**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 January 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 þ Smaller
      Reporting Company o




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
      March 1, 2008 there were 14,316,934 shares of the registrant’s common stock
      outstanding.







**SteelCloud,
      Inc.**


**Form
      10-Q Index**


**for
      the Quarterly period ended January 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
              8ITEM
                  4.
              CONTROLS
                  AND PROCEDURES
              8PART
                  II. OTHER INFORMATION
              12ITEM
                  1.
              LEGAL
                  PROCEEDINGS
              12ITEM
                  1A.
              RISK
                  FACTORS
              12ITEM
                  2.
              UNREGISTERED
                  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
              12ITEM
                  3.
              DEFAULTS
                  UPON SENIOR SECURITIES
              12ITEM
                  4.
              SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY HOLDERS
              12ITEM
                  5.
              OTHER
                  INFORMATION
              12ITEM
                  6.
              EXHIBITS
              12SIGNATURES
              
              13




i


**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


**CONDENSED
      CONSOLIDATED BALANCE SHEET**




**October
                31,**
            
            **January
                31,****2007**
            
            **2008**ASSETS
            
            
            
            **(unaudited)**Current
                assetsCash
                and cash equivalents
            
            $
            2,622,654
            
            $
            2,665,204Accounts
                receivable, net
            
            
            2,625,372
            
            
            2,446,242Inventory,
                net
            
            
            1,178,395
            
            
            2,930,519Prepaid
                expenses and other current assets
            
            
            255,924
            
            
            231,227Deferred
                contract costs
            
            
            83,753
            
            
            71,078Total
                current assets
            
            
            6,766,098
            
            
            8,344,270Property
                and equipment, net
            
            
            802,288
            
            
            740,774Equipment
                on lease, net
            
            
            323,904
            
            
            250,144Other
                assets
            
            
            44,053
            
            
            50,456Total
                assets
            
            $
            7,936,343
            
            $
            9,385,644LIABILITIES
                AND STOCKHOLDERS’ EQUITYCurrent
                liabilitiesAccounts
                payable
            
            $
            1,789,329
            
            $
            3,260,459Accrued
                expenses
            
            
            1,158,641
            
            
            1,789,674Notes
                payable, current
            
            
            12,842
            
            
            10,808Unearned
                revenue
            
            
            98,255
            
            
            70,021Total
                current liabilities
            
            
            3,059,067
            
            
            5,130,962Long-term
                liabilitiesNotes
                payable, long-term
            
            
            15,442
            
            
            13,591Other,
                including severance obligations
            
            
            154,520
            
            
            146,556Total
                long-term liabilities
            
            
            169,962
            
            
            160,147Stockholders’
                equityPreferred
                stock, $.001 par value: 2,000,000 shares authorized, no shares issued
                and
                outstanding at October 31, 2007 and January 31, 2008
            
            
            -
            
            
            -Common
                stock, $.001 par value: 50,000,000 shares authorized,14,716,934and14,716,934shares
                issued at October 31, 2007 and January 31, 2008,
                respectively
            
            
            14,717
            
            
            14,717Additional
                paid in capital
            
            
            50,234,099
            
            
            50,297,367Treasury
                stock, 400,000 shares at October 31, 2007 and January 31,
                2008
            
            
            (3,432,500
            )
            
            (3,432,500
            )Accumulated
                deficit
            
            
            (42,109,002
            )
            
            (42,785,049
            )Total
                stockholders’ equity
            
            
            4,707,314
            
            
            4,094,535Total
                liabilities and stockholders’ equity
            
            $
            7,936,343
            
            $
            9,385,644


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


F-1


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**




**Three
                Months Ended**
              **January
                31,****2007**
              **(restated)**
            
