UNITED STATESSECURITIES AND
EXCHANGE COMMISSIONWASHINGTON, 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, 2005

OR

|[_] | 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 [X]     No
[_]

Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).

Yes [_]     No
[X]

As of September 1, 2005
there were 14,021,862 shares of the registrants common stock outstanding.

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|1
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SteelCloud, Inc.Form 10-Q
IndexFor the Quarterly period ended July 31, 2005

|Description | Page
|----------- | ----
|            |     
|Part I.     |     
|            |     
|Item 1.     |     
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|Item 2.     |     
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|Item 3.     |     
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|Item 4.     |     
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|Part II.    |     
|            |     
|Item 1.     |     
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|Item 2.     |     
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|Item 3.     |     
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|Item 4.     |     
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|Item 5.     |     
|            |     
|Item 6.     |     

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

STEELCLOUD, INC.CONSOLIDATED BALANCE SHEET

|                                                    | October 31,2004 |  | July 31,2005 |            
|--------------------------------------------------- | --------------- |  | ------------ | -----------
|                                                    |                 |  |              |            
|ASSETS                                              |                 |  |              |            
|Current assets                                      |                 | 
|Cash and cash equivalents                           |                 |  | $            | 3,108,941  
|Accounts receivable, net                            |                 |  |              | 9,532,770  
|Inventory, net                                      |                 |  |              | 3,629,685  
|Prepaid expenses and other current assets           |                 |  |              | 307,427    
|Deferred contract cost                              |                 |  |              | 40,085     
|                                                    |                 |  |              |            
|Total current assets                                |                 |  |              | 16,618,908 
|                                                    |                 | 
|Property and equipment, net                         |                 |  |              | 454,928    
|Equipment on lease, net                             |                 |  |              | 373,590    
|Goodwill and other intangible assets, net           |                 |  |              | 4,687,105  
|Deferred tax asset                                  |                 |  |              | 400,000    
|Other assets                                        |                 |  |              | 196,244    
|                                                    |                 |  |              |            
|                                                    |                 | 
|Total assets                                        |                 |  | $            | 22,730,775 
|                                                    |                 |  |              |            
|                                                    |                 | 
|LIABILITIES AND STOCKHOLDERS' EQUITY                |                
|Current liabilities                                 |                 | 
|Accounts payable                                    |                 |  | $            | 4,866,079  
|Accrued expenses                                    |                 |  |              | 1,441,350  
|Notes payable, current                              |                 |  |              | 71,176     
|Unearned revenue                                    |                 |  |              | 373,017    
|                                                    |                 |  |              |            
|Total current liabilities                           |                 |  |              | 6,751,622  
|                                                    |                 | 
|Notes payable, long-term                            |                 |  |              | 120,660    
|Other                                               |                 |  |              | 20,083     
|                                                    |                 |  |              |            
|Total long-term liabilities                         |                 |  |              | 140,743    
|                                                    |                 | 
|Stockholders' equity                                |                 | 
|Preferred stock, $.001 par value: 2,000,000 shares  |                
|authorized, no shares issued and outstanding at     |                
|October 31, 2004 and July 31, 2005                  |                 |  |              |           
|Common stock, $.001 par value: 50,000,000 shares    |                 | 
|authorized, 14,213,514 and 14,421,862 shares issued |                 | 
|at October 31, 2004 and July 31, 2005, respectively |                 |  |              | 14,214     
|Additional paid in capital                          |                 |  |              | 50,934,453 
|Treasury stock, 400,000 shares at October 31, 2004  |                 | 
|and July 31, 2005, respectively                     |                 |  |              | (3,432,500 
|Accumulated deficit                                 |                 |  |              | (31,677,757
|                                                    |                 |  |              |            
|Total stockholders' equity                          |                 |  |              | 15,838,410 
|                                                    |                 |  |              |            
|                                                    |                 | 
|Total liabilities and stockholders' equity          |                 |  | $            | 22,730,775 
|                                                    |                 |  |              |            

The accompanying notes
are an integral part of these consolidated financial statements.

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STEELCLOUD, INC.CONSOLIDATED
STATEMENTS OF OPERATIONS(unaudited)

|                                             | Three Months EndedJuly 31, |  | Nine Months EndedJuly 31, |           
|-------------------------------------------- | -------------------------- |  | ------------------------- | ----------
|
|                                             |                            |  |                           |           
|Revenues                                     |                            |  |                           |           
|Products                                     |                            |  | $                         | 5,566,452 
|Services                                     |                            |  |                           | 1,033,844 
|                                             |                            |  |                           |           
|Total revenues                               |                            |  |                           | 6,600,296 
|                                             |                            |  |                           |           
|                                             |                            | 
|Cost of revenues                            
|Products                                     |                            |  |                           | 4,844,877 
|Services                                     |                            |  |                           | 615,674   
|                                             |                            |  |                           |           
|Total cost of revenues                       |                            |  |                           | 5,460,551 
|                                             |                            |  |                           |           
|                                             |                            | 
|Gross profit                                 |                            |  |                           | 1,139,745 
|                                             |                            | 
|Selling and marketing                        |                            |  |                           | 646,786   
|Research and product development             |                            |  |                           | 161,694   
|General and administrative                   |                            |  |                           | 1,367,304 
|Amortization of other intangible assets      |                            |  |                           | 51,933    
|                                             |                            |  |                           |           
|                                             |                            | 
|(Loss) income from operations                |                            |  |                           | (1,087,972
|                                             |                            | 
|Interest (income), net                       |                            |  |                           | (11,045   
|                                             |                            |  |                           |           
|                                             |                            | 
|Net (loss) income                            |                            |  | $                         | (1,076,927
|                                             |                            | 
|(Loss) earnings per share:                  
|                                             |                            | 
|Basic (loss) earnings per share              |                            |  | $                         | (0.08     
|Diluted (loss) earnings per share            |                            |  | $                         | (0.08     
|                                             |                            | 
|Weighted-average shares outstanding, basic   |                            |  |                           | 13,646,284
|Weighted-average shares outstanding, diluted |                            |  |                           | 13,646,284

