**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 July 31, 2008




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.**


(Exact
      name of registrant as specified in its charter)




**VIRGINIA**
            
            **54-1890464**(State
                or other jurisdiction of
              incorporation
                or organization)
            
            (I.R.S.
                Employer
              Identification
                No.)


14040 Park Center Road, Herndon, VA
              
              20171(Address of principal executive offices)
              
              (Zip code)




(703) 674-5500


(Registrant’s telephone number, including area code)




(Former name,
      former address and former fiscal year, if changed since last
      report)




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.




Yes þ No o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company.
      See
      definition of “accelerated filer,” “large accelerated” and “smaller reporting
      company” in Rule 12b-2 of the Exchange Act. (Check one)


Large
      Accelerated filer o  Accelerated
      filer o  Non-accelerated
      filer o Smaller
      Reporting Company þ




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).




Yes o No þ




As
      of
      September 1, 2008 there were 14,737,739 shares of the registrant’s common stock
      outstanding.












*Table
        of Contents*




**SteelCloud,
      Inc.**


**Form
      10-Q Index**


**for
      the Quarterly period ended July 31, 2008**




PART
                I. FINANCIAL INFORMATION
            1ITEM
                1.
            FINANCIAL
                STATEMENTS
            1ITEM
                2.
            MANAGEMENT’S
                DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                AND RESULTS OF OPERATIONS
            2ITEM
                3.
            QUANTITATIVE
                AND QUALITATIVE DISCLOSURES ABOUT MARKET
                RISK
            12ITEM
                4.
            CONTROLS
                AND PROCEDURES
            12PART
                II. OTHER INFORMATION
            15ITEM
                1.
            LEGAL
                PROCEEDINGS
            15ITEM
                1A.
            RISK
                FACTORS
            15ITEM
                2.
            UNREGISTERED
                SALES OF EQUITY SECURITIES AND USE OF
                PROCEEDS
            15ITEM
                3.
            DEFAULTS
                UPON SENIOR SECURITIES
            15ITEM
                4.
            SUBMISSION
                OF MATTERS TO A VOTE OF SECURITY
                HOLDERS
            15ITEM
                5.
            OTHER
                INFORMATION
            16ITEM
                6.
            EXHIBITS
            16SIGNATURES
            17




i
 *Table
          of Contents*




**PART
      I. FINANCIAL INFORMATION******




**ITEM
      1.****FINANCIAL
      STATEMENTS******




**Index
      to Financial Statements**




Condensed
                Consolidated Balance Sheet
            F–1Unaudited
                Condensed Consolidated Statements of
                Operations
            F–2Unaudited
                Condensed Consolidated Statements of Cash
                Flows
            F–3Notes
                to Unaudited Condensed Consolidated Financial
                Statements
            F–4





1
 *Table
          of Contents*


**STEELCLOUD,
      INC.**


**CONDENSED
      CONSOLIDATED BALANCE SHEET**




**October 31,**
            
            **July 31,****2007**
            
            **2008****(unaudited)**ASSETSCurrent
                assetsCash
                and cash equivalents
            
            $
            2,622,654
            
            $
            1,806,932Accounts
                receivable, net
            
            
            2,625,372
            
            
            1,111,274Inventory,
                net
            
            
            1,178,395
            
            
            1,176,868Deferred
                contract costs
            
            
            83,753
            
            
            31,536Prepaid
                expenses and other current assets
            
            
            255,924
            
            
            193,152Total
                current assets
            
            
            6,766,098
            
            
            4,319,762Property
                and equipment, net
            
            
            802,288
            
            
            655,799Equipment
                on lease, net
            
            
            323,904
            
            
            481,824Other
                assets
            
            
            44,053
            
            
            9,615Total
                assets
            
            $
            7,936,343
            
            $
            5,467,000LIABILITIES
                AND STOCKHOLDERS’ EQUITYCurrent
                liabilitiesAccounts
                payable
            
            $
            1,789,329
            
            $
            988,011Notes
                payable, current
            
            
            12,842
            
            
            7,450Unearned
                revenue
            
            
            98,255
            
            
            46,049Accrued
                expenses and other current liabilities
            
            
            1,158,641
            
            
            677,448Total
                current liabilities
            
            
            3,059,067
            
            
            1,718,958Long-term
                liabilitiesNotes
                payable, long-term
            
            
            15,442
            
            
            9,822Other,
                including severance obligations
            
            
            154,520
            
            
            133,680Total
                long-term liabilities
            
            
            169,962
            
            
            143,502Commitments
                and contingenciesStockholders’
                equityPreferred
                stock, $.001 par value: 2,000,000 shares authorized, no shares issued
                and
                outstanding at October 31, 2007 and July 31, 2008
            
            
            –
            
            
            -Common
                stock, $.001 par value: 50,000,000 shares authorized, 14,716,934
                and
                15,116,489 shares issued at October 31, 2007 and July 31, 2008,
                respectively
            
            
            14,717
            
            
            15,116Additional
                paid in capital
            
            
            50,234,099
            
            
            50,738,768Treasury
                stock, 400,000 shares at October 31, 2007 and July 31,
                2008
            
            
            (3,432,500
            )
            
            (3,432,500
            )Accumulated
                deficit
            
            
            (42,109,002
            )
            
            (43,716,844
            )Total
                stockholders’ equity
            
            
            4,707,314
            
            
            3,604,540Total
                liabilities and stockholders’ equity
            
            $
            7,936,343
            
            $
            5,467,000





**The
      Accompanying Notes Are an Integral Part of these Condensed Consolidated
      Financial Statements**


F–1
 *Table
          of Contents*


**STEELCLOUD,
      INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF
      OPERATIONS**




**Three Months Ended**
              **July 31,**
            
            **Nine Months Ended**
              **July 31,****2007**
              **(restated)**
            
            **2008**
            
            **2007**
              **(restated)**
            
            **2008**RevenuesProducts
            
            $
            3,479,961
            
            $
            1,715,476
            
            $
            11,766,032
            
            $
            14,796,243Services
            
            
            487,926
            
            
            848,995
            
            
            1,461,765
            
            
            1,959,334Total
                revenues
            
            
            3,967,887
            
            
            2,564,471
            
            
            13,227,797
            
            
            16,755,577Cost
                of revenuesProducts
            
            
            2,635,358
            
            
            1,300,098
            
            
            9,294,090
            
            
            12,351,221Services
            
            
            330,597
            
            
            675,966
            
            
            985,118
            
            
            1,596,479Total
                cost of revenues
            
            
            2,965,955
            
            
            1,976,064
            
            
            10,279,208
            
            
            13,947,700Gross
                profit
            
            
            1,001,932
            
            
            588,407
            
            
            2,948,589
            
            
            2,807,877Selling
                and marketing
            
            
            393,269
            
            
            325,794
            
            
            1,148,023
            
            
            927,756Research
                and product development
            
            
            183,144
            
            
            166,748
            
            
            477,741
            
            
            573,861General
                and administrative
            
            
            1,091,372
            
            
            1,031,726
            
            
            3,388,051
            
            
            2,919,519(Loss)
                from operations
            
            
            (665,853
            )
            
            (935,861
            )
            
            (2,065,226
            )
            
            (1,613,259
            )Interest
                (expense) income, net
            
            
            (7,005
            )
            
            (5,825
            )
            
            18,685
            
            
            5,417(Loss)
                before income taxes
            
            
            (672,858
            )
            
            (941,686
            )
            
            (2,046,541
            )
            
            (1,607,842
            )Provision
                for income taxes
            
            
            -
            
            
            -
            
            
            -
            
            
            -Net
                (loss)
            
            $
            (672,858
            )
            $
            (941,686
            )
            $
            (2,046,541
            )
            $
            (1,607,842
            )(Loss)
                per share (basic and diluted):Basic
                and diluted (loss) per share
            
            $
            (0.05
            )
            $
            (0.06
            )
            $
            (0.14
            )
            $
            (0.11
            )Weighted–average
                shares outstanding:Basic
                and diluted
            