            **2008**RevenuesProducts
            
            $
            3,890,161
            
            **$**
            **5,253,027**Services
            
            
            532,906
            
            
            **553,445**Total
                revenues
            
            
            4,423,067
            
            
            **5,806,472**Cost
                of revenuesProducts
            
            
            3,316,233
            
            
            **4,615,803**Services
            
            
            371,078
            
            
            **440,309**Total
                cost of revenues
            
            
            3,687,311
            
            
            **5,056,112**Gross
                profit
            
            
            735,756
            
            
            **750,360**Selling
                and marketing
            
            
            418,109
            
            
            **320,244**Research
                and product development
            
            
            142,827
            
            
            **198,225**General
                and administrative
            
            
            1,160,403
            
            
            **914,353**(Loss)
                from operations
            
            
            (985,583
            )
            
            **(682,462**
            **)**Interest
                income (expense), net
            
            
            14,223
            
            
            **6,415**(Loss)
                before income taxes
            
            
            (971,360
            )
            
            **(676,047**
            **)**Provision
                for income taxes
            
            
            -
            
            
            **-**Net
                (loss)
            
            
            (971,360
            )
            
            **(676,047**
            **)**(Loss)
                per share (basic and diluted):Basic
                and diluted (loss) per share
            
            $
            (0.07
            )
            **$**
            **(0.05**
            **)**Weighted-average
                shares outstanding, basic and diluted
            
            
            14,262,176
            
            
            **14,316,934**




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




F-2


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**




**Three
                Months Ended**
              **January
                31,****2007**
              **(restated)**
            
            **2008****Operating
                activities**Net
                (loss)
            
            $
            (971,360
            )
            **$**
            **(676,047**
            **)**Adjustments
                to reconcile net (loss) to net cash (used in) provided by operating
                activities:Depreciation
                and amortization
            
            
            158,239
            
            
            **137,437**Stock-based
                compensation
            
            
            125,591
            
            
            **63,268**Warrant-based
                expense
            
            
            40,000
            
            
            **-**Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            1,057,069
            
            
            **179,130**Inventory
            
            
            (305,334
            )
            
            **(1,752,124**
            **)**Prepaid
                expenses and other assets
            
            
            (66,915
            )
            
            **18,294**Deferred
                contract costs
            
            
            (3,770
            )
            
            **12,675**Accounts
                payable
            
            
            (474,294
            )
            
            **1,471,130**Unearned
                revenue
            
            
            343,296
            
            
            **(28,650**
            **)**Accrued
                expenses and other liabilities
            
            
            (140,046
            )
            
            **623,485**Net
                cash (used in) provided by operating activities
            
            
            (237,524
            )
            
            **48,598****Investing
                activities**Purchase
                of property and equipment
            
            
            (28,406
            )
            
            **(2,163**
            **)**Net
                cash (used in) investing activities
            
            
            (28,406
            )
            
            **(2,163**
            **)****Financing
                activities**Payments
                on notes payable
            
            
            (3,803
            )
            
            **(3,885**
            **)**Net
                cash provided by financing activities
            
            
            (3,803
            )
            
            **(3,885**
            **)**Net
                (decrease) increase in cash and cash equivalents
            
            
            (269,733
            )
            
            **42,550**Cash
                and cash equivalents at beginning of period
            
            
            3,655,163
            
            
            **2,622,654**Cash
                and cash equivalents at end of period
            
            $
            3,385,430
            
            **$**
            **2,665,204****Supplemental
                cash flow information**Interest
                paid
            
            $
            342
            
            **$**
            **4,230**Income
                taxes paid
            
            $
            -
            
            **$**
            **-**




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




F-3
 
  **STEELCLOUD,
        INC.**
 **NOTES
          TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
          STATEMENTS**


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




Founded
      in 1987, SteelCloud, Inc (the “Company”) is a leading manufacturer of embedded
      integrated computing systems solutions for the federal marketplace and
      Independent Software Vendors (“ISVs”). The Company designs, manufactures and
      integrates specialized servers for federal market prime contractors (“federal
      integrators”) and ISVs who use the specialized servers to deliver application
      software to their clients.




For
      ISV
      customers, the Company designs, manufactures and integrates low-maintenance
      servers (called “appliances” in this market) so ISVs 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.




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 which mainly target military COTS
      server applications.