The
accompanying notes are an integral part of these consolidated financial
statements.

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STEELCLOUD, INC.CONSOLIDATED
STATEMENTS OF CASH FLOWS(unaudited)

|                                                       | Nine Months EndedJuly 31, | 
|------------------------------------------------------ | ------------------------- | 
|
|                                                       |                           | 
|Operating activities                                   |                           | 
|Net (loss) income                                      |                           | 
|                                                       |                           | 
|Adjustments to reconcile net (loss) income to net cash
|(used in) provided by operating activities:           
|                                                       |                           | 
|Depreciation and amortization                          |                           | 
|                                                       |                           | 
|Changes in operating assets and liabilities, net of   
|effects of acquisition:                               
|Accounts receivable                                    |                           | 
|Inventory                                              |                           | 
|Prepaid expenses and other assets                      |                           | 
|Deferred contract costs                                |                           | 
|Accounts payable                                       |                           | 
|Accrued expenses                                       |                           | 
|Unearned revenue and other liabilities                 |                           | 
|                                                       |                           | 
|Net cash (used in) provided by operating activities    |                           | 
|                                                       |                           | 
|Investing activities                                   |                           | 
|Purchase of property and equipment                     |                           | 
|Cash paid in acquisition                               |                           | 
|                                                       |                           | 
|Net cash used by investing activities                  |                           | 
|                                                       |                           | 
|Financing activities                                   |                           | 
|Proceeds from issuance of common stock                 |                           | 
|Proceeds from exercise of common stock options         |                           | 
|Payments on notes payable                              |                           | 
|                                                       |                           | 
|Net cash provided by financing activities              |                           | 
|Net (decrease) increase in cash and cash equivalents  
|of operations                                          |                           | 
|                                                       |                           | 
|Cash and cash equivalents at beginning of period       |                           | 
|                                                       |                           | 
|Cash and cash equivalents at end of period             |                           | 
|                                                       |                           | 
|                                                       |                           | 
|Supplemental cash flow information                     |                           | 
|Common stock issued in acquisition                     |                           | 
|Interest paid                                          |                           | 
|Income taxes paid                                      |                           | 

The accompanying notes
are an integral part of these consolidated financial statements.

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STEELCLOUD, INC.CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY(unaudited)

|                            | Preferred Stock |  | Common Stock |   | AdditionalPaid-In |  | Treasury |  | Accumulated |            | Shares |  
|--------------------------- | --------------- |  | ------------ | - | ----------------- |  | -------- |  | ----------- | ---------- | ------ | -
|
|                            |                 | 
|Balance at November 1, 2003 |                 |  |              |  |                   |  |         |  |             | 13,008,553 |        | $
|                            |                 | 
|Issuance of common stock    |                 | 
|in connection with exercise |                 | 
|of employee incentive stock |                 | 
|option plan                 |                 |  |              |  |                   |  |         |  |             | 325,649    |        |  
|                            |                 | 
|Issuance of common stock   
|in connection with exercise
|of warrants                 |                 |  |              |  |                   |  |         |  |             | 247,525    |        |  
|                            |                 | 
|Issuance of common stock    |                 | 
|in connection with employee |                 | 
|stock purchase plan         |                 |  |              |  |                   |  |         |  |             | 24,846     |        |  
|                           
|Issuance of common stock   
|in connection with         
|acquisition                 |                 |  |              |  |                   |  |         |  |             | 575,000    |        |  
|                            |                 | 
|Net loss                    |                 |  |              |  |                   |  |         |  |             |           |        |  
|                            |                 | 
|Balance at July 31, 2004    |                 |  |              |  |                   |  |         |  |             | 14,181,573 |        | $
|                            |                 | 
|                            |                 | 
|                            |                 | 
|Balance at November 1, 2004 |                 |  |              |  |                   |  |         |  |             | 14,213,514 |        | $
|                            |                 | 
|                            |                 | 
|Issuance of common stock   
|in connection with exercise
|of employee incentive stock
|option plan                 |                 |  |              |  |                   |  |         |  |             | 175,625    |        |  
|                            |                 | 
|Issuance of common stock    |                 | 
|in connection with employee |                 | 
|stock purchase plan         |                 |  |              |  |                   |  |         |  |             | 32,723     |        |  
|                            |                 | 
|Net income                  |                 |  |              |  |                   |  |         |  |             |           |        |  
|                            |                 | 
|Balance at July 31, 2005    |                 |  |              |  |                   |  |         |  |             | 14,421,862 |        | $
|                            |                 | 

The accompanying notes are
an integral part of these consolidated financial statements.