            
            14,293,560
            
            
            14,595,649
            
            
            14,277,024
            
            
            14,426,565





**The
      Accompanying Notes Are an Integral Part of these Condensed Consolidated
      Financial Statements**


F–2
 *Table
          of Contents*


**STEELCLOUD,
      INC.**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**




**Nine Months Ended**
              **July 31,****2007**
              **(restated)**
            
            **2008****Operating
                activities**Net
                (loss)
            
            $
            (2,046,541
            )
            $
            (1,607,842
            )Adjustments
                to reconcile net (loss) to net cash (used in) provided by operating
                activities:Depreciation
                and amortization
            
            
            439,144
            
            
            370,931Warrant-based
                expense
            
            
            40,000
            
            
            -Stock-based
                compensation
            
            
            275,543
            
            
            273,771Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            324,411
            
            
            1,514,098Inventory
            
            
            (289,971
            )
            
            1,527Deferred
                contract costs
            
            
            (41,977
            )
            
            52,217Prepaid
                expenses and other assets
            
            
            (2,519,666
            )
            
            97,210Accounts
                payable
            
            
            881,323
            
            
            (801,318
            )Unearned
                revenue
            
            
            3,385,546
            
            
            (59,285
            )Accrued
                expenses and other liabilities
            
            
            (304,280
            )
            
            (494,954
            )Net
                cash provided by (used in) operating activities
            
            
            143,532
            
            
            (653,645
            )**Investing
                activities**Purchase
                of property and equipment
            
            
            (211,158
            )
            
            (382,362
            )Net
                cash (used in) investing activities
            
            
            (211,158
            )
            
            (382,362
            )**Financing
                activities**Proceeds
                from exercise of common stock options
            
            
            12,587
            
            
            231,297Payments
                on notes payable
            
            
            (11,471
            )
            
            (11,012
            )Net
                cash provided by financing activities
            
            
            1,116
            
            
            220,285Net
                (decrease) in cash and cash equivalents
            
            
            (66,510
            )
            
            (815,722
            )Cash
                and cash equivalents at beginning of period
            
            
            3,655,163
            
            
            2,622,654Cash
                and cash equivalents at end of period
            
            $
            3,588,653
            
            $
            1,806,932**Supplemental
                cash flow information**Interest
                paid
            
            $
            19,652
            
            $
            17,514Income
                taxes paid
            
            $
            -
            
            $
            -




**The
      Accompanying Notes Are an Integral Part of these Condensed Consolidated
      Financial Statements**


F–3
 *Table
          of Contents*


**STEELCLOUD,
      INC.**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**




**1.**  **Nature
      of Business and Basis of Presentation**




Founded
      in 1987, SteelCloud, Inc. (the “Company” or “SteelCloud”) is a developer and
      leading manufacturer of compliance-based technology solutions for government
      and
      commercial markets. The Company designs and manufactures specialized servers
      and
      appliances for federal integrators, software vendors and volume users.
      SteelCloud’s SteelWorks Mobile line of products provides compliance-based
      solutions for the wireless Blackberry Enterprise Server Market.




For
      commercial customers, the Company designs, manufactures and integrates
      low-maintenance servers (called “appliances” in this market) so its customers
      can make their software products easier to deploy and support, more competitive
      and open new markets by delivering their application software on
      fully-integrated, ready-to-use appliances.




In
      addition, the Company serves information technology end users directly, in
      both
      the public and private sectors, with products and services focused on
      information technology (“IT”) centric solutions. The Company’s IT centric
      solutions include its appliance servers, products from its strategic partners
      along with its consulting services.




The
      Company supplements its existing public sector sales force by utilizing the
      services of manufacturer representatives. Manufacturer representatives serve
      as
      strategic vehicles for gaining access to key decision makers within major
      federal integrator organizations. These companies act as commission-based field
      sales teams which market the Company’s products and services to nationally
      recognized federal contracting companies that mainly target military Commercial
      off the Shelf (“COTS”) server applications.




The
      Company’s ISO 9001:2000 certified Quality Management System establishes
      measurable quality objectives throughout the organization and provides
      procedures for continuous quality improvement in all aspects of its business.
      This certification is particularly critical to the Company’s success in the
      federal government market space, as most government end customers require their
      contractors and sub-contractors to be ISO 9001:2000 certified.




The
      accompanying unaudited interim condensed consolidated financial statements
      have
      been prepared pursuant to the rules and regulations of the Securities and
      Exchange Commission for quarterly reports on Form 10-Q and, therefore omit
      or
      condense certain note disclosures and other information required by U.S.
      Generally Accepted Accounting Principles for complete financial statements.
      Except for the condensed consolidated balance sheet as of October 31, 2007,
      which is derived from audited financial statements, the consolidated financial
      statements for the three and nine month periods ended July 31, 2008 and 2007
      are
      unaudited. In the opinion of the Company’s management, all adjustments which are
      necessary to present fairly the financial position as of July 31, 2008 and
      2007
      and the results of operations and cash flows for the periods then ended have
      been included. All such adjustments are of a normal and recurring nature. These
      condensed consolidated financial statements should be read in conjunction with
      the Company’s Annual Report on Form 10-K, which includes consolidated financial
      statements and notes thereto for the years ended October 31, 2007 and
      2006.




Management
      believes that existing cash and cash equivalents on hand as of July 31, 2008
      will be sufficient to fund its operations for the upcoming twelve months.




F–4
 *Table
          of Contents*


**STEELCLOUD,
        INC.**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**2.**  **Restatement
      of Previously Issued Financial Statements**




After
      undertaking the review of its financial information for the fiscal year ended
      October 31, 2007, the Company determined that certain historic direct and
      indirect manufacturing costs had been incorrectly classified in its consolidated
      statements of operations and that certain of these costs had not been properly
      allocated to inventory. The Company corrected these errors through a restatement
      of its previously issued financial statements for (i) the fiscal year ended
      October 31, 2005, (ii) the fiscal year ended October 31, 2006, (iii) the
      unaudited quarterly financial data for each of the quarters in-between the
      fiscal years ended October 31, 2005 and October 31, 2006, and (iv) the unaudited
      quarterly financial data for each of the quarters in the nine months ended
      July
      31, 2007.




The
      restatement reclassified direct and indirect manufacturing costs from operating
      expenses (general & administrative costs) to cost of goods sold and
      increases in inventory. As such, cost of goods sold increased, gross profit
      decreased and operating expenses (general & administrative costs) decreased
      for the periods indicated above. In addition, net income (loss) was restated
      for
      the periods indicated above as a result of the appropriate allocation of certain
      direct and indirect costs to inventory.




The
      restatement adjustments reflected in the following table corrects the
      misallocations described above for the three months ended July 31,
      2007:




**Three Months Ended July 31, 2007****As Previously**
              **Reported**
            
            **Restatement**
              **Adjustments**
            
            **Restated**Revenue
            
            $
            3,967,887
            
            $
            –
            
            $
            3,967,887Gross profit
            
            
            1,211,280
            
            
            (209,348
            )
            
            1,001,932Net
                (loss) income available to common shareholders
            
            
            (675,012
            )
            
            2,154
            
            
            (672,858
            )Per
                Share DataNet
                (loss) earnings per share, basic and diluted
            
            $
            (0.05
            )
            $
            (0.00
            )
            $
            (0.05
            )




The
      restatement adjustments reflected in the following table corrects the
      misallocations described above for the nine months ended July 31,
      2007:




**Nine
                Months Ended July 31, 2007****As
                Previously Reported**
            
            **Restatement
                Adjustments**
            
            **Restated**Revenue
            
            $
            13,227,797
            
            $
            –
            
            $
            13,227,797Gross
                profit
            
            
            3,515,164
            
            
            (566,575
            )
            
            2,948,589Net
                (loss) income available to common shareholders
            
            
            (2,104,166
            )
            
            57,625
            
            
            (2,046,541
            )Per
                Share DataNet
                (loss) earnings per share, basic and diluted
            
            $
            (0.15
            )
            $
            0.01
            
            $
            (0.14
            )




F–5
 *Table
          of Contents*


**STEELCLOUD,
        INC.**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**3.**  **Recently
      Issued Accounting Pronouncements**




On
      November 1, 2007, the Company adopted Financial Accounting Standards Board
      (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”
(“FIN 48”). FIN 48 prescribes a recognition threshold that a tax position is
      required to meet before being recognized in the financial statements and
      provides guidance on derecognition, measurement, classification, interest and
      penalties, accounting in interim periods, disclosure and transition issues.
      The
      Company’s adoption of FIN 48 is more fully described in Note 11 “Income
      Tax”.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      (“SFAS”) No. 157, “ *Fair
      Value Measurements* ”
(“SFAS
      No. 157”). SFAS No. 157 provides a common definition of fair value and
      establishes a framework to make the measurement of fair value in U.S. Generally
      Accepted Accounting Principles more consistent and comparable. SFAS No. 157
      also
      requires expanded disclosures to provide information about the extent to which
      fair value is used to measure assets and liabilities, the methods and
      assumptions used to measure fair value, and the effect of fair value measures
      on
      earnings. SFAS No. 157 is effective for fiscal years beginning after November
      15, 2007. The Company is in the process of evaluating the effect, if any, the
      adoption of SFAS No. 157 will have on its financial statements.




