing Architecture (referred to as ATCA), the new products are
available for demonstration at SteelClouds Solutions Center at its Company
Headquarters. 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 OEMs. Over the last five years, the Company
conducted transactions with over 600 customers. The Company will focus on further
developing and nurturing these customers in order to promote new sales. In the
past, the Company has had a strong dependence on a few
concentrated customers. In the future, the Company will strive to reduce this
dependence through the addition of new customers and sales.
 11




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
    
    Sales & Marketing  We have begun the process of transforming our sales and
marketing organization so that it will return the Companys attention and focus on its
core integration business. Resources have been recently added, refocused and
realigned in order to target and capture new business. We believe 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
one of our critical initiatives.
  
 Integration and OEM Business
 TM
  Network Security and Infrastructure Solutions
   12




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Research and Development
 
 TM TM TM TM
 
 Significant Customer Contracts
 
  
  CRITICAL ACCOUNTING POLICIES
  Revenue Recognition
 Revenue
Recognition in Financial Statements, corrected copy
 Revenue Arrangements with Multiple Deliverables Revenue Arrangements with Multiple Deliverables
   13




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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,
  
 14




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RESULTS OF OPERATIONS
 For the three and six months ended April 30, 2006 compared to the three and six months ended April
30, 2005
   
  
 
  
 
  
 15




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LIQUIDITY AND CAPITAL RESOURCES
     
 16




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Contractual Obligations and Commercial Commitments:
  Contractual Obligations
    
    Payments Due by PeriodLess than 1
    
    
    
    
    
    
    
    
    
    More than 5Total
    
    year
    
    1-3 years
    
    3-5 years
    
    yearsOperating Leases
    
    $
    3,419,691
    
    
    $
    636,140
    
    
    $
    1,251,155
    
    
    $
    635,760
    
    
    $
    896,636
  17




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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
  18




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PART II. OTHER INFORMATION
 ITEM 1. LEGAL PROCEEDINGS
   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
  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.*
 
 *
    
    The Exhibit attached to this Form 10-Q shall not be deemed filed for purposes of Section 18 of
the Securities Exchange Act of 1934 (the Exchange Act) or otherwise subject to liability under
that section, nor shall it be deemed incorporated by reference in any filing under the Securities
Act of 1933, as amended, or the Exchange Act, except as expressly set forth by specific reference
in such filing. 19




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SIGNATURES
  June 22, 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
 20