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|6
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STEELCLOUD, INC.NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS

|1. | Nature of Business and Basis of Presentation
|-- | --------------------------------------------

Founded in 1987,
SteelCloud, Inc, (the Company) based in Herndon, Virginia, designs
and manufactures ready-to-deploy server appliances through strategic
relationships with software and technology companies. The Companys server
appliances are designed to meet the precise needs of volume customers.
SteelClouds consulting services organization provides clients with
technical services, including network analysis and design; security audits and
assessments and managed security services. The Company also resells the software
products of its strategic partners and certain other software providers. In
addition, the Company is making research and development investments to develop
intellectual property in the form of SteelCloud branded software and server
appliances that will help organizations be compliant with federal and state
legislative acts such as Sarbanes-Oxley, Gramm-Leach-Bliely and Health Insurance
Portability and Accountability Act (HIPAA).

The consolidated
financial statements for the three and nine month periods ended July 31, 2005
and 2004 are unaudited and include all adjustments which, in the opinion of
management, are necessary to present fairly the results of operations for the
periods then ended. All such adjustments are of a normal and recurring nature.
These consolidated financial statements should be read in conjunction with the
Annual Report on Form 10-K of the Company, which includes consolidated financial
statements and notes thereto for the years ended October 31, 2004 and 2003.

|2. | Employee Stock Options
|-- | ----------------------

The Company accounts for
employee stock option grants using the intrinsic method in accordance with
Accounting Principles Board (APB) Opinion No. 25 Accounting for Stock
Issued to Employees and accordingly associated compensation expense, if
any, is measured as the excess of the underlying stock price over the exercise
price on the date of grant. The Company complies with the disclosure option of
Statement of Financial Accounting Standards (SFAS) No. 123 Accounting for
Stock Based Compensation, and SFAS No. 148 Accounting for
Stock-Based CompensationTransition and Disclosure which requires
pro-forma disclosure of compensation expense associated with stock options under
the fair value method.

The Companys pro
forma information follows:

|                                                     | Three Months EndedJuly 31, |  | Nine Months EndedJuly 31, |           
|---------------------------------------------------- | -------------------------- |  | ------------------------- | ----------
|
|                                                     |                            |  |                           |           
|Net (loss) earnings, as reported                     |                            |  | $                         | (1,076,927
|Less: Total stock based employee compensation        |                            | 
|expense determined under the fair-value based method |                            |  |                           | 88,421    
|                                                     |                            |  |                           |           
|Pro-Forma net (loss)                                 |                            |  | $                         | (1,165,348
|                                                     |                            |  |                           |           
|                                                     |                            | 
|Basic (loss) earnings per share as reported          |                            |  | $                         | (0.08     
|                                                     |                            |  |                           |           
|Basic pro-forma net (loss) per share                 |                            |  | $                         | (0.09     
|                                                     |                            |  |                           |           
|                                                     |                            | 
|Diluted (loss) earnings per share as reported        |                            |  | $                         | (0.08     
|                                                     |                            |  |                           |           
|Diluted pro-forma net (loss) per share               |                            |  | $                         | (0.09     
|                                                     |                            |  |                           |           

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|3. | Operating Leases
|-- | ----------------

The
Company moved its headquarters and operations facilities in April 2005. As such,
the Company has executed non-cancelable leases for these new facilities. The
leases expire in August 2009 and August 2014, respectively. Rent expense under
these leases, which is recorded on a straight-line basis over the life of each
lease, is approximately $44,000 per month. The new monthly lease amounts include
certain operational and maintenance expenses above and beyond the base rent. The
Company recognizes rent holiday periods, scheduled rent increases and tenant
improvement allowances on a straight-line basis over the lease term beginning
with the commencement date of the lease.

|4. | Debt
|-- | ----

On March 21, 2005, 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 Companyand expires on
March 31, 2006. There were no outstanding borrowings on the line of credit at
October 31, 2004 and July 31, 2005.

On February 17, 2004, the
Company executed two three-year promissory notes in conjunction with the
purchase of the assets of Asgard Holding LLC (Asgard) for an
aggregate principal amount of $170,138. The promissory notes each bear interest
at 4% and mature in February 2007. The Company makes monthly aggregate payments
of $4,726 plus accrued interest. The outstanding balance on the two notes at
October 31, 2004 and July 31, 2005 was $132,330 and $89,795, respectively.

|5. | Deferred Revenue
|-- | ----------------

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

|6. | Earnings Per Share
|-- | ------------------

Basic earnings per share
is based on the weighted average number of common shares outstanding during the
period and is calculated by dividing the net earnings (loss) by the weighted
average number of common shares outstanding. Diluted earnings per share is based
on the weighted average number of common shares outstanding plus common stock
equivalents associated with stock options and warrants and is calculated by
dividing net earnings by the weighted average number of common shares
outstanding used in the basic earnings per share calculation plus the common
stock equivalent of stock options and warrants.

|7. | Segment Reporting
|-- | -----------------

FASB Statement No. 131,
Disclosures about Segments of an Enterprise and Related Information,
establishes standards for reporting information about operating segments.
Operating segments are defined as components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision maker, or decision making group, in deciding how to
allocate resources and in assessing performance. The Companys chief
operating decision maker is the Companys President. While the President is
apprised of a variety of financial metrics and information, the President makes
decisions regarding how to allocate resources and assess performance based on a
single operating unit.

