UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





(Mark
one)





x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
quarterly period ended July 31, 2010





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.)20110
      Ashbrook Place, Suite 130, Ashburn, VA 20147(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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes o No o





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


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





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


Yes o No þ





As of
September 8, 2010 there were 18,105,001 shares of the registrant’s common stock
outstanding.







SteelCloud,
Inc.


Form
10-Q Index


for
the Quarterly period ended July 31, 2010




PART
      I. FINANCIAL INFORMATIONITEM
      1.
              
              FINANCIAL
      STATEMENTS
              3ITEM
      2.
              
              MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
              4ITEM
      3.
              
              QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
              9ITEM
      4.
              
              CONTROLS
      AND PROCEDURES
              10PART
      II. OTHER INFORMATIONITEM
      1.
              
              LEGAL
      PROCEEDINGS
              11ITEM 1A.
              
              RISK
      FACTORS
              11ITEM
      2.
              
              UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
              11ITEM
      3.
              
              DEFAULTS
      UPON SENIOR SECURITIES
              11ITEM
      4.
              
              REMOVED
      AND RESERVED
              11ITEM
      5.
              
              OTHER
      INFORMATION
              11ITEM
      6.
              
              EXHIBITS
              11SIGNATURES
              
              
              12




2




PART
I. FINANCIAL INFORMATION





ITEM
      1.
            FINANCIAL
      STATEMENTS





Index
to Financial Statements




Condensed
      Consolidated Balance Sheets
            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




3





STEELCLOUD,
INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS




October 31,
                
                
                July 31,2009
                
                
                2010(unaudited)ASSETSCurrent
      assetsCash
      and cash equivalents
                
                $
                60,650
                
                
                $
                1,406,441Accounts
      receivable, net
                
                
                147,203
                
                
                
                265,305Inventory,
      net
                
                
                10,587
                
                
                
                18,576Prepaid
      expenses and other current assets
                
                
                141,259
                
                
                
                52,948Deferred
      contract costs
                
                
                33,830
                
                
                
                -Total
      current assets
                
                
                393,529
                
                
                
                1,743,270Property
      and equipment, net
                
                
                166,754
                
                
                
                20,119Equipment
      on lease, net
                
                
                1,456
                
                
                
                381Other
      assets
                
                
                5,374
                
                
                
                1,020Total
      assets
                
                $
                567,113
                
                
                $
                1,764,790LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesAccounts
      payable
                
                $
                577,197
                
                
                $
                398,923Accrued
      expenses
                
                
                174,763
                
                
                
                501,581Notes
      payable, current
                
                
                217,919
                
                
                
                -Total
      current liabilities
                
                
                969,879
                
                
                
                900,504Long-term
      liabilitiesNotes
      payable, long-term
                
                
                -
                
                
                
                1,466,639Deferred
      rent, long-term
                
                
                269,332
                
                
                
                -Other
      long-term
                
                
                1,129
                
                
                
                -Total
      long-term liabilities
                
                
                270,461
                
                
                
                1,466,639Stockholders’
      equityPreferred
      stock, $.001 par value, $3,000,000 liquidation preference: 2,000,000
      shares authorized, no shares and 540,000 issued and outstanding at October
      31, 2009 and July 31, 2010, respectively
                
                
                –
                
                
                
                540Common
      stock, $.001 par value: 80,000,000 shares authorized, 15,993,501 and
      17,690,001 shares issued at October 31, 2009 and July 31, 2010,
      respectively
                
                
                15,994
                
                
                
                17,690Additional
      paid in capital
                
                
                51,348,405
                
                
                
                52,761,888Treasury
      stock, 400,000 shares at October 31, 2009 and July 31,
2010
                
                
                (3,432,500
                )
                
                
                (3,432,500
                )Accumulated
      deficit
                
                
                (48,605,126
                )
                
                
                (49,949,971
                )Total
      stockholders’ deficit
                
                
                (673,227
                )
                
                
                (602,353
                )Total
      liabilities and stockholders’ deficit
                
                $
                567,113
                
                
                $
                1,764,790





The
accompanying notes are an integral part of these Condensed Consolidated
Financial Statements