In
      February 2007, the FASB issued SFAS No. 159, “ *The
      Fair Value Option for Financial Assets and Financial
      Liabilities* ”
(“SFAS
      No. 159”). SFAS No. 159 provides a choice to measure many financial instruments
      and certain other items at fair value and requires disclosures about the
      election of the fair value option. Unrealized gains and losses on items for
      which the fair value option has been elected are reported in earnings. SFAS
      No.
      159 is effective for fiscal years beginning after November 15, 2007. Therefore,
      the Company is required to adopt SFAS No. 159 in the first quarter of 2009.
      The
      Company is in the process of evaluating the effect, if any; the adoption of
      SFAS
      No. 159 will have on its financial statements.




In
      December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS
      No. 141R”). SFAS No. 141R, which replaces SFAS No. 141, requires that the
      acquisition method of accounting (which SFAS No. 141 called the “purchase
      method”) be used for all business combinations and for an acquirer to be
      identified for each business combination. SFAS No. 141R also establishes
      principles and requirements for how the acquirer recognizes and measures in
      its
      financial statements the identifiable assets acquired, the liabilities assumed,
      and any noncontrolling interest in the acquiree; recognizes and measures the
      goodwill acquired in the business combination or a gain from a bargain purchase;
      and determines what information to disclose to enable users of the financial
      statements to evaluate the nature and financial effects of the business
      combination. SFAS No. 141R also requires that acquisition-related costs be
      recognized separately from the business combination. SFAS No. 141R will apply
      prospectively to business combinations for which the acquisition date is after
      fiscal years beginning on or after December 15, 2008. The Company has not yet
      determined the impact that the implementation of SFAS No. 141R will have on
      its
      results of operations or financial condition.




F–6
 *Table
          of Contents*


**STEELCLOUD,
        INC.**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**4.
      Significant Customers**





For
      the
      three month period ended July 31, 2008, the Company’s significant customers were
      an Independent Software Vendor (“ISV”) Customer and two Federal Government
      Customers representing 23%, 15% and 11% of the Company’s revenue, respectively.
      For the nine month period ended July 31, 2008, the Company’s significant
      customers were a Federal Integrator and an ISV Customer representing 57% and
      11%
      of the Company’s revenue, respectively. The significant accounts receivable
      balances as of July 31, 2008 included amounts from a Federal Integrator, an
      ISV
      Customer, and two Federal Government Customers representing, 14%, 27%, 11%,
      and
      18% of total net account receivables, respectively.




**5.**  **Stock-based
      Compensation**




The
      Company recognized approximately $110,000 and $61,000 of stock based
      compensation expense for the three month periods ended July 31, 2008 and 2007,
      respectively. For the nine month periods ended July 31, 2008 and 2007, the
      Company recognized stock-based compensation expense of approximately $274,000
      and $254,000, respectively. Stock-based compensation expense for the three
      and
      nine month periods ended July 31, 2007 increased the Company’s basic and diluted
      loss per share by $0.01 and $0.02, respectively. Stock based compensation
      expense for the three and nine month period ended July 31, 2008 increased the
      Company’s basic and dilutive loss per share by $0.00 and $0.02, respectively.
      The estimated fair value of the Company’s stock-based awards is amortized on a
      straight-line basis over the awards’ original service period.





On
      March
      7, 2007, the Company issued 21,504 shares of its common stock to members of
      its
      Board of Directors. The shares were valued at $0.99. The total expense
      associated with this stock issuance was approximately $21,000.




**6.**  **Equity**




***Warrants***


On
      October 6, 2006, the Company issued warrants to purchase 250,000 shares of
      common stock in exchange for the engagement of a financial services firm which
      services were valued at $40,000. The warrants were issued at an exercise price
      of $0.54 and expire October 6, 2010. The total expense associated with the
      issuance of the warrants was $40,000 and was recognized over the nine month
      period ended July 31, 2007.




***Restricted
      Stock***


The
      Amended 2007 Stock Option and Restricted Stock Plan was approved at the 2007
      annual shareholders meeting. During the fourth quarter of the fiscal year 2008,
      the Company will re-issue 80,000 shares of restricted stock which was rescinded
      on December 21, 2007, and will begin to recognize stock-based compensation
      expense associated with the stock award.




F–7
 *Table
          of Contents*


**STEELCLOUD,
        INC.**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**7.**  **Debt**




On
      March
      6, 2008, the Company renewed its bank line of credit that allows the Company
      to
      borrow an amount to the lesser of its collateralized cash on hand or $3.5
      million. The line of credit bears interest at the LIBOR Market Index rate plus
      1.25%. The line of credit is secured by all assets of the Company and expires
      on
      March 31, 2009. There were no outstanding borrowings on the line of credit
      at
      October 31, 2007 and July 31, 2008.




**8.**  **Unearned
      Revenue and Deferred Contract Costs**




Unearned
      revenue and deferred contract costs includes amounts received from customers
      for
      which revenue has not been recognized and the associated costs of those
      revenues. This generally results from certain customer contracts, ISV releases,
      warranties, hardware maintenance and support, and consulting services. The
      unearned revenue and contract costs associated with customer contracts and
      ISV
      releases represents payments received for milestones achieved prior to
      recognition of revenue. This revenue and associated cost will be recognized
      as
      products are shipped. Revenues and associated costs from warranties and hardware
      maintenance and support are recognized ratably over the service term selected
      by
      the customer. Service revenues and associated costs from consulting are
      recognized as the services are performed.




**9.**  **Inventories**




Inventories
      consisted of the following:




**October 31,**
            
            **July 31,****2007**
            
            **2008**Raw
                materials
            
            $
            758,154
            
            $
            740,239Work
                in process
            
            
            290,603
            
            
            257,987Finished
                goods
            
            
            129,638
            
            
            178,642$
            1,178,395
            
            $
            1,176,868





**10.**  **Earnings
      per Share**




Basic
      earnings per share is based on the weighted average number of shares of common
      stock outstanding during the period and is calculated by dividing the net
      earnings (loss) by the weighted average number of shares of common stock
      outstanding. Diluted earnings per share is based on the weighted average number
      of shares of common stock outstanding plus common stock equivalents associated
      with stock options and warrants and is calculated by dividing net earnings
      by
      the weighted average number of shares of common stock outstanding used in the
      basic earnings per share calculation plus the common stock equivalent of stock
      options and warrants. The dilutive weighted average number of common stock
      outstanding excluded potential common stock from stock options and warrants
      of
      approximately 340,000 and 841,000 for the three month period ended July 31,
      2008
      and 2007, respectively, and 404,000 and 646,000 for the nine month periods
      ended
      July 31, 2008 and 2007, respectively. These shares were excluded from the
      earnings per share calculation due to their antidilutive effect resulting from
      the loss from operations.




F–8
 *Table
          of Contents*


**STEELCLOUD,
        INC.**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


**11.**  **Income
      Tax**




On
      November 1, 2007, the Company adopted FIN 48. FIN 48 prescribes a recognition
      threshold that a tax position is required to meet before being recognized in
      the
      financial statements and provides guidance on derecognition, measurement,
      classification, interest and penalties, accounting in interim periods,
      disclosure and transition issues.




During
      the quarter ended July 31, 2008 the
      Company had a net decrease in its unrecognized tax benefit of $608,000. The
      Company’s unrecognized tax benefit at July 31, 2008 is $59,000. The Company
      reduced its unrecognized tax benefit $655,000 by adjusting its NOL carryforwards
      and making an automatic change in accounting method. Both of these adjustments
      were made with the filing of the Company’s 2007 income tax return. The Company
      added $47,000 of unrecognized tax benefit associated with tax deductions for
      stock option and warrant exercises in excess of corresponding book charges
      per
      Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
      Payment”. The
      Company has a valuation allowance against the full amount of its net deferred
      tax assets and therefore the adoption of FIN 48 had no impact on the Company’s
      retained earnings. The amount of unrecognized tax benefits that, if recognized,
      would impact the effective tax rate is $0.