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|8
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|8. | Significant Customer
|-- | --------------------

For the three and nine
months ending July 31, 2005, the Company had multiple contracts with one
significant third party customer, Lockheed Martin. Lockheed Martin revenues were
approximately 51% and 64% of total net revenues for the three and nine months
ended July 31, 2005, respectively. Accounts receivable balances at October 31,
2004 and July 31, 2005 included amounts due from Lockheed Martin of
approximately 63% and 29%, respectively, of total net accounts receivable.

|9. | Recent Accounting Pronouncements
|-- | --------------------------------

In December 2004, the
FASB issued SFAS No.123 (revised 2004), Share-Based Payment.
Statement 123(R) will provide investors and other users of financial statements
with more complete and neutral financial information by requiring that the
compensation cost relating to share-based payment transactions be recognized in
financial statements. That cost will be measured based on the fair value of the
equity or liability instruments issued. Statement 123(R) covers a wide range of
share-based compensation arrangements including share options, restricted share
plans, performance-based awards, share appreciation rights, and employee share
purchase plans. Statement 123(R) replaces FASB Statement No. 123, Accounting for
Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for
Stock Issued to Employees. Statement 123, as originally issued in 1995,
established as preferable a fair-value-based method of accounting for
share-based payment transactions with employees. However, that Statement
permitted entities the option of continuing to apply the guidance in Opinion 25,
as long as the footnotes to financial statements disclosed what net income would
have been had the preferable fair-value-based method been used. In April 2005,
the Securities and Exchange Commission amended the compliance dates for
implementing Statement 123(R). Public entities (other than those filing as small
business issuers) will be required to apply Statement 123(R) effective as of the
beginning of the next fiscal year that begins after June 15, 2005, with early
adoption encouraged. The Company expects to adopt 123(R) November 1, 2005 and is
currently evaluating which alternatively permitted method of adoption will be
used and the financial statement impact of the adoption of Statement 123(R).

|10. | Reclassification
|--- | ----------------

Certain prior years
amounts have been reclassified to conform to current year presentation.

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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 the Companys significant contracts, the Companys inability
to maintain working capital requirements to fund future operations, or the
Companys 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 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, the Company does not undertake, and the Company specifically
disclaims, 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 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, 2004 filed by
the Company with the Securities and Exchange Commission.

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|10
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OVERVIEW

SteelCloud, Inc. (the
Company) designs and manufactures server appliances through
strategic relationships with software and technology companies. Products are
sold through system integrators and in collaboration with strategic partners
specializing in network security solutions. The Company is also developing its
own proprietary software and appliances under the SteelCloud brand. SteelCloud
compliments its software and appliance solutions with professional services
consulting organization.

Appliances and
Servers

The Company designs and
manufactures specialized servers and infrastructure solutions for large
commercial and government integrators as well as for certain governmental
agencies. The Companys specialized servers are designed to meet the
precise needs of volume customers and reduce the customers investments in
logistics, integration-capacity and support. In the course of designing
specialized servers, the Company often designs proprietary software to optimize
overall system performance. The software provides the Company with intellectual
property to differentiate future server/appliance product offerings. The Company
enhances its custom-design and manufacturing offerings by providing custom
supply-chain and logistics support services to its partners.

In addition, the Company
integrates either its partners or other third-party software into the
SteelCloud custom-designed server platform or appliance and manufactures the
product under a co-branded name or its partners brand name. This allows
the partner to deliver a complete turnkey solution.

Security Solutions

The Company serves the
information technology security marketplace with a suite of network security
products from its strategic partners. The Company sells the products to end
users along with SteelCloud consulting, installation and integration services.

SteelClouds
professional consulting services organization provides clients with a seamless
extension of their Information Technology (IT) organizations.
Technical services include network analysis, network security audits and
appraisals, incident response and remediation services, system design and
managed security services. SteelCloud provides these professional services to
public sector organizations as well as to commercial customers.

Advanced Technology

The Company has an
advanced technology organization that designs and develops SteelCloud
intellectual property in the form of proprietary SteelCloud software products.
The Company will begin marketing these SteelCloud-brand software and appliance
products during its fiscal 2005 fourth quarter. The products will be sold
directly to select end user organizations and through channel partners who buy
and resell the products to their end-user customers.

Significant
Customer Contracts

In fiscal 2004, The
Company was awarded several contracts by Lockheed Martin valued at more than $15
million for customized servers. These contracts included options for the
government integrator to purchase a substantial number of additional appliances.
Additional contract options were exercised early in fiscal year 2005 and the
total contract value currently exceeds $22 million. For the three and nine
months ending July 31, 2005, the Company recognized revenue associated with
these contracts of approximately $3.6 million and $15.1 million, respectively.
Given the nature of the products manufactured by the Company as well as the
delivery schedules established by its partners, revenue and accounts receivable
concentration by any single customer will fluctuate from quarter to quarter.
Future revenues and results of operations could be adversely affected should
this customer reduce its purchases, eliminate product lines or choose not to
continue to buy products and services from SteelCloud.