F-1





STEELCLOUD,
INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS




Three Months Ended
                  July 31,
                
                
                Nine Months Ended
                  July 31,2009
                
                
                2010
                
                
                2009
                
                
                2010Revenue
                
                $
                281,705
                
                
                $
                554,421
                
                
                $
                1,160,264
                
                
                $
                1,375,377Cost
      of revenues
                
                
                162,499
                
                
                
                358,972
                
                
                
                827,781
                
                
                
                844,418Gross
      profit
                
                
                119,206
                
                
                
                195,449
                
                
                
                332,483
                
                
                
                530,959Selling
      and marketing
                
                
                153,412
                
                
                
                138,770
                
                
                
                369,276
                
                
                
                356,776Research
      and product development
                
                
                53,637
                
                
                
                89,184
                
                
                
                151,869
                
                
                
                239,917General
      and administrative
                
                
                591,397
                
                
                
                328,564
                
                
                
                1,886,485
                
                
                
                1,594,446Severance
      and restructuring
                
                
                -
                
                
                
                -
                
                
                
                73,205
                
                
                
                -Operating
      loss from continuing operations
                
                
                (679,240
                )
                
                
                (361,069
                )
                
                
                (2,148,352
                )
                
                
                (1,660,180
                )Interest
      expense
                
                
                (21,386
                )
                
                
                (41,619
                )
                
                
                (22,779
                )
                
                
                (153,078
                )Other
      income (expense), net
                
                
                625
                
                
                
                143,839
                
                
                
                2,428
                
                
                
                468,415Loss
      from continuing operations before income taxes
                
                
                (700,001
                )
                
                
                (258,849
                )
                
                
                (2,168,703
                )
                
                
                (1,344,843
                )Provision
      for income taxes
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Loss
      from continuing operations
                
                
                (700,001
                )
                
                
                (258,849
                )
                
                
                (2,168,703
                )
                
                
                (1,344,843
                )
      )Loss
      from discontinued operations
                
                
                (198,433
                )
                
                
                -
                
                
                
                (583,434
                )
                
                
                -Net
      loss
                
                $
                (898,434
                )
                
                $
                (258,849
                )
                
                $
                (2,752,137
                )
                
                $
                (1,344,843
                )Basic
      and diluted loss per share:Continuing
      operations
                
                $
                (0.05
                )
                
                $
                (0.01
                )
                
                $
                (0.14
                )
                
                $
                (0.08
                )Discontinued
      operations
                
                
                (0.01
                )
                
                
                -
                
                
                
                (0.04
                )
                
                
                -Basic
      and diluted loss per share
                
                $
                (0.06
                )
                
                $
                (0.01
                )
                
                $
                (0.18
                )
                
                $
                (0.08
                )Weighted-average
      shares outstanding, basic and diluted
                
                
                15,140,024
                
                
                
                18,720,871
                
                
                
                14,903,494
                
                
                
                16,907,190





The
accompanying notes are an integral part of these Condensed Consolidated
Financial Statements


F-2





STEELCLOUD,
INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS




Nine Months Ended
                                    July 31,2009
                                  
                                  
                                  2010Operating
      activitiesNet
      loss
                                  
                                  $
                                  (2,752,137
                                  )
                                  
                                  $
                                  (1,344,843
                                  )Adjustments
      to reconcile net (loss) to net cash used in operating
      activities:Loss
      on disposal
                                  
                                  
                                  19,565
                                  
                                  
                                  
                                  -Depreciation
      and amortization
                                  
                                  
                                  228,795
                                  
                                  
                                  
                                  154,258Gain
      on sale of professional services
    assets
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (140,000
                                  )Gain
      on lease settlement
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (118,755
                                  )Stock-based
      compensation
                                  
                                  
                                  181,394
                                  
                                  
                                  
                                  186,218Amortization
      of deferred rent
                                  
                                  
                                  -
                                  
                                  
                                  
                                  7,175Amortization
      of deferred revenue
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (1,129
                                  )Non-cash
      interest expense
                                  
                                  
                                  -
                                  
                                  
                                  
                                  82,221Loss
      on extinguishment of debt
                                  
                                  
                                  -
                                  
                                  
                                  