In
      addition, the Company serves information technology end users directly, in
      both
      the public and private sectors, with products and services focused on 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’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-month period ended January 31, 2008 and 2007 are
      unaudited. In the opinion of management, all adjustments which are necessary
      to
      present fairly the financial position as of January 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.




The
      Company believes that its enhanced focus on the Company’s chosen markets,
      coupled with cost reductions, will allow the Company to manage its costs of
      operations in relation to its revenues. Management believes that existing cash
      and cash equivalents on hand as of January 31, 2008 will be sufficient
      to fund its operations during the upcoming 12 months.




F-4
 
  **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 historically certain 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 and the unaudited
      quarterly financial data for each of the quarters in-between the fiscal years
      ended October 31, 2005 and October 31, 2006, and (iii) 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 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 January 31,
      2007




**Three
                Months Ended January 31, 2007****As
                Previously Reported**
            
            **Restatement
                Adjustments**
            
            **Restated**Revenue
            
            $
            4,423,067
            
            $
            -
            
            $
            4,423,067Gross
                profit
            
            
            786,015
            
            
            (50,259
            )
            
            735,756Net
                (loss) income available to common shareholders
            
            
            (1,136,155
            )
            
            164,795
            
            
            (971,360
            )Per
                Share DataNet
                (loss) earnings per share, basic and diluted
            
            $
            (0.08
            )
            $
            -
            
            $
            (0.07
            )




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




On
      November 1, 2007, the Company adopted 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
      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 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.




F-5
 
  **STEELCLOUD,
          INC.**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
            STATEMENTS**




In
      February 2007, the FASB issued Financial Accounting Standards 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.




**4.**  **Significant
      Customers**





For
      the
      three month period ended January 31, 2008, the Company’s significant customers
      were a Federal Integrator, a Commercial Customer and a Federal Customer
      representing 58%, 6% and 16% of the Company’s revenue, respectively. The
      accounts receivable balance as of January 31, 2008 included amounts from a
      Federal Integrator, a Commercial Customer and a Federal Customer representing
      66%, 9%, and 0% of total net account receivables, respectively.




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




The
      Company recognized approximately $63,000 and $126,000 of stock-based
      compensation expense during the three month periods ended January 31, 2008
      and
      2007, respectively. Stock-based compensation expense for the three-month period
      ended January 31, 2008 and 2007 increased the Company’s basic and diluted loss
      per share by $0.01 and $0.01, 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.




**6.**  **Equity**




***Warrants***




On
      October 6, 2006, the Company issued warrants to purchase 250,000 shares of
      common stock in exchange for the retainage of a financial services firm 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
      is $40,000 and is being recognized over the period of service.




***Additional
      Paid-in Capital***




Additional
      paid in capital has increased approximately $63,000 during the three month
      period ended January 31, 2007 due to stock-based compensation expense of
      approximately $63,000.




F-6


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




***Restricted
      Stock***




As
      of
      January 31, 2008, the Company had granted 100,000 shares of restricted stock.
      The weighted average of the restricted stock grants’ fair value is $1.20. None
      of the restricted stock grants were vested or forfeited in the three month
      period ended January 31, 2008. The Company’s restricted stock grants are
      accounted for as equity awards. The expense is based on the price of the
      Company’s common stock, and is recognized on a straight-line basis over the
      requisite service period. The Company’s restricted stock agreements do not
      contain any post-vesting restrictions. The restricted stock grants vest ratably
      over a three year period. For the three month period ended January 31, 2008,
      the
      Company recognized $10,000 of stock-based compensation expense associated with
      restricted stock awards.





On
      December 21, 2007 the Company rescinded 80,000 shares of restricted stock issued
      to one of its executives. The Company intends to obtain shareholder approval
      for
      its Amended 2007 Stock Option and Restricted Stock Plan at its next annual
      shareholder meeting, which is scheduled for May 7, 2008. Following shareholder
      approval of the Amended 2007 Stock Option and Restricted Stock Plan, the Company
      will re-issue the 80,000 shares of restricted stock to the affected
      executive.