The Company has a
multiple award schedule contract with GSA (the GSA Contract). The
Companys GSA Contract was originally awarded in April 1996. It was renewed
in fiscal 2002 and is valid through March 31, 2007. The GSA Contract enables
government IT purchasers to acquire all of their requirements from a particular
vendor and largely limits the competition to selected vendors holding GSA
Contracts. For the three and nine month period ending July 31, 2005, the
Companys GSA Contract had sales of $1.2 million and $2.6 million,
respectively, or 13% and 9%, respectively, of the Companys total revenues.

|  
|--
|11
|  

CRITICAL
ACCOUNTING POLICIES

The Company believes the
following represent its critical accounting policies:

Revenue Recognition

The Company recognizes
revenue in accordance with Staff Accounting Bulletin No, 104, Revenue
Recognition in Financial Statements (SAB 104) on appliance and server
orders. SAB 104 requires that four basic criteria be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has
occurred or services have been rendered; (3) the sellers price to the
buyer is fixed or determinable; and (4) collectibility is reasonably assured.

For product sales to
commercial customers, the Company recognizes revenue at the time of shipment
(shipping FOB shipping point) when both title andrisk of loss transfers
to the customer. For product sales to government customers, the Company
recognizes revenue when customer receipt of goods is confirmed (shipping FOB
destination) and risk of loss transfers to the customer. For technology support
services under time and material contracts, the Company recognizes revenue as
services are provided. Revenue from hardware leased to customers under operating
lease arrangements is recognized over the contract term. When product and
installation services that are not essential to the functionality of the product
are sold as part of a bundled agreement, the fair value of the installation
services, based on the price charged for the services when sold separately, is
deferred and recognized when the services are performed. The products sold are
generally covered by a warranty for periods ranging from one to three years. The
Company accrues an estimated warranty reserve in the period of sale to provide
for estimated costs for warranty services.

The Company is a
value-added reseller for certain software products. When resold software
licenses, and related maintenance, customization and training services are all
provided together to an individual customer, the Company recognizes revenue for
the arrangement after the Company has delivered the software license and the
customer has approved all customization and training services provided. In
instances where the Company only resells the software license and maintenance to
the customer, the Company recognizes revenue after the customer has acknowledged
and accepted delivery of the software. The software manufacturer is responsible
for providing software maintenance. Accordingly, revenue from maintenance
contracts is recognized upon delivery or acceptance, as the Company has no
future obligation to provide the maintenance services and no right of return
exists.

The Company incurs
shipping and handling costs, which are recorded in cost of revenues.

Deferred Tax Assets

Deferred tax assets and
liabilities are recorded to reflect the tax consequences on future years of
temporary differences of revenue and expense items for financial statement and
income tax purposes. A valuation allowance is provided to reduce related assets
to an amount that is more likely than not realizable. The Company determines its
valuation allowance pursuant to the provisions of Financial Accounting Standards
Board Statement of Financial Accounting Standards Number 109, Accounting for
Income Taxes, which requires the Company to weigh all positive and negative
evidence including past operating results and forecasts of future taxable
income. If forecasts of taxable income change in the future, the Company may be
required to adjust the valuation allowance against deferred tax assets, which
would result in additional tax expense or benefit.

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RESULTS OF
OPERATIONS

For the three and
nine months ended July 31, 2005 compared to the three and nine months ended July
31, 2004

Product revenues
increased to $8,457,362 and $25,605,314 for the three and nine months ended July
31, 2005 from $5,566,452 and $13,498,126 for the same period in fiscal 2004, an
increase of $2,890,910 and $12,107,188, or 51.9% and 89.7%, respectively. The
increase is primarily attributable to deliveries associated with several
significant contracts with a federal integrator during the first nine months of
fiscal year 2005. These contracts are currently valued at approximately $22
million from which the Company generated revenue of approximately $3.6 million
during the third quarter of fiscal year 2005 and approximately $15.1 million for
the nine month period ending July 31, 2005. These deliveries resulted in an
increase in revenues of approximately $1.6 million and $12.2 million for the
three and nine month periods ended July 31, 2005, as compared to the same
periods in fiscal 2004. Higher demand caused an increase in OEM (Original
Equipment Manufacturer) sales by approximately $460,000 and $370,000 for the
three and nine month periods ending July 31, 2005, respectively, as compared to
the same periods in fiscal 2004. The Company has been engaging new reselling
partners in an effort to enhance and diversify its product offerings and expand
its revenue base. As a result, reseller revenues increased by $330,000 for the
three months ending July 31, 2005 from the same period in 2004. For the nine
months ending July 31, 2005, the Company experienced a net decrease in reseller
revenue of $530,000 from the same period in fiscal 2004.

Service revenues
decreased to $751,878 and $2,351,557 for the three and nine months ended July
31, 2005 from $1,033,844 and $3,057,631 for the same period in fiscal 2004, a
decrease of $281,966 or 27.3% and $706,074 or 23.1%, respectively. The decrease
in service revenues for the three and nine month periods ended July 31, 2005 as
compared to the same periods in fiscal 2004 is primarily the result of the
changes in the Companys reselling partner relationships which is a key
driver of services revenues. In addition, investments in training and technical
consultant staff were made in order to position the Company to enter new market
segments and provide growth opportunities. As such, revenue activities have been
impacted as time and resources have been required to cultivate these new
relationships and develop these additional service capabilities. Service revenue
associated with the acquisition of Asgard for the nine month period ending July
31, 2005 increased to approximately $465,000 from $266,000 in the same period in
fiscal year 2004. No revenues associated with the Asgard acquisition were
recognized in the first quarter of fiscal year 2004.