                                  30,000Late
      payment penalty on debt paid in common stock
                                  
                                  
                                  -
                                  
                                  
                                  
                                  20,000Changes
      in operating assets and liabilities:Accounts
      receivable
                                  
                                  
                                  1,362,354
                                  
                                  
                                  
                                  (118,102
                                  )Inventory
                                  
                                  
                                  174,533
                                  
                                  
                                  
                                  (7,989
                                  )Prepaid
      expenses and other assets
                                  
                                  
                                  (122,998
                                  )
                                  
                                  
                                  13,980Deferred
      contract costs
                                  
                                  
                                  (38,140
                                  )
                                  
                                  
                                  33,830Accounts
      payable
                                  
                                  
                                  (103,951
                                  )
                                  
                                  
                                  (178,274
                                  )Unearned
      revenue
                                  
                                  
                                  (8,786
                                  )
                                  
                                  
                                  -Accrued
      expenses and other liabilities
                                  
                                  
                                  (146,358
                                  )
                                  
                                  
                                  417,750Net
      cash used in operating activities
                                  
                                  
                                  (1,205,729
                                  )
                                  
                                  
                                  (963,660
                                  )Investing
      activitiesProceeds
      from sale of professional services
assets
                                  
                                  
                                  -
                                  
                                  
                                  
                                  140,000Lease
      settlement payment
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (170,000
                                  )Purchase
      of property and equipment
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (6,549
                                  )Sale
      of hardware integration business
                                  
                                  
                                  150,000
                                  
                                  
                                  
                                  -Sale
      of property and equipment
                                  
                                  
                                  347,544
                                  
                                  
                                  
                                  -Net
      cash provided/(used) by investing
    activities
                                  
                                  
                                  497,544
                                  
                                  
                                  
                                  (36,549
                                  )Financing
      activitiesProceeds
      from notes payable
                                  
                                  
                                  250,000
                                  
                                  
                                  
                                  1,278,000Proceeds
      from issuance of common stock
                                  
                                  
                                  87,500
                                  
                                  
                                  
                                  186,000Proceeds
      from issuance of preferred stock
                                  
                                  
                                  -
                                  
                                  
                                  
                                  882,000Payments
      on notes payable
                                  
                                  
                                  (15,456
                                  )
                                  
                                  
                                  -Net
      cash provided by financing activities
                                  
                                  
                                  322,044
                                  
                                  
                                  
                                  2,346,000Net
      (decrease) increase in cash and cash
      equivalents
                                  
                                  
                                  (386,141
                                  )
                                  
                                  
                                  1,345,791Cash
      and cash equivalents at beginning of
    period
                                  
                                  
                                  752,351
                                  
                                  
                                  
                                  60,650Cash
      and cash equivalents at end of period
                                  
                                  $
                                  366,210
                                  
                                  
                                  $
                                  1,406,441Supplemental cash flow
      informationInterest
      paid
                                  
                                  $
                                  22,779
                                  
                                  
                                  $
                                  59,025Income
      taxes paid
                                  
                                  $
                                  –
                                  
                                  
                                  $
                                  –Supplemental disclosure of
      non-cash investing and financing
      activitiesDiscount
      on note payable
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  231,501





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. (referred to herein as the “Company” or “SteelCloud”)
is a developer of mobility appliance software solutions primarily for the
Research In Motion® (“RIM”) BlackBerry market.  SteelCloud designs and
integrates its software into specialized server appliances targeted at
Department of Defense (“DoD”), public sector, commercial, and remote hosting
customers.  Until July 2009, SteelCloud offered computer
integration solutions for the federal marketplace and independent software
vendors.  In July 2009, SteelCloud entered into an Asset Purchase
Agreement with NCS Technologies, Inc., a Virginia corporation (“NCS”), pursuant
to which SteelCloud agreed to sell to NCS, and NCS agreed to purchase, all of
SteelCloud’s right, title and interest in and to the assets relating to its
computer integration business.  Further, in July 2009 SteelCloud’s
management and Board of Directors determined to shift the focus of its
operations, resources and investments to its mobility-related technologies and
products.