**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 January 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:




F-7
 
  **STEELCLOUD,
          INC.**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
            STATEMENTS**




**October
                31,**
            
            **January
                31,****2007**
            
            **2008**Raw
                materials
            
            $
            758,154
            
            $
            1,586,466Work
                in process
            
            
            290,603
            
            
            731,989Finished
                goods
            
            
            129,638
            
            
            612,063$
            1,178,395
            
            $
            2,930,519





**10.**  **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.
      The
      dilutive weighted average number of common shares outstanding excluded potential
      common shares from stock options of approximately 444,000 and 371,000 for the
      three month periods ended January 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.




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




On
      November 1, 2007, the Company adopted 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 has an unrecognized tax benefit of approximately $616,000. Of this
      amount $460,000 may reverse in the next twelve months related to stock option
      deductions for which the company is updating its documentation and compliance.
      The Company has a valuation allowance against the full amount of its net
      deferred tax assets and therefore the adoption of FIN 48 has 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 tax in that
      jurisdiction. 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 October 31, 2003, although carryforward tax attributes that were
      generated prior to October 31, 2003 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 had $0
      accrued for interest and penalties as of January 31, 2008.




F-8
 
  **STEELCLOUD,
          INC.**
 **NOTES
            TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
            STATEMENTS**




**12.**  **Reclassification**




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




F-9




**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 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 leading manufacturer of embedded integrated computing systems
      solutions for the federal marketplace and Independent Software Vendors (“ISVs”).
      We design, manufacture and integrate specialized servers for federal market
      prime contractors (“federal integrators”) and ISVs who use the specialized
      servers to deliver application software to their clients.




***Federal
      Integrator and ISV Business***




Our
      primary target markets are federal integrators and ISVs. 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.




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.




2




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.




***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. 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.




***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 month period ended January 31, 2008,
      we
      incurred research and product development costs of approximately $198,225.
      We
      will continue to incur costs for product development in future
      periods.




***Significant
      Customer Contracts***




During
      the quarter ending January 31, 2008, we were awarded a contract by a major
      federal integrator with a contract dollar value that exceeds $7.9 million.
      We
      produced, shipped and recognized approximately $2.2 million of revenue
      associated with this contract for the quarter ending January 31,
      2008.




***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.




***Notices
          from Nasdaq***
  On
          March
          13, 2008, we received notice, under Marketplace Rule 4310(c)(4)(the "Rule"),
          that our common stock is subject to potential delisting from the Nasdaq
          Capital
          Market because the bid price of our common stock closed below the minimum
          $1.00
          per share requirement for 30 consecutive business days prior to March 13,
          2008.
          Under Marketplace Rule 4310(c)(8)(D), we have been granted an initial 180
          calendar days, or until September 9, 2008, to regain
          compliance.


3




**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**




The
      preparation of financial statements in conformity with US 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. No changes to our critical accounting policies have taken
      place since October 31, 2007.




***Recently
      Issued Accounting Pronouncements***




On
      November 1, 2007, we adopted 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.




We
      have
      an unrecognized tax benefit of approximately $616,000. Of this amount $460,000
      may reverse in the next twelve months related to stock option deductions for
      which the company is updating its documentation and compliance. We have a
      valuation allowance against the full amount of our net deferred tax assets
      and
      therefore the adoption of FIN 48 has no impact on our retained earnings. The
      amount of unrecognized tax benefits that, if recognized, would impact the
      effective tax rate is $0.




We
      conduct business in the U.S. and are subject to tax in that jurisdiction. 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 October 31, 2003, although
      carryforward tax attributes that were generated prior to October 31, 2003 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 had $0 accrued for interest
      and penalties as of January 31, 2008.




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      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 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 Financial Accounting Standards 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, 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 our
      financial statements.