Product gross margin, as
a percentage of net revenues, increased to 23.1% for the three months ended July
31, 2005 from 13.0% for the same period in fiscal 2004. Product gross margin, as
a percentage of net revenues, increased to 25.3% for the nine months ended July
31, 2005 from 18.6% for the same period in fiscal 2004. The increase in gross
margin for the three and nine months ended July 31, 2005 is primarily due to
lower product costs realized with the significant product backlog, as the
Company utilized its cash on hand and purchasing power to take advantage of
product discounts, incentives and rebates available in the marketplace. In
addition, start up costs associated with the Companys contracts from
fiscal year 2004 were primarily incurred during the initial delivery phase. As
the Company anticipated, gross margins have increased since these initial
deliveries. The Company expects gross margin as a percentage of net revenues 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 gross margin for
services, as a percentage of net revenues, was 26.4% and 40.5% for the three
months ended July 31, 2005 and 2004, respectively. The gross margin for
services, as a percentage of net revenues, decreased to 31.3% for the nine
months ended July 31, 2005 from 37.8% for the same period in fiscal 2004. The
decrease in gross margin from services is the result of lower service revenue
associated with the resale products during the first nine months of fiscal year
2005 as compared to the similar period in fiscal year 2004. The decrease can
also be attributable to the Companys transition of its services group from
focusing on general IT to specializing in security services. Accordingly, this
transformation requires high-end channel resources, significant training of
these resources, pre-sales support and performing non-billable engagements to
gain qualifications, all of which has had a direct impact on gross margin. As
the Company deploys its new service offerings, it anticipates margin growth.

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Sales and marketing
expenses decreased to $450,061 for the three months ended July 31, 2005 from
$646,786 for the same period in fiscal 2004, a decrease of $196,725 or 30.4%.
Sales and marketing expenses decreased to $1,259,654 for the nine months ended
July 31, 2005 from $1,631,601 for the same period in fiscal 2004, a decrease of
$371,947 or 22.8%. Sales and marketing efforts associated with new server
appliance relationships in 2004 did not generate the business results
anticipated. As a result, the Company realigned its resources during fiscal 2005
to better support its more successful product lines and bring new products to
market. The Company anticipates selling and marketing expenses to increase as
the Company continues to support its new products and services.

Research and product
development expenses increased to $208,405 and $599,700 for the three and nine
months ended July 31, 2005, respectively, from $161,694 and $437,111 for the
same periods in fiscal 2004, an increase of $46,711 or 28.9% for the three month
period ending July 31, 2005 and $162,589 or 37.2% for the nine month period
ending July 31, 2005. The increase is primarily the result of the Company
intensifying its research and product development work in an effort to release
new proprietary products in late fiscal year 2005. On May 3, 2005, the Company
announced one of its new products, SteelCloud Audit Compliance System (ACS),
which is expected to be available for customer deliveries in the Companys
fourth fiscal quarter of 2005. The Audit Compliance product incorporates
patent-pending SteelCloud intellectual property. The Company collaborated with
Intel Corporation to create a line of SteelCloud-branded servers based upon
blade technology which was released in July 2005. The Company expects to
continue to incur additional research and product development costs in future
quarters as new products are brought to market.

General and
administrative expenses increased to $1,451,026 for the three months ended July
31, 2005 from $1,367,304 for the same period in fiscal 2004, an increase of
$83,722 or 6.1%. For the nine months ending July 31, 2005, general and
administrative expenses decreased to $4,475,820 from $4,570,071 for the same
period in fiscal 2004, a decrease of $94,251 or 2.1%. During the third quarter
of fiscal year 2005, the Company completed its move to its new facilities and
incurred non-recurring moving expenses of approximately $150,000 as well as
additional rent and depreciation expenses associated with the Companys new
facilities. This increase was offset by a reduction in the Companys
professional service expense for the quarter. The nine month decrease is largely
attributable to non-recurring costs such as professional services of
approximately $85,000, accrued severance pay of approximately $140,000 and
accrued regulatory costs of $45,000 that were incurred during the first nine
months of fiscal year 2004. This decrease was partially offset by the
non-recurring costs associated with the Companys facilities move during
the nine month period ending July 31, 2005. As a percentage of revenue, general
and administrative expenses decreased to 16% for the three month period ending
July 31, 2005 from 21% for the same period in fiscal 2004. For the nine month
period ended July 31, 2005, general and administrative expenses, as a percentage
of revenue, decreased to 16% from 28% for the same period in fiscal 2004. These
decreases were a result of the significant revenue growth in 2005. Although the
Company continues to manage its costs relative to its revenues and gross
margins, additional resources will be required in order to support its new
product lines. In addition, the Company expects to incur additional general and
administrative expenses associated with Sarbanes-Oxley compliance. However, at
present, it is difficult to predict the timing and extent of such costs to be
incurred in fiscal 2005 due to the recently announced delay in the
implementation date for certain provisions related to internal control
reporting. Management is currently assessing the impact of this deferral on its
plans.