The
      Company conducts business in the U.S. and is subject to U.S. taxes. As a result
      of its business activities, the Company files tax returns that are subject
      to
      examination by the respective federal and state tax authorities. For income
      tax
      returns filed by the Company, the Company is no longer subject to U.S. federal,
      or state tax examination by tax authorities for years before the tax year ended
      October 31, 2004, although significant net operation loss carryforward tax
      attributes that were generated prior to the tax year ended October 31, 2004
      may
      still be adjusted upon examination by tax authorities if they either have been
      or will be utilized.




The
      Company’s accounting policy is to recognize interest and penalties related to
      income tax matters in general and administrative expense. The Company has $0
      accrued for interest and penalties as of July 31, 2008.




**12.**  **Commitments
      and contingencies**




The
      Company has accrued approximately $58,000 pertaining to non-income taxes and
      related interest and penalties that would have resulted from the failure to
      file
      the associated returns. The Company intends to file the necessary returns to
      resolve the contingency.




**13.**  **Reclassification**




Certain
      prior period amounts have been reclassified to conform to current period
      presentation **.**




**14.**  **Subsequent
      Events**




The
      Company has signed a non-binding letter with a third-party financing source.
      The
      terms of such financing have not been finalized and may never be
      concluded.




F–9
 *Table
          of Contents*




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




Certain
      statements contained herein may constitute forward-looking statements within
      the
      meaning of the Private Securities Litigation Reform Act of 1995. The words
      or
      phrases “would be,” “will allow,” “intends to,” “will likely result,” “are
      expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or
      similar expressions are intended to identify “forward-looking statements.”
Because such statements include risks and uncertainties, actual results may
      differ materially from those expressed or implied by such forward-looking
      statements. Factors that could cause actual results to differ materially
      include, but are not limited to, risks associated with the integration of
      businesses following an acquisition, competitors with broader product lines
      and
      greater resources, emergence into new markets, the termination of any of our
      significant contracts, our inability to maintain working capital requirements
      to
      fund future operations, or our inability to attract and retain highly qualified
      management, technical and sales personnel. Statements made herein are as of
      the
      date of the filing of this Quarterly Report on Form 10-Q with the Securities
      and
      Exchange Commission and should not be relied upon as of any subsequent date.
      Unless otherwise required by applicable law, we do not undertake, and we
      specifically disclaim, any obligation to update any forward-looking statements
      to reflect occurrences, developments, unanticipated events or circumstances
      after the date of such statement.




The
      following discussion should be read in conjunction with the unaudited condensed
      consolidated financial statements and notes thereto included in Item 1 in this
      Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the fiscal
      year ended October 31, 2007, filed by us with the Securities and Exchange
      Commission.




**OVERVIEW**




Founded
      in 1987, we are a developer and leading manufacturer of compliance-based
      technology solutions for government and commercial markets. We design and
      manufacture specialized servers and appliances for federal integrators, software
      vendors and volume users. Our SteelWorks Mobile line of products provides
      compliance-based solutions for the wireless Blackberry Enterprise Server
      Market.




***Evolution
      of the Company***




During
      the past two years we have continuously evolved from a mix of hardware and
      reseller business to the development of hardware and appliance products that
      represent ever increasing intellectual content and advanced technology. The
      development of information assurance compliance based solutions associated
      with
      our SteelWorks Mobile products and our complex hardware solutions in direct
      support of the Department of Defense are examples of this strategy.




***Federal
      Integrator and ISV Business***




Our
      primary target markets are the government and private-sector companies. We
      believe that our specialized server products are best suited to the high volume
      needs of the federal government. We team with large federal integrators as
      our
      primary channel for delivering our specialized servers.




Federal
      integrators outsource their specialized requirements to us. We design and
      manufacture specialized computing platforms that are the foundation upon which
      the integrators develop and deliver their solutions. This allows the integrators
      to shift their attention to application software and services. As a result,
      integrators shorten their time to deliver and lower their overall development
      costs.




2
 *Table
          of Contents*




We
      complement our specialized servers, which are often designed to withstand
      unusual environmental conditions, with software integration and testing
      services. We also provide configuration management, program management,
      logistics and support services that are generally unavailable from traditional
      computer vendors.




For
      our
      ISV customers, we serve as their “virtual hardware division.” We create a unique
      product for the ISV by integrating the ISV’s software onto a specialized
      appliance platform running Linux or one of Microsoft’s operating systems.




In
      addition, we augment the ISV’s internal capabilities by taking responsibility
      for those tasks necessary to successfully bring an appliance to market, but
      which are impractical for the ISV to perform. Services include branding, asset
      tagging, supply chain and inventory management, fulfillment, logistics and
      program management. The final deliverable is a branded, unique, optimized
      appliance that is ready to deploy when it arrives at the ISV’s end customer’s
      site.




We
      supplement our existing public sector sales force by utilizing the services
      of
      manufacturer representatives. Manufacturer representatives serve as strategic
      vehicles for gaining access to key decision makers within major federal
      integrator organizations. These companies act as a commission-based field sales
      teams which market our products and services to nationally recognized federal
      contracting companies, which mainly target military COTS server
      applications.




We
      are
      adding our own products and services to our end user solutions line to increase
      sales revenue and gross profit margins. End user products and services are
      sold
      into the federal market space via our General Services Administration (“GSA”)
      Schedule, Indefinite Delivery/Indefinite Quantity (“ID/IQ”) agreements, and
      Blanket Purchase Agreement (“BPA”) contracts.




We
      believe that our enhanced focus on our chosen
      markets, coupled with cost reductions, will allow us
      to
      manage our costs of
      operations in relation to our
      revenues. We believe that
      existing cash and cash equivalents on hand as of July 31, 2008 will
      be
      sufficient to fund our operations during the upcoming twelve
      months.




***SteelWorks
      Mobile Blackberry Enterprise Server***




SteelWorks
      Mobile and SteelWorks FedMobile are solutions that combine hardware, the
      BlackBerry Enterprise Server software, a customized installation tool and user
      auditing software in a plug and play appliance that assists customers with
      rapid
      installation. SteelWorks Mobile and SteelWorks FedMobile enable full
      installation in less than 30 minutes and support Microsoft® Exchange, IBM®
Lotus® Domino® and Novell® GroupWise® environments.




SteelWorks
      FedMobile is compliant with the guidelines of the DISA (Defense Information
      Systems Agency) STIG (Security Technical Implementation Guide, v. 5, rel. 2)
      Wireless policy. This Guide (STIG) addresses the design, implementation and
      management of wireless devices and networks that are used to provide email
      to
      mobile workers in the Department of Defense.




***IT
      Services***




Our
      IT
      services are marketed directly to end users and target medium to
      enterprise-level organizations in the government and commercial markets across
      the United States, with an emphasis on the Washington, D.C. metropolitan area.
      Many of our IT services incorporate technologies from Microsoft Corporation
      (“Microsoft”). As a Microsoft Gold Certified Partner, we have demonstrated the
      highest level of competence with Microsoft products. Microsoft-sponsored
      customer surveys since 2005 have ranked us on criteria such as timeliness,
      technical competency, ability to solve problems, return on investment and
      customer support. All respondents ranked us in the highest category for customer
      satisfaction.




3
 *Table
          of Contents*




***Research
      and Product Development***




By
      investing in product development, we believe we will have more control over
      the
      functionality and marketing of our products. We also believe that the resulting
      intellectual property will increase the competitiveness of our offerings and
      improve product margins. For the three and nine month periods ended July 31,
      2008, we incurred research and product development costs of approximately
      $167,000 and $574,000, respectively. For the three and nine month periods ended
      July 31, 2007, we incurred research and product development costs of
      approximately $183,000 and $478,000, respectively. We will continue to incur
      costs for product development in future periods.