SteelCloud
was originally incorporated as Dunn Computer Operating Company on July 27,
1987 under the laws of the Commonwealth of Virginia.  On February 26,
1998, Dunn Computer Corporation ("Dunn") was formed and incorporated in the
Commonwealth of Virginia to become a holding company for several entities
including Dunn Computer Operating Company.  The Company's subsidiary
is International Data Products ("IDP"), acquired in May 1998.  On May
15, 2001, the Company’s shareholders approved an amendment to the Company’s
articles of incorporation to change the corporate name from Dunn Computer
Corporation to SteelCloud, Inc.  On December 31, 2003, Dunn was
merged with and into SteelCloud.  On February 17, 2004, the
Company acquired the assets of Asgard Holding, LLC ("Asgard").  In
July of 2006, as part of its restructuring efforts, the Company closed its sales
office and ceased all of its operations in Florida.  The Company’s
former subsidiaries, Puerto Rico Industrial Manufacturing Operations Acquisition
Corporation (“PRIMO”), and STMS Corporation (“STMS”), are inactive.





The
accompanying financial statements include the accounts of SteelCloud and its
subsidiaries, IDP, PRIMO, and STMS.  All intercompany accounts and
activity have been eliminated in the consolidation process.





The
following unaudited condensed financial statements have been prepared pursuant
to the rules and regulations of the Securities and Exchange Commission. Certain
information and note disclosures normally included in annual financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to those rules and regulations, although
the Company believes that the disclosures made are adequate to make the
information not misleading.  It is suggested that these condensed
financial statements be read in conjunction with the financial statements and
the Footnotes thereto included in the Company’s latest Annual Report on Form
10-K, as amended.





All
adjustments that are of a normal recurring nature, in the opinion of management,
and necessary for a fair presentation for the periods presented have been
reflected as required by Regulation S-X, Rule 10-01.





Going
Concern





SteelCloud
has experienced recurring annual operating losses since its fiscal year ended
October 31, 2004.  The Company expects that such losses may continue
at least through its fiscal year ending October 31, 2010.  The report
of SteelCloud’s independent registered public accounting firm on SteelCloud’s
consolidated financial statements for the fiscal year ended October 31, 2009
contains an explanatory paragraph regarding SteelCloud’s ability to continue as
a going concern based upon its history of net losses, net working capital
deficit and uncertainty regarding its ability to satisfy its obligations as they
come due in the near term.





As
further discussed in Note 4 and Note 5 below, on July 2, 2010, the Company
entered into a series of transactions with Clipper Investors LLC (“Clipper”)
which generated, after deducting legal fees, $1,960,000 in long-term debt and
equity financing proceeds.





2. New Accounting
Pronouncements





There
have been no recent accounting pronouncements or changes in accounting
pronouncements during the nine months ended July 31, 2010, as compared to the
recent accounting pronouncements described in the 2009 Annual Report that were
implemented, of significance, or of potential significance, to the
Company.





F-4





STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





3. Significant
Customers





For the
nine-month period ended July 31, 2010, 30% of the Company’s revenues were
attributed to one customer.  For the nine-month period ended July 31,
2009, 87% of the Company’s revenues were attributed to five
customers.





As of
July 31, 2010, 33% of the accounts receivable balance was attributed to two
customers.  As of October 31, 2009, 93% of the accounts receivable
balance was attributed to three customers.





4. Equity




Preferred
Stock Agreements




Convertible
Preferred Stock




On July
2, 2010, the Company issued at total of 540,000 shares of its Series A preferred
stock (“Series A Preferred Stock”), for $2.00 per share, of which 450,000 shares
were issued to Clipper and 90,000 shares were issued to Caledonia Capital
Corporation (“Caledonia”).  The Series A Preferred Stock is
convertible into shares of the Company’s common stock (“Common Stock”) at the
option of the holder at an initial conversion rate equal to $0.10 per share,
subject to proportional adjustment for stock splits, stock dividends,
recapitalizations and similar events.