Interest income, net,
decreased to $10,205 for the three months ended July 31, 2005 from $11,045 of
interest income, net, for the same period in fiscal 2004, a decrease of $840 or
7.6%. Interest income, net, decreased to $22,276 for the nine months ended July
31, 2005 from $22,690 for the same period in fiscal 2004, a decrease of $414 or
1.8%. The Companys average cash balance, and corresponding interest
income, for the three and nine month periods ending July 31, 2005 was lower than
the comparable periods in fiscal year 2004. This decrease in interest income is
the result of the Companys utilization of its cash balance for its
purchasing efforts undertaken to take advantage of available vendor discounts,
incentives and rebates.

The Company reported net
income of $21,087 and $803,689 for the three and nine months ended July 31,
2005, respectively, as compared to a net loss of $(1,076,927) and $(2,998,955)
for the same period in fiscal 2004. The increase in net income for the three and
nine months ended July 31, 2005 as compared to the same periods in fiscal 2004
is attributable to the Companys increased deliveries of products
associated with significant contract awards. The Company has also realigned its
resources and streamlined operating costs to better position itself in its
significant markets.

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LIQUIDITY AND
CAPITAL RESOURCES

Our primary source of
working capital is cash flow from our operations. 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.

As of July 31, 2005, the
Company had working capital of $10.1 million. The Company believes cash on hand
together with cash generated from operations will provide sufficient financial
resources to finance current operations of the Company during the upcoming 12
months.

For the nine months ended
July 31, 2005, the Company generated $6,346,150 in cash flow from operating
activities. The Company generated cash from the collection of its accounts
receivables of $4,700,018 and reduction of its inventories of $2,597,866. The
Companys pimary use of cash was in the reduction of its accounts payable
by $2,574,797.

For the nine months ended
July 31, 2005, the Company invested $1,542,172 in property and equipment. These
expenditures consisted of purchases of equipment leased to customers and
improvements made to the Companys new leased facilities.

For the nine months ended
July 31, 2005, the Company generated $183,883 from financing activities. The
exercise of employee stock options generated $237,870 in cash. In addition, the
Company reduced its notes payable balance by $53,987.

On March 21, 2005, 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 Companyand expires on
March 31, 2006.

In addition, the Company
assumed $170,138 of Asgards debt by executing two three-year promissory
notes. The promissory notes each bear interest at 4% and mature in February
2007. The Company makes monthly aggregate payments of $4,726 plus accrued
interest. The outstanding balance on the two notes at July 31, 2005 was $89,795.

From time to time, the
Company may pursue strategic acquisitions or mergers, which may require
significant additional capital to satisfy unusual or infrequent expenses. In
such event, the Company may seek additional financing of debt and/or equity.

Contractual
Obligations and Commercial Commitments:

The Companys
significant contractual obligations as of July 31, 2005 are for debt and
operating leases. In April 2005 the Company moved its headquarters and
operations facilities. The total obligation for the new leases, expiring in
August 2009 and August 2014, is approximately $44,000 a month. Debt by year of
maturity and future rental payments under operating lease agreements are
presented below. The Company does not have any purchase obligations, capital
lease obligations or any material commitments for capital expenditures as of
July 31, 2005. The Company has not engaged in off-balance sheet financing,
commodity contract trading or significant related party transactions.

|Contractual Obligations | Payments Due by Period | 
|----------------------- | ---------------------- | 
|                        |                       
|
|                        |                       
|Notes Payable - Current |                        | 
|Long Term Debt          |                        | 
|Operating Lease         |                        | 
|                        |                       

Management believes that
these commitments will be satisfied with current operating cash flow.

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ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to
market risk related to fluctuations in interest rates on its debt. Increase in
prevailing interest rates could increase the Companys interest payment
obligations relating to variable rate debt. For example, a 100 basis point
increase in interest rates would increase annual interest expense by $35,000 if
the Company fully utilized its existing line of credit.

ITEM 4. CONTROLS
AND PROCEDURES

Evaluation of
SteelCloud's Disclosure Controls and Internal Controls

SteelCloud evaluated the
effectiveness of the design and operation of its disclosure controls and
procedures, or Disclosure Controls, as of the end of the period
covered by this quarterly report on Form 10-Q. This evaluation, or
Controls Evaluation, was performed under the supervision, and with
the participation, of management, including our Chairman of the Board, Chief
Executive Officer and Director (CEO), our President, and our Chief
Financial Officer (CFO).

CEO, President and
CFO Certifications

The certifications of the
CEO, President, and the CFO required by Rule 13a-15(e) of the Securities
Exchange Act of 1934, as amended, or the Rule 13a-15(e)
Certifications are filed as Exhibit 31 of this quarterly report on Form
10-Q. This Controls and Procedures section of the quarterly report includes the
information concerning the Controls Evaluation referred to in the Rule 13a-15(e)
Certifications and it should be read in conjunction with the Rule 13a-15(e)
Certifications for a more complete understanding of the topics presented.