***GSA
      Contract***




We
      have a
      multiple award schedule contract with the General Services Administration (the
      “GSA Contract”). Our GSA Contract was originally awarded in April 1996. The
      contract was renewed in fiscal year 2007 and is valid through March 31, 2012.
      In
      August 2006, GSA Contract auditors awarded us with an “Outstanding” rating for
      the management and execution of our GSA Contract. The GSA Contract enables
      government IT purchasers to acquire all of their needed goods and services
      from
      a particular vendor and largely limits the competition to selected vendors
      holding GSA Contracts.




**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**




The
      preparation of financial statements in conformity with U.S. Generally Accepted
      Accounting Principles requires management to make certain judgments, estimates
      and assumptions that could affect the reported amounts of assets and liabilities
      at the date of the financial statements and the reported amounts of revenue
      and
      expenses during the reporting period. We based our estimates and assumptions
      on
      historical experience and on various other assumptions believed to be
      applicable, and evaluated them on an on-going basis to ensure they remained
      reasonable under current conditions. Actual results could differ significantly
      from those estimates.




***Recently
      Issued Accounting Pronouncements***




On
      November 1, 2007, we adopted FIN 48. FIN 48 prescribes a recognition threshold
      that a tax position is required to meet before being recognized in the financial
      statements and provides guidance on derecognition, measurement, classification,
      interest and penalties, accounting in interim periods, disclosure and transition
      issues.




During
      the quarter ended July 31, 2008 we had a net decrease in our unrecognized tax
      benefit of $608,000. Our unrecognized tax benefit at July 31, 2008 is $59,000.
      We reduced our unrecognized tax benefit $655,000 by adjusting our NOL
      carryforwards and making an automatic change in accounting method. Both of
      these
      adjustments were made with the filing of our 2007 income tax return. We added
      $47,000 of unrecognized tax benefit associated with tax deductions for stock
      option and warrant exercises in excess of corresponding book charges per
      Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based
      Payment”. We have a valuation allowance against the full amount of our net
      deferred tax assets and therefore the adoption of FIN 48 had no impact on our
      retained earnings. The amount of unrecognized tax benefits that, if recognized,
      would impact the effective tax rate is $0.




4
 *Table
          of Contents*




We
      conduct business in the U.S. and are subject to U.S. taxes. As a result of
      our
      business activities, we file tax returns that are subject to examination by
      the
      respective federal and state tax authorities. For income tax returns filed
      by
      us, we are no longer subject to U.S. federal, or state tax examination by tax
      authorities for years before the tax year ended October 31, 2004, although
      significant net operating loss carryforward tax attributes that were generated
      prior to the tax year ended October 31, 2004 may still be adjusted upon
      examination by tax authorities if they either have been or will be
      utilized.




Our
      accounting policy is to recognize interest and penalties related to income
      tax
      matters in general and administrative expense. We have $0 accrued for interest
      and penalties as of July 31, 2008.




In
      September 2006, the FASB issued SFAS No. 157. SFAS No. 157 provides a common
      definition of fair value and establishes a framework to make the measurement
      of
      fair value in U.S. Generally Accepted Accounting Principles more consistent
      and
      comparable. SFAS No. 157 also requires expanded disclosures to provide
      information about the extent to which fair value is used to measure assets
      and
      liabilities, the methods and assumptions used to measure fair value, and the
      effect of fair value measures on earnings. SFAS No. 157 is effective for fiscal
      years beginning after November 15, 2007. We are in the process of evaluating
      the
      effect, if any, the adoption of SFAS No. 157 will have on our financial
      statements.




In
      February 2007, the FASB issued SFAS No. 159. SFAS No. 159 provides a choice
      to
      measure many financial instruments and certain other items at fair value and
      requires disclosures about the election of the fair value option. Unrealized
      gains and losses on items for which the fair value option has been elected
      are
      reported in earnings. SFAS No. 159 is effective for fiscal years beginning
      after
      November 15, 2007. Therefore, we are required to adopt SFAS No. 159 in the
      first
      quarter of 2009. We are in the process of evaluating the effect, if any, the
      adoption of SFAS No. 159 will have on our financial statements.




In
      December 2007, the FASB issued SFAS No. 141(R). SFAS No. 141R, which replaces
      SFAS No. 141, requires that the acquisition method of accounting (which SFAS
      No.
      141 called the “purchase method”) be used for all business combinations and for
      an acquirer to be identified for each business combination. SFAS No. 141R also
      establishes principles and requirements for how the acquirer recognizes and
      measures in its financial statements the identifiable assets acquired, the
      liabilities assumed, and any noncontrolling interest in the acquiree; recognizes
      and measures the goodwill acquired in the business combination or a gain from
      a
      bargain purchase; and determines what information to disclose to enable users
      of
      the financial statements to evaluate the nature and financial effects of the
      business combination. SFAS No. 141R also requires that acquisition-related
      costs
      be recognized separately from the business combination. SFAS No. 141R will
      apply
      prospectively to business combinations for which the acquisition date is after
      fiscal years beginning on or after December 15, 2008. We have not yet determined
      the impact that the implementation of SFAS No. 141R will have on our financial
      statements.




5
 *Table
          of Contents*




**RESULTS
      OF OPERATIONS**




**For
      the three months ended July 31, 2008 compared to the three months ended July
      31,
      2007:**




***Net
      Revenue Discussion:***




The
      following table summarizes our net revenue for the three months ended July
      31,
      2007 and 2008 in dollars and as a percentage of net revenues.




**Three Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            3,479,961
            
            
            87.70
            %
            $
            1,715,476
            
            
            66.89
            %
            $
            (1,764,485
            )
            
            (50.70
            )%Services
            
            
            487,926
            
            
            12.30
            %
            
            848,995
            
            
            33.11
            %
            
            361,069
            
            
            74.00
            %Total
                net revenues
            
            $
            3,967,887
            
            
            100.00
            %
            $
            2,564,471
            
            
            100.00
            %
            $
            (1,403,416
            )
            
            (35.37
            )%





The
      decrease in product revenues for the three month period ended July 31, 2008
      as
      compared to the three month period ended July 31, 2007 is primarily attributable
      to a decrease in our integrator business as a result of certain program delays.
      We plan for revenue to grow as we continue to focus our resources on our chosen
      markets and our end user solution line of products.




Services
      revenue increased 74% for the three month period ended July 31, 2008 as compared
      to the same period in fiscal 2007. This increase is the result of expanding
      our
      service offerings throughout the local Washington D.C. technology market. We
      expect service revenue to continue to grow in the future.




***Gross
      Profit Discussion:***




The
      following table summarizes our gross profit for the three months ended July
      31,
      2007 and 2008 in dollars, as a percentage of gross profit and as a percentage
      of
      net revenues.




**Three Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of**
              **Gross**
            
            
            
            **% of**
              **Gross****Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            844,603
            
            
            84.30
            %
            $
            415,378
            
            
            70.59
            %
            $
            (429,225
            )
            
            (50.82
            )%*Products
                - GP%*
            
            
            *24.27*
            *%*
            
            
            
            
            *24.21*
            *%*Services
            
            
            157,329
            
            
            15.70
            %
            
            173,029
            
            
            29.41
            %
            
            15,700
            
            
            9.98
            %*Services
                – GP%*
            
            
            *32.24*
            *%*
            
            
            
            
            *20.38*
            *%*Total
                gross profit
            
            $
            1,001,932
            
            
            100.00
            %
            $
            588,407
            
            
            100.00
            %
            $
            (413,525
            )
            
            (41.27
            )%*Total
                – GP%*
            
            
            *25.25*
            *%*
            
            
            
            
            *22.94*
            *%*





Product
      gross profit percentage remained relatively the same during the three month
      period ended July 31, 2008 when compared to the same period in fiscal 2007.
      We
      expect gross profit as a percentage of net revenues to continue to fluctuate
      from quarter to quarter as product lines expand, new products are brought to
      market, start up costs are incurred and new discounts, incentives and rebates
      become available.




6
 *Table
          of Contents*




The
      decrease in services gross profit percentage for the three months ended July
      31,
      2008 as compared to the same period in fiscal 2007 is attributable to our
      incurring costs associated with obtaining new clients. We have been successful
      in expanding our customer base for the three month period ended July 31, 2008
      as
      compared to the same period in fiscal 2007 which contributed to an increase
      in
      services revenue. We will continue to incur lower initial margins as we expand
      into new markets and increase our service offerings. We anticipate gross profit
      for services to fluctuate in future quarters as we continue to realign and
      grow
      the services division.