The
holders of the Series A Preferred Stock are entitled to dividends, as
follows:  (a) Quarterly dividends (“Preferred Dividends”) of 10% per
annum, paid in cash, until such time as the amount of aggregate Contingent
Preferred Dividends (described in clause (b) below) paid equals $3,000,000, at
which time the quarterly 10% dividend shall terminate; and (b) Contingent
quarterly dividends (“Contingent Preferred Dividends”), paid in cash, equal to
40% of the Company's income for the past rolling four quarters (less the amount
of Preferred Dividends payable as described in clause (a) above and paid for any
of such quarters) in excess of $1,500,000, until the aggregate amount paid by
the Company for such dividends equals $3,000,000. In the event that the
Company’s available cash is insufficient to pay the foregoing dividends, then
payment shall be deferred until such time as Company cash is sufficient to make
such payments.




The
Series A Preferred Stock has a liquidation preference equal to $3,000,000, less
the amount of Contingent Preferred Dividends previously paid, plus any accrued
but unpaid Preferred Dividends and thereafter participates in distributions with
the Common Stock on an as-converted-to-Common-Stock basis.




The
Clipper Transaction





On July
2, 2010, the Company issued new equity and debt securities to
Clipper.  The securities issued to Clipper consist of the following:
(a) 450,000 shares of Series A Preferred Stock for $2.00 per share, (b)
warrants to purchase 20,000,000 shares of the Company’s common stock for a
period of five years at an initial conversion rate equal to $0.14 per share,
subject to proportional adjustment for stock splits, stock dividends,
recapitalizations and similar events and (c) a convertible promissory note in
the principal amount of $1,100,000 and convertible into Common Stock. 
Refer to Note 5 below for additional information regarding the convertible
promissory note.  These securities were issued in exchange for an
aggregate purchase price of $2,000,000 paid in cash.  Collectively,
the foregoing transactions are the “Clipper Transaction.”  After
deducting legal fees of $40,000, the net proceeds of $1,960,000 were allocated
based on their relative fair values, resulting in a net value of Long Term Debt
of $941,500 and Preferred Stock and Warrants of $1,018,500.





The
Caledonia Transaction





On July
2, 2010, concurrently with the closing the Clipper Transaction, the Company
issued new equity and debt securities to Caledonia.  The securities
issued to Caledonia consist of the following: (a) 90,000 shares of Series A
Preferred Stock for $2.00 per share; and (b) $70,000 of additional debt
convertible into Common Stock pursuant to an Amended and Restated Promissory
Note in the principal amount of $570,000.  These securities were
issued in exchange for 2,500,000 shares of Common Stock held by Caledonia and a
convertible promissory note in the principal amount of $450,000 held by
Caledonia.  A $50,000 debt modification fee was added to the principal
amount.  Refer to Note 5 below for additional information regarding
the convertible promissory note.  Collectively, the foregoing
transactions are the “Caledonia Transaction.”





Registration
Rights





Pursuant
to the Clipper Transaction and Caledonia Transaction, the Company granted
Clipper and Caledonia piggyback registration rights and demand registration
rights for all or any portion of their Investor Registrable
Securities.


F-5





STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Stock-based
Compensation





The
Company recognized $186,218 and $181,394 of stock-based compensation expense
during the nine-month periods ended July 31, 2010 and 2009, respectively.
Stock-based compensation expense for the nine-month period ended July 31, 2010
and 2009 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.  Included in stock-based compensation expense for the
nine-month period ended July 31, 2010 is $90,000 related to compensation to
external members of the Company’s Board of Directors.





Stock
grants




In the
first nine months of fiscal year 2010 we granted 2,480,000 shares of the
Company’s common stock to employees and directors at a weighted-average market
value per share of $0.10 as of the date of grant.




Stock
Options




In the
first nine months of fiscal year 2010 we granted options to purchase 500,000
shares of the Company’s common stock to employees at a weighted-average exercise
price of $0.10, which represented the weighted-average market value per share as
of the date of grant.  No stock options were exercised during the
first nine months of fiscal 2010.