4




**RESULTS
      OF OPERATIONS**




For
      the
      three months ended January 31, 2008 compared to the three months ended January
      31, 2007




***Net
      Revenue Discussion:***




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




**Three
                Months Ended January 31,****2007
                (restated)**
            
            **2008**
            
            **Increase
                (decrease)****%
                of Net**
            
            
            
            **%
                of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            3,890,161
            
            
            87.95
            %
            $
            5,253,027
            
            
            90.47
            %
            $
            1,362,866
            
            
            35.03
            %Services
            
            
            532,906
            
            
            12.05
            %
            
            553,445
            
            
            9.53
            %
            
            20,539
            
            
            3.85
            %Total
                net revenues
            
            $
            4,423,067
            
            
            100.00
            %
            $
            5,806,472
            
            
            100.00
            %
            $
            1,383,405
            
            
            31.28
            %





The
      increase in product revenues is primarily attributable to increases in our
      core
      business. We recognized a revenue increase in our integrator and ISV business,
      our core business, of approximately $1.1 million dollars for the three months
      ended January 31, 2008 as compared to the same period in fiscal year
      2007.




The
      increase in service revenues for the three-month period ended January 31, 2008
      as compared to the same period in fiscal 2007 is the result of us commencing
      our
      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 three months ended January
      31, 2007 and 2008 in dollars, as a percentage of gross profit and as a
      percentage of net revenues.




**Three
                Months Ended January 31,****2007
                (restated)**
            
            **2008**
            
            **Increase
                (decrease)****%
                of Gross**
            
            
            
            **%
                of Gross****Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Profit**
            
            **Dollars**
            
            **Percentage**Products
            
            $
            573,928
            
            
            78.01
            %
            $
            637,224
            
            
            84.92
            %
            $
            63,296
            
            
            11.03
            %*Products
                - GM%*
            
            
            *14.75*
            *%*
            
            
            
            
            *12.13*
            *%*Services
            
            $
            161,828
            
            
            21.99
            %
            
            113,136
            
            
            15.08
            %
            $
            (48,692
            )
            
            (30.09
            )%*Services
                - GM%*
            
            
            *30.37*
            *%*
            
            
            
            
            *20.44*
            *%*Total
                gross profit
            
            $
            735,756
            
            
            100.00
            %
            $
            750,360
            
            
            100.00
            %
            $
            14,604
            
            
            1.98
            %*Total
                - GM%*
            
            
            *16.63*
            *%*
            
            
            
            
            *12.92*
            *%*




5





The
      decrease in gross profit percentage for the three months ended January 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. This residual contract, in its final year, resulted in lower margins
      than
      prior years. 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 for the three months ended January 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.




***Operating
      Expense Discussion:***




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




**Three
                Months Ended January 31,****2007
                (restated)**
            
            **2008**
            
            **Increase
                (decrease)****%
                of Net**
            
            
            
            **%
                of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Selling
                and marketing
            
            $
            418,109
            
            
            9.45
            %
            $
            320,244
            
            
            5.52
            %
            $
            (97,865
            )
            
            (23.41
            )%Research
                and product development
            
            
            142,827
            
            
            3.23
            %
            
            198,225
            
            
            3.41
            %
            
            55,398
            
            
            38.79
            %General
                and administrative
            
            
            1,160,403
            
            
            26.24
            %
            
            914,353
            
            
            15.75
            %
            
            (246,050
            )
            
            (21.20
            )%Total
                operating expenses
            
            $
            1,721,339
            
            
            38.92
            %
            $
            1,432,822
            
            
            24.68
            %
            $
            (288,517
            )
            
            (16.76
            )%





The
      decrease in selling and marketing expense is the result of aligning expenses
      to
      our current and future business models. For the three months ended January
      31,
      2008 compared to the three months ended January 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 three months ended January
      31, 2008 compared to the three months ended January 31, 2007 is the result
      of us
      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 three months ended
      January 31, 2008 compared to the three months ended January 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. 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.