***Operating
      Expense Discussion:***




The
      following table summarizes our operating expenses for the three months ended
      July 31, 2007 and 2008 in dollars and as a percentage of net
      revenues.




**Three Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Selling
                and marketing
            
            $
            393,269
            
            
            9.91
            %
            $
            325,794
            
            
            12.70
            %
            $
            (67,475
            )
            
            (17.16
            )%Research
                and product development
            
            
            183,144
            
            
            4.62
            %
            
            166,748
            
            
            6.50
            %
            
            (16,396
            )
            
            (8.95
            )%General
                and administrative
            
            
            1,091,372
            
            
            27.51
            %
            
            1,031,726
            
            
            40.23
            %
            
            (59,646
            )
            
            (5.47
            )%Total
                operating expenses
            
            $
            1,667,785
            
            
            42.03
            %
            $
            1,524,268
            
            
            59.44
            %
            $
            (143,517
            )
            
            (8.61
            )%





The
      decrease in selling and marketing expenses is the result of aligning expenses
      to
      our current and future business models in the beginning of the fiscal year.
      For
      the three months ended July 31, 2008 compared to the three months ended July
      31,
      2007, marketing activities and expense associated with selling and marketing
      personnel decreased as a result of cost cutting efforts. We will continue to
      evaluate our costs relative to our revenues and gross margins.




The
      decrease in research and product development expenses for the three months
      ended
      July 31, 2008 compared to the three months ended July 31, 2007 is the result
      of
      certain product launches and associated expenses which fluctuate from quarter
      to
      quarter. We continue to make investments in research and product development
      to
      maintain and enhance current products. We believe that research and product
      development expenses will fluctuate from quarter to quarter as new products
      are
      being developed and introduced into the marketplace.




The
      decrease in general and administrative expenses for the three months ended
      July
      31, 2008 compared to the three months ended July 31, 2007 is primarily
      attributable to cost cutting efforts. The cost reductions continue to include
      curtailing expenses related to non-revenue generating activities, terminating
      non-essential employees, and instituting across the board departmental expense
      reductions. Our cost reductions were offset by approximately $61,000 of fees
      incurred related to us implementing FIN 48 for the three months ended July
      31,
      2008 compared to the same period in fiscal year 2007. Although we continue
      to
      manage our costs relative to our revenues and gross margins, additional
      resources may be required in order to invest in our federal integrator, ISV,
      and
      SteelWorks Mobile business.




7
 *Table
          of Contents*




***Interest
      Income Discussion:***




The
      following table summarizes our interest income for the three months ended July
      31, 2007 and 2008 in dollars and as a percentage of net revenues.




**Three Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Interest
                (expense), net
            
            $
            (7,005
            )
            
            (0.18
            )%
            $
            (5,825
            )
            
            (0.23
            )%
            $
            (1,180
            )
            
            (16.85
            )%





The
      decrease in net interest expense for the three month period ended July 31,
      2008
      is attributable to less interest expense associated with severance payments
      at
      net present value compared to the same period in fiscal year 2007.




***Net
      (Loss) Discussion:***




The
      following table summarizes our net (loss) for the three months ended July 31,
      2007 and 2008 in dollars and as a percentage of net revenues.




**Three Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Net
                (loss)
            
            $
            (672,858
            )
            
            (16.96
            )%
            $
            (941,686
            )
            
            (36.72
            )%
            
            268,828
            
            
            39.95
            %





The
      increase in net loss for the three months ended July 31, 2008 as compared to
      the
      same period in fiscal 2007 is a result of lower revenues and corresponding
      gross
      margin dollars. We plan for revenue to grow while keeping expenses in alignment
      with our revenue and gross margins.




**For
      the nine months ended July 31, 2008 compared to the nine months ended July
      31,
      2007:**




***Net
      Revenue Discussion:***




The
      following table summarizes our net revenue for the nine months ended July 31,
      2007 and 2008 in dollars and as a percentage of net revenues.




**Nine Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            11,766,032
            
            
            88.95
            %
            $
            14,796,243
            
            
            88.31
            %
            $
            3,030,211
            
            
            25.75
            %Services
            
            
            1,461,765
            
            
            11.05
            %
            
            1,959,334
            
            
            11.69
            %
            
            497,569
            
            
            34.04
            %Total
                net revenues
            
            $
            13,227,797
            
            
            100.00
            %
            $
            16,755,577
            
            
            100.00
            %
            $
            3,527,780
            
            
            26.67
            %




8
 *Table
          of Contents*




The
      increase in product revenues is primarily attributable to significant deliveries
      we made during the nine month period ended July 31, 2008 specifically related
      to
      our major federal integrator contract delivered in Q2 compared to the same
      period in fiscal year 2007.




Service
      revenue increased approximately 34% for the nine month period ended July 31,
      2008 as compared to the same period in fiscal 2007. The increase is the result
      of the expansion of our service offerings throughout the local Washington D.C.
      technology market. We expect service revenue to continue to grow in the future.




***Gross
      Profit Discussion:***




The
      following table summarizes our gross profit for the nine months ended July
      31,
      2007 and 2008 in dollars, as a percentage of gross profit and as a percentage
      of
      net revenues.




**Nine Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Gross**
            
            
            
            **% of Gross****Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            2,471,942
            
            
            83.83
            %
            $
            2,445,022
            
            
            87.08
            %
            $
            (26,920
            )
            
            (1.09
            )%*Products
                – GP%*
            
            
            *21.01*
            *%*
            
            
            
            
            *16.52*
            *%*Services
            
            $
            476,647
            
            
            16.17
            %
            
            362,855
            
            
            12.92
            %
            
            (113,792
            )
            
            (23.87
            )%*Services –
                GP%*
            
            
            *32.61*
            *%*
            
            
            
            
            *18.52*
            *%*Total
                gross profit
            
            $
            2,948,589
            
            
            100.00
            %
            $
            2,807,877
            
            
            100.00
            %
            $
            (140,712
            )
            
            (4.77
            )%*Total –
                GP%*
            
            
            *22.29*
            *%*
            
            
            
            
            *16.76*
            *%*





The
      decrease in product gross profit percentage for the nine months ended July
      31,
      2008 as compared to the same period in fiscal 2007 is primarily due to our
      recognizing revenue associated with a residual multi-year low margin reseller
      order during fiscal year 2008. This residual contract, in its final year,
      resulted in lower margins than prior years. Additionally, the decrease is due
      to
      lower margins associated with our major federal integrator contract. These
      contracts were awarded with a quick turnaround delivery period which
      significantly reduced our ability to improve the overall contract margins over
      the life of the contract. We expect gross profit as a percentage of net revenues
      to continue to fluctuate from quarter to quarter as product lines expand, new
      products are brought to market, start up costs are incurred and new discounts,
      incentives and rebates become available.




The
      decrease in services gross profit percentage for the nine months ended July
      31,
      2008 as compared to the same period in fiscal 2007 is attributable to our
      incurring costs associated with new client contracts. We will incur lower
      initial margins as we expand into new markets and increase our service
      offerings. We anticipate gross profit for services to fluctuate in future
      quarters as we continue to realign and grow the services division.




9
 *Table
          of Contents*




***Operating
      Expense Discussion:***




The
      following table summarizes our operating expenses for the nine months ended
      July
      31, 2007 and 2008 in dollars and as a percentage of net revenues.




**Nine Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Selling
                and marketing
            
            $
            1,148,023
            
            
            8.68
            %
            $
            927,756
            
            
            5.54
            %
            $
            (220,267
            )
            
            (19.19
            )%Research
                and product development
            
            
            477,741
            
            
            3.61
            %
            
            573,861
            
            
            3.42
            %
            
            96,120
            
            
            20.12
            %General
                and administrative
            
            
            3,388,051
            
            
            25.61
            %
            
            2,919,519
            
            
            17.42
            %
            
            (468,532
            )
            
            (13.83
            )%Total
                operating expenses
            
            $
            5,013,815
            
            
            37.90
            %
            $
            4,421,136
            
            
            26.39
            %
            $
            (592,679
            )
            
            (11.82
            )%





The
      decrease in selling and marketing expense is the result of aligning expenses
      to
      our current and future business models. For the nine months ended July 31,
      2008
      compared to the nine months ended July 31, 2007, marketing activities and
      expense associated with selling and marketing personnel decreased as a result
      of
      cost cutting efforts. We will continue to evaluate our costs relative to our
      revenues and gross margins.