Additional
Paid-in Capital





Additional
paid in capital has increased $1, 413,483 during the nine-month period ended
July 31, 2010 due to the issuance of preferred stock and warrants pursuant to
the agreements discussed above under the heading “Preferred Stock Agreements”
of  $950,460, the issuance of common stock to Caledonia of $183,500,
the issuance of common stock as payment for a loan modification fee of $49,500,
warrants issued in connection with the Line of Credit and Security Agreement
entered into with Caledonia on November 3, 2009 of $45,001 (as disclosed in Note
6 to the Company’s financial statements included in its Quarterly Report on Form
10-Q for the period ended January 31, 2010, as filed with the SEC on March 19,
2010), and stock-based compensation expense of approximately
$185,000.





5. Debt





Clipper
Note Purchase Agreement





On July 2, 2010, as a part of the
Clipper Transaction mentioned in Note 4, the Company entered into a Note
Purchase Agreement (the “Clipper Note Purchase Agreement”) with Clipper pursuant
to which Clipper agreed to lend to the Company $1,100,000 in the form of a
secured convertible promissory note (the “Clipper Note”) which was issued on
July 2, 2010 (the “Issuance Date”). The Clipper Note bears interest at a rate of
12% per annum, with interest payable in monthly installments commencing July 31,
2010.  The principal amount of the Clipper Note is due and payable in
full on the maturity date, which is July 2, 2013. The note is convertible into
shares of the Company’s Common Stock at the option of the holder at an initial
conversion rate equal to $0.10 per share, subject to proportional adjustment for
stock splits, stock dividends, recapitalizations and similar
events.  There are no penalties for prepayment of the Clipper
Note.  As discussed in Note 4, “The Clipper Transaction”, the carrying
value of this debt is $941,500 resulting in a discount of
$158,500.  This discount is being amortized on a straight line basis
over the term of the Clipper Note.





Caledonia
Note Modification





On July
2, 2010, as a part of  the Caledonia Transaction mentioned in Note 4,
the Company entered into a Consolidated, Amended and Restated Promissory Note in
the principal amount of $570,000 (the “New Caledonia Note”) with Caledonia
pursuant to which Caledonia and the Company agreed to (a) consolidate into a
single note (1) the Secured Promissory Note dated July 1, 2009, by and between
the Company and Caledonia, in the original principal amount of $250,000 and
subsequently increased to $300,000 (“Caledonia Note 1”), and (2) the Revolving
Line of Credit Promissory Note dated November 3, 2009, by and between the
Company and Caledonia, in the original principal amount of $150,000 (“ Caledonia
Note 2 ,” and together with Caledonia Note 1, the “Old Caledonia Notes ”), (b)
extend the maturity of the Old Caledonia Notes to July 2, 2013 and (c) reduce
the interest rate of the Old Caledonia Notes from 20% to 12% per
annum.  The Company, Clipper and Caledonia entered into an
Intercreditor Agreement dated July 2, 2010 (the “Intercreditor Agreement”) in
connection with the closing of the issuance of the New Caledonia Note, pursuant
to which the New Caledonia Note and the Clipper Note rank equally with respect
to payment, collateral and enforcement. In consideration of Caledonia’s
agreement to consolidate, extend the maturity date of, and reduce the interest
rate of, the Old Caledonia Notes, and Caledonia’s agreement to share its lien on
the Company’s assets with Clipper pursuant to the Intercreditor Agreement, the
Company paid Caledonia a note modification fee of $50,000, which fee is included
in the principal balance of the New Caledonia Note and is being amortized as
additional discount over the term of the note.   The note is
convertible into shares of the Company’s Common Stock at the option of the
holder at an initial conversion rate equal to $0.10 per share, subject to
proportional adjustment for stock splits, stock dividends, recapitalizations and
similar events.  There are no penalties for prepayment of the New
Caledonia Note.


F-6





STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





6. Fair Value of Financial
Instruments





The
carrying values of cash and cash equivalents, contract receivables and accounts
payable approximate fair value because of the short-term nature of these
instruments.  The carrying value of notes payable approximate fair
value due to their stated interest rate.  Considerable judgment is
necessary to estimate the fair value of financial instruments.  Due to
current limitations on credit availability and market conditions, the estimates
of fair value presented herein are not necessarily indicative of the amounts
that could be realized upon disposition of the financial
instruments.