Disclosure
Controls and Internal Control over Financial Reporting

Disclosure Controls are
controls and other procedures designed to ensure that information required to be
disclosed in our reports filed under the Securities Exchange Act of 1934, as
amended, such as this quarterly report, is recorded, processed, summarized and
reported within the time periods specified in the U.S. Securities and Exchange
Commissions rules and forms. Disclosure Controls include, without
limitation, controls and procedures designed to ensure that information required
to be disclosed in our reports filed under the Exchange Act is accumulated and
communicated to our management, including our CEO, President, and CFO, or
persons performing similar functions, as appropriate to allow timely decisions
regarding required disclosure.

Internal control over
financial reporting is a process designed to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with generally accepted
accounting principles and includes those policies and procedures that (1)
pertain to the maintenance of records that in reasonable detail accurately and
fairly reflect the transactions and dispositions of our assets; (2) provide
reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted
accounting principles, and that our receipts and expenditures are being made
only in accordance with authorizations of our management and directors; and (3)
provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of our assets that could have a
material effect on the financial statements.

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Limitations on the
Effectiveness of Controls

Our management, including
our CEO, President, and CFO, does not expect that our Disclosure Controls or our
internal controls will prevent all error and all fraud. 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 SteelCloud 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 error or mistake.
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 associated 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.

Conclusions

Based upon the Controls
Evaluation, our CEO, President, and CFO have concluded that, subject to the
limitations noted above, our Disclosure Controls are effective to ensure that
material information relating to SteelCloud is made known to management,
including the CEO, President, and CFO, particularly during the period when our
periodic reports are being prepared.

During the period covered
by this quarterly report on Form 10-Q, there were no changes in our internal
control over financial reporting that have materially affected or are reasonably
likely to materially affect our internal control over financial reporting.

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PART II. OTHER
INFORMATION

ITEM 1. LEGAL
PROCEEDINGS

There are routine legal
claims pending against the Company 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 the financial condition
and results of operation of the Company.

Other than the items
previously disclosed, we are not a party in any other material legal
proceedings.

ITEM 2. CHANGES IN
SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY  SECURITIES

Not applicable.

ITEM 3. DEFAULTS
UPON SENIOR SECURITIES

Not applicable.

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

On May 12, 2005, the
Company held its 2004 Annual Meeting of Shareholders. At the annual meeting, the
Companys shareholders were asked to vote upon: (i) the election of two
Class I directors, (ii) the approval of the appointment of an independent
accounting firm for the ensuing year.

The following persons
were elected as Board of Directors of the Company to serve until the 2007 annual
meeting of shareholders by the votes next to such persons name:

|                 | FOR |            | WITHHELD |          
|---------------- | --- | ---------- | -------- | ---------
|                
|Jay M. Kaplowitz |     | 11,730,147 |          | 1,191,890
|Arthur L. Money  |     | 12,564,707 |          | 357,330  

Jay M. Kaplowitz and
Arthur L. Money were each elected as Class I Directors and shall serve until
their respective successors have been duly elected and qualified.

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

| | FOR        | AGAINST | ABSTAIN
| | ---------- | ------- | -------
|
| | 12,886,704 |         | 27,185 

ITEM 5. OTHER
INFORMATION

Not applicable

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ITEM 6.  EXHIBITS
AND REPORTS ON FORM 8-K

|(a) | Exhibits
|--- | --------

|Exhibit 11.1 | Statement
of computation of earnings per share.*
|------------ | ------------------------------------------------

|Exhibit 31.1 | Certification
of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.*
|------------ | -----------------------------------------------------------------------------------------------------

|Exhibit 31.2 | Certification
of President Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*
|------------ | --------------------------------------------------------------------------------------

|Exhibit 31.3 | Certification
of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.*
|------------ | -----------------------------------------------------------------------------------------------------

|Exhibit 32.1 | Certification
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes -
Oxley Act of 2002.*
|------------ | ---------------------------------------------------------------------------------------------------------------------------

|Exhibit 32.2 | Certification
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes -
Oxley Act of 2002.*
|------------ | ---------------------------------------------------------------------------------------------------------------------------

|Exhibit 32.3 | Certification
Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes -
Oxley Act of 2002.*
|------------ | ---------------------------------------------------------------------------------------------------------------------------

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

|(b) | Reports
on Form 8-K
|--- | -------------------

On July 15, 2005, the Company filed a report on Form
8-K pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On June 21, 2005, the Company filed a report on Form
8-K pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On June 15, 2005, the Company filed a report on Form
8-K pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On June 9, 2005, the Company filed a report on Form 8-K
pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On June 6, 2005, the Company filed a report on Form 8-K
pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On May 18, 2005, the Company filed a report on Form 8-K
pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

On May 5, 2005, the Company filed a report on Form 8-K
pursuant to Item 8.01 Other Events and Item 9.01 Financial Statements and
Exhibits.

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SIGNATURES

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

|September 13, 2005 |                                                                            | STEELCLOUD, INC.
|------------------ | -------------------------------------------------------------------------- | ----------------
|                  
|                  
|                   | By: /s/ Thomas P. DunneName: Thomas P. DunneTitle: Chief Executive Officer
|                  
|                   | By: /s/ Brian HajostName: Brian HajostTitle: President                    
|                  
|                   | By: /s/ Kevin MurphyName: Kevin MurphyTitle: Chief Financial Officer      

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