The
      increase in research and product development for the nine months ended July
      31,
      2008 compared to the nine months ended July 31, 2007 is the result of our
      continuing to make investments in research and product development to maintain
      and enhance current products. We believe that research and product development
      expenses will fluctuate from quarter to quarter as new products are being
      developed and introduced into the marketplace.




The
      decrease in general and administrative expenses for the nine months ended July
      31, 2008 compared to the nine months ended July 31, 2007 is primarily
      attributable to cost cutting efforts. The cost reductions continue to include
      curtailing expenses related to non-revenue generating activities, terminating
      non-essential employees, and instituting an across the board departmental
      expense reductions. Our cost reductions were offset by approximately $195,000
      of
      fees incurred related to us implementing FIN 48 for the nine months ended July
      31, 2008 compared to the same period in fiscal year 2007. Although we continue
      to manage our costs relative to our revenues and gross margins, additional
      resources may be required in order to invest in our core federal integrator
      and
      ISV business.




10
 *Table
          of Contents*




***Interest
      Income Discussion:***




The
      following table summarizes our interest income for the nine months ended July
      31, 2007 and 2008 in dollars and as a percentage of net revenues.




**Nine Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Interest
                income, net
            
            $
            18,685
            
            
            0.14
            %
            $
            5,417
            
            
            0.03
            %
            $
            (13,268
            )
            
            (71.01
            )%





The
      decrease in net interest income for the nine month period ended July 31, 2008
      is
      attributable to lower interest income earned due to lower cash balances over
      the
      nine month period ended July 31, 2008 compared to the same period in fiscal
      year
      2007.




***Net
      (Loss) Discussion:***




The
      following table summarizes our net (loss) for the nine months ended July 31,
      2007 and 2008 in dollars and as a percentage of net revenues.




**Nine Months Ended July 31,****2007 (restated)**
            
            **2008**
            
            **Increase (decrease)****% of Net**
            
            
            
            **% of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Net
                (loss)
            
            $
            (2,046,541
            )
            
            (15.47
            )%
            $
            (1,607,842
            )
            
            (9.60
            )%
            $
            (438,699
            )
            
            (21.44
            )%





The
      decrease in net loss for the nine months ended July 31, 2008 as compared to
      the
      same period in fiscal year 2007 is a result of higher revenues and corresponding
      gross margin dollars and the effects of us continuing to manage our costs
      relative to our revenue during the nine months ended July 31, 2008 compared
      to
      the same period in fiscal year 2007. We plan to continue to keep expenses in
      alignment with our revenue and gross margins.




**LIQUIDITY
      AND CAPITAL RESOURCES**




As
      of
      July 31, 2008, we had working capital of approximately $2.6 million. While
      we
      have incurred a loss in the nine month period ended July 31, 2008, we believe
      cash on hand and cash equivalents will provide sufficient financial resources
      to
      finance operations during the upcoming 12 months.




For
      the
      nine months ended July 31, 2008, we used approximately $654,000 in cash from
      operating activities. Our primary use of cash was to finance our operating
      loss
      and reduce our accounts payable balance by $801,000. A decrease in accounts
      receivable generated approximately $1.5 million of cash. This decrease was
      due
      to more efficient collections of significant accounts receivable payments.
      The
      use and availability of our cash is affected by the timing, pricing, and
      magnitude of orders for our products, and the timing of cash outflows relating
      to these orders.




For
      the
      nine months ended July 31, 2008, we invested approximately $382,000 in property
      and equipment. These expenditures primarily consisted of purchases of equipment
      leased to customers.





For
      the
      nine months ended July 31, 2008, we generated approximately $220,000 from
      financing activities primarily as a result of the exercise of employee stock
      options.




On
      March
      6, 2008, we renewed our bank line of credit that allows us to borrow an amount
      equal to the lesser of our collateralized cash on hand or $3.5 million. The
      line
      of credit bears interest at the LIBOR Market Index rate plus 1.25%. The line
      of
      credit is secured by all of our assets and expires on March 31, 2009. There
      were
      no outstanding borrowings on the line of credit at October 31, 2007 and July
      31,
      2008.




11
 *Table
          of Contents*




From
      time
      to time, we may pursue strategic acquisitions or mergers, which may require
      significant additional capital. In such event, we may seek additional financing
      of debt and/or equity. We make no assurance that any such financings will be
      consummated.




***Contractual
      Obligations and Commercial Commitments:***




We
      have
      significant contractual obligations as of July 31, 2008 and beyond for our
      operating leases and employment agreements. The total obligation for our office
      leases, expiring in August 2009 and August 2014, is approximately $44,000 a
      month. The total obligation for our employment agreements, expiring in August
      and October 2010, is approximately $40,000 a month and does not include
      applicable employment taxes and potential bonuses. Future rental and salary
      payments under our operating lease and employment agreements are presented
      below. We do not have any purchase obligations, capital lease obligations or
      any
      material commitments for capital expenditures. We have not engaged in
      off-balance sheet financing, commodity contract trading or significant related
      party transactions.




**Contractual Obligations**
            
            **Payments Due by Period****Total**
            
            **Less than 1 year**
            
            **2-3 years**
            
            **4-5 years**
            
            **After 5**
              **years**Notes payable
            
            $
            17,272
            
            $
            7,450
            
            $
            9,822
            
            
            -
            
            
            -Operating leases
            
            
            1,921,714
            
            
            543,071
            
            
            549,254
            
            
            537,982
            
            
            291,407Employment
                agreements
            
            
            1,262,917
            
            
            475,000
            
            
            787,917
            
            
            -
            
            
            -Total
            
            $
            3,201,903
            
            $
            1,025,521
            
            $
            1,346,993
            
            $
            537,982
            
            $
            291,407





We
      believe that these commitments will be satisfied with cash on hand and future
      operating cash flows.




**ITEM
      3.****QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**




We
      are
      exposed to market risk related to fluctuations in interest rates on our debt.
      Increases in prevailing interest rates could increase our interest payment
      obligations relating to variable rate debt. For example, a 100 basis point
      increase in interest rates would increase our annual interest expense by $35,000
      if we fully utilized our existing line of credit.




**ITEM
      4.****CONTROLS
      AND PROCEDURES**




***Evaluation
      of the Company’s Disclosure Controls and Internal Controls***




As
      required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended
      (the “Exchange Act”), we carried out an evaluation, under the supervision and
      with the participation of our management, including our President and Chief
      Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), of the
      effectiveness, as of the end of the quarter covered by this report, of the
      design and operation of our “disclosure controls and procedures” as defined in
      Exchange Act Rule 13a-15(e) promulgated by the Securities and Exchange
      Commission (“SEC”) under the Exchange Act. Based upon this evaluation, our CEO
      and CFO concluded that our disclosure controls and procedures, as of the end
      of
      such period, were not adequate and effective to ensure that information required
      to be disclosed by us in the reports that we file or submit under the Exchange
      Act is recorded, processed, summarized and reported within the time periods
      specified in the SEC’s rules and forms, and to ensure that such information is
      accumulated and communicated to our management, including our CEO and CFO,
      as
      appropriate to allow timely decisions regarding required disclosure.


12
 *Table
          of Contents*




In
      making
      this evaluation, the CEO and CFO considered, among other matters:




·
            The
                material weakness in our internal control over financial reporting
                that
                existed as of October 31, 2007 and that, we believe, continued to
                exist as
                of July 31, 2008; and




·
            Management’s
                conclusion, as reported in Item 9A of our Annual Report on Form 10-K
                for
                the fiscal year ended October 31, 2007, that our internal control
                over
                financial reporting was not effective as of October 31, 2007; and
                the
                conclusion of our CEO and CFO, as reported in Item 9A of our Annual
                Report
                on Form 10-K for the fiscal year ended October 31, 2007, that our
                disclosure controls and procedures as of October 31, 2007 were not
                effective.




Notwithstanding
      the material weakness in our internal control over financial reporting that
      existed as of July 31, 2008, management believes that (i) this Quarterly Report
      on Form 10-Q does not contain any untrue statement of a material fact or omit
      to
      state a material fact necessary to make the statements made, in light of the
      circumstances under which they were made, not misleading with respect to the
      periods covered by this Report and (ii) the financial statements, and other
      financial information included in this Report, fairly present in all material
      respects our financial condition, results of operations and cash flows as of,
      and for, the dates and periods presented in this Quarterly Report.