6




***Other
      Income (Expense) Discussion:***




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




**Three
                Months Ended January 31,****2007
                (restated)**
            
            **2008**
            
            **Increase
                (decrease)****%
                of Net**
            
            
            
            **%
                of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Interest
                income
            
            $
            14,223
            
            
            0.32
            %
            $
            6,415
            
            
            0.11
            %
            $
            (7,808
            )
            
            (54.90
            )%Total
                interest income
            
            $
            14,223
            
            
            0.32
            %
            $
            6,415
            
            
            0.11
            %
            $
            (7,808
            )
            
            (54.90
            )%





The
      decrease in net interest income for the three-month period ended January 31,
      2008 is attributable to the recording of severance payments at net present
      value, offset by lower interest income compared to the same period in fiscal
      year 2007.




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




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




**Three
                Months Ended January 31,****2007
                (restated)**
            
            **2008**
            
            **Increase
                (decrease)****%
                of Net**
            
            
            
            **%
                of Net****Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Revenues**
            
            **Dollars**
            
            **Percentage**Net
                (loss)...
            
            $
            (971,360
            )
            
            (21.96
            )%
            $
            (676,047
            )
            
            (11.64
            )%
            $
            (295,313
            )
            
            (30.40
            )%





The
      decrease in net loss for the three months ended January 31, 2008 as compared
      to
      the same period in fiscal 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 three months ended January 31, 2008 compared
      to the same period in fiscal year 2007. We plan for revenue to grow while
      keeping expenses in alignment with our revenue and gross margins.




**LIQUIDITY
      AND CAPITAL RESOURCES**




As
      of
      January 31, 2008, we had working capital of $3.2 million. While we have incurred
      a loss in the three month period ended January 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
      three months ended January 31, 2008, we generated $49,000 in cash from operating
      activities. Our primary use of cash was to finance our operating loss. The
      increase in inventory and accounts payable of approximately $1.8 million and
      $1.5 million, respectively, is the result of us purchasing components for
      contracts during the quarter for deliveries in future periods. A decrease in
      accounts receivable generated approximately $179,000 of cash. 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.




We
      generated approximately $43,000 from our operating, investing and financing
      activities for the three months ended January 31, 2008.




7




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 January
      31, 2008.




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 January 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 June
      2008, September 2007 and June 2009, is approximately $50,000 a month and does
      not include applicable employment taxes and potential bonuses. Future rental
      and
      salary payments under 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
            
            $
            24,399
            
            $
            10,808
            
            $
            13,591
            
            
            -
            
            
            -Operating
                leases
            
            
            2,198,531
            
            
            548,352
            
            
            686,294
            
            
            537,982
            
            
            425,903Employment
                agreements
            
            
            1,262,917
            
            
            475,000
            
            
            787,917
            
            
            -
            
            
            -Total
            
            $
            3,485,847
            
            $
            1,034,160
            
            $
            1,487,802
            
            $
            537,982
            
            $
            425,903





We
      believe that these commitments will be satisfied with 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.




8




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 January 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 January 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 January 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.




Remedial
      measures to be implemented by management to address the material weakness that
      existed at October 31, 2007 and, we believe, continued to exist as of January
      31, 2008, include the following:




•
            Develop
                and implement policies and procedures to identify and properly allocate
                manufacturing cost to inventory costs of goods sold.




9




•
            Establish
                new key controls and strengthen existing controls surrounding the
                review
                and approval of our financial statements and disclosures. Specifically,
                we
                will enhance certain key controls around the analysis of new accounts
                and
                identification of significant variances in existing accounts.





•
            Enhance
                processes and controls within our financial statement close process,
                including the preparation and review of a financial statement disclosure
                and 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.




•
            Strengthen
                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.





Our
      testing and evaluation of the operating effectiveness and sustainability of
      these changes to our internal control over financial reporting have not yet
      been
      completed as the above-referenced remediation actions are still in the
      implementation process. In addition, our efforts to remediate deficiencies
      surrounding the levels of our staffing and related levels of expertise may
      take
      some time to remediate over the next several quarters.





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.




10




***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.




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**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 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
      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**




Not
      applicable.




**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 pursuant to Section
                906 of
                the Sarbanes - Oxley Act of 2002.




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**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.




March
                21, 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




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