7. Inventories





Inventories
consisted of the following:




October 31,
                    
                    
                    July
      31,2009
                    
                    
                    2010Raw
      materials
                    
                    $
                    6,259
                    
                    
                    $
                    -Finished
      goods
                    
                    
                    4,328
                    
                    
                    
                    18,576$
                    10,587
                    
                    
                    $
                    18,576





8. Property, Plant and
Equipment





The
Company signed a lease for new headquarters in Ashburn, Virginia on February 2,
2010 and subsequently vacated its Herndon, Virginia
facility.   During the first quarter of fiscal 2010, the Company
wrote off the remaining balance, or approximately $138,000, of its leasehold
improvements related to this facility.  As discussed in Note 10, the
Company and its former landlord agreed to the major terms for termination of its
obligation under the Herndon, Virginia lease for a cash payment of $170,000 and
forfeiture of its security deposit with the landlord.





9. Interest Expense





For the
three-month period ended July 31, 2010, the Company incurred interest expense of
$41,619 on its notes payable of which $5,139 represented amortization of the
discount on its notes payable.





In the
nine-month period ended July 31, 2010, the Company incurred interest expense of
$153,079 on its notes payable of which $82,221 represented amortization of the
discount on its notes payable.





10. Other
Income (Expense)





Legal settlement





In
December 2007 the Company was notified that there was a class action lawsuit
settlement with defendants which may have affected entities who directly
purchased Dynamic Random Access Memory (“DRAM”) during the period of April 1,
1999 through June 30, 2002.  As a purchaser of DRAM from one of the
defendants during that period, the Company submitted a claim of approximately
$1.4 million.  In December 2009 the Company received a payment of
$155,757 as a result of this settlement.





Royalties





In the
three-month and nine-month periods ended July 31, 2010, the Company earned
$25,084 and $82,441, respectively, of royalties associated with the July 2009
sale of the Integration Business.


F-7





STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Sale
of Professional Services Assets





On
January 11, 2010, the Company entered into a Purchase and Sale Agreement
(referred to herein as “Agreement”) with Global Technology Partners, Inc., a
Maryland corporation (referred to herein as “Purchaser”).  Pursuant to
the Agreement the Company sold to
the Purchaser a large portion of its professional services assets, consisting of
certain consulting contracts and related agreements, and assigned all of its
rights to employment and independent contractor contracts for certain of the
Company’s contractors and employees engaged in the consulting business (referred
to herein as “Assets”).  As consideration for the sale of the Assets,
the Purchaser agreed to pay a base price of one hundred forty thousand dollars
($140,000) of which (a) seventy thousand dollars ($70,000) was paid upon the
execution of the Agreement, and (b) seventy thousand dollars ($70,000) was paid
on January 15, 2010.





Extinguishment
of debt





On March
31, 2010, the Company recognized a loss on extinguishment of debt of $30,000 due
to a modification of the Caledonia notes which was accounted for as an
extinguishment of debt due to the addition of conversion
privileges.





Lease
settlement





On June
30, 2010, the Company settled its remaining obligations with respect to the
lease of its facility located at 13960-13964 Park Center Road, Herndon, Virginia
20171 by entering into a Lease Termination Agreement (the “Lease Termination
Agreement”) with the landlord, OTR, an Ohio general partnership, acting as the
duly authorized nominee of the Board of the State Teachers Retirement System of
Ohio (“OTR”).  Under the Lease Termination Agreement, the Company
became obligated to pay $313,654.87 to OTR (the “Settlement Receivable”), and
waived and released its interest in its security deposit, in complete
satisfaction of its obligations under the lease.  On July 1, 2010, in
connection with the closing of the Clipper Transaction, Clipper entered into a
Receivable Purchase Agreement with OTR (the “Receivable Purchase Agreement”),
pursuant to which Clipper purchased all of OTR’s rights with respect to the
Settlement Receivable from OTR for $170,000.  On July 1, 2010, in
connection with the closing of the Clipper Transaction, Clipper entered into a
letter agreement with the Company (the “Letter Agreement”), pursuant to which
Clipper, as the new owner of the Settlement Receivable, agreed to accept
$170,000 in complete satisfaction of the Settlement Receivable.  As a
result of the Company’s entry into the Letter Agreement, the Settlement