A
      material weakness is a control deficiency, or a combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. Management has concluded that our disclosure controls and
      procedures were ineffective as of July 31, 2008 as a result of the following
      material weakness:




·
            Lack
                of effective policies and procedures surrounding the review and
                determination of manufacturing costs which should have been allocated
                to
                inventory and cost of goods sold which contributed to the understatement
                of inventory and cost of goods sold and overstatement of general
                and
                administrative expenses.




This
      material weakness resulted in the restatement of our consolidated balance sheets
      for the fiscal year ended October 31, 2006, the related consolidated statements
      of operations, shareholders’ equity, and cash flows for each of the fiscal years
      ended October 31, 2006 and 2005, the unaudited quarterly financial information
      for each of the quarters in the nine months ended July 31, 2007 and unaudited
      quarterly financial information in each of the quarters in the year ended
      October 31, 2006. Additionally, this control deficiency could result in a
      misstatement of the aforementioned accounts or disclosures that would result
      in
      a material misstatement of our annual and unaudited interim consolidated
      financial statements that would not be prevented or detected.




Our management
      has implemented the following remedial measures to address the material weakness
      that existed at October 31, 2007 and, we believe, continued to exist as of
      July
      31, 2008:




·
            Developed
                and implemented policies and procedures to identify and properly
                allocate
                manufacturing cost to inventory costs of goods sold.




·
            Established
                new key controls and strengthened existing controls surrounding the
                review
                and approval of our financial statements and disclosures. Specifically,
                we
                enhanced certain key controls around the analysis of new accounts
                and
                identification of significant variances in existing accounts.


13
 *Table
          of Contents*





·
            Enhanced
                processes and controls within our financial statement close process,
                including the preparation and review of a financial statement disclosure
                andU.S.Generally
                Accepted Accounting Principles (“GAAP”)checklist for all of our SEC filings. This checklist will be reviewed
                on a
                quarterly basis by financial management and our Disclosure Committee
                specifically as it applies to the application of, and compliance
                with,
                GAAP.




·
            Strengthened
                our review of all financial statement filings and supporting details,
                including (i) review of the financial statement disclosure and GAAP
                checklist discussed above and (ii) requiring financial management
                review
                and approval of all supporting documentation associated with the
                financial
                statements.





We
      anticipate that our testing and evaluation of the operating effectiveness and
      sustainability of these changes to our internal control over financial reporting
      will be completed by the end of the 2008 fiscal year. We plan to automate many
      processes and procedures associated with the review and determination of
      manufacturing costs and the associated allocation to inventory and cost of
      goods
      sold.





The
      above-mentioned improvements in our internal control over financial reporting,
      when taken in the aggregate, will materially improve our internal control over
      financial reporting for the years ending after October 31, 2007. We will
      continue to actively look to develop and implement additional measures that
      are
      reasonably likely to materially improve and strengthen our internal control
      over
      financial reporting in the future. Our management and members of our Audit
      Committee will continue to closely monitor these efforts to ensure that we
      fully
      remediate the material weakness identified as of October 31, 2007. The
      effectiveness of the steps we are proposing are subject to continued management
      review and Audit Committee oversight and, accordingly, we may make additional
      changes to our internal control over financial reporting to further address
      this
      material weakness.




***Limitations***




A
      control
      system, no matter how well designed and operated, can provide only reasonable,
      not absolute, assurance that the control system’s objectives will be met.
      Further, the design of a control system must reflect the fact that there are
      resource constraints, and the benefits of controls must be considered relative
      to their costs. Because of the inherent limitations in all control systems,
      no
      evaluation of controls can provide absolute assurance that all control issues
      and instances of fraud, if any, within the Company have been detected. These
      inherent limitations include the realities that judgments in decision-making
      can
      be faulty, and that breakdowns can occur because of simple errors or mistakes.
      Controls can also be circumvented by the individual acts of some persons, by
      collusion of two or more people, or by management override of the controls.
      The
      design of any system of controls is based in part upon certain assumptions
      about
      the likelihood of future events, and there can be no assurance that any design
      will succeed in achieving its stated goals under all potential future
      conditions. Over time, controls may become inadequate because of changes in
      conditions or deterioration in the degree of compliance with its policies or
      procedures. Because of the inherent limitations in a cost-effective control
      system, misstatements due to error or fraud may occur and not be detected.
      We
      continuously evaluate our internal controls and make changes to improve
      them.




***Changes
      in Internal Controls over Financial Reporting***




There
      was
      no change in our internal controls over financial reporting (as defined in
      Rules
      13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period
      covered by this Quarterly Report on Form 10-Q that has materially affected,
      or
      is reasonably likely to materially affect, our internal control over financial
      reporting.


14
 *Table
          of Contents*




**PART
      II. OTHER INFORMATION******




**ITEM
      1.****LEGAL
      PROCEEDINGS**




There
      are
      routine legal claims pending against us that occur in the ordinary course of
      business, but in the opinion of management, liabilities, if any, arising from
      such claims will not have a material adverse effect on our financial condition
      and results of operation.




We
      are
      not otherwise a party to any other material legal proceedings.




**ITEM
      1A.****RISK
      FACTORS**




There
      have been no material changes from the risk factors disclosed in the “Risk
      Factors” sections of our Annual Report on Form 10-K for the fiscal year ended
      October 31, 2007.




**ITEM
      2.****UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**




Not
      applicable.




**ITEM
      3.****DEFAULTS
      UPON SENIOR SECURITIES**




Not
      applicable.




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




On
      May 7,
      2008, we held our 2007 Annual Meeting of Shareholders. At the Annual Meeting,
      our shareholders were asked to vote upon: (i) the election of Directors; (ii)
      the approval of our Amended 2007 Stock Option and Restricted Stock Plan and;
      (iii) the approval of Grant Thornton, as our independent accounting firm as
      the
      Company’s independent certified public accountants for the ensuing year.





The
      following persons were elected as Directors to serve on our Board of Directors
      until the 2008 Annual Meeting of Shareholders by the votes noted next to such
      persons name:





**FOR**
            
            **WITHHELD**Rear
                Admiral Robert E. Frick
            
            
            11,685,312
            
            
            1,466,821James
                Bruno
            
            
            12,892,212
            
            
            259,921VADM
                E.A. Burkhalter
            
            
            12,618,071
            
            
            534,062Jay
                Kaplowitz
            
            
            11,545,036
            
            
            1,607,097Benjamin
                Krieger
            
            
            12,661,609
            
            
            490,524Ashok
                Kaveeshwar
            
            
            12,922,592
            
            
            229,541





Rear
      Admiral Robert E. Frick, James Bruno, VADM E.A. Burkhalter, Jr., Jay Kaplowitz,
      Benjamin Krieger, and Ashok Kaveeshwar were each elected as Directors and shall
      serve until their respective successors have been duly elected and
      qualified.





15
 *Table
          of Contents*




Our
      Amended 2007 Stock Option and Restricted Stock Plan was approved by the
      following vote:





**FOR**
            
            **AGAINST**
            
            **ABSTAIN**3,708,305
            
            
            1,749,721
            
            
            15,495




Grant
      Thornton LLP was approved to act as our independent certified public accountants
      for the ensuing year by the following vote:





**FOR**
            
            **AGAINST**
            
            **ABSTAIN**12,949,661
            
            
            177,749
            
            
            24,723




**ITEM
      5.****OTHER
      INFORMATION**




Not
      applicable.




**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 pursuantto
                Section 906 of the Sarbanes - Oxley Act of
                2002.




16
 *Table
          of Contents*




**SIGNATURES**




Pursuant
      to the requirements of the Securities Exchange Act of 1934, as amended, the
      registrant has duly caused this report to be signed on its behalf by the
      undersigned thereunto duly authorized.




September
                15, 2008
            **STEELCLOUD,
                INC.**By:
            /s/
                Robert E. Frick.Name:
                Robert E. FrickTitle:
                Chief Executive Officer and PresidentBy:
            /s/
                Kevin MurphyName:
                Kevin MurphyTitle:
                Chief Financial Officer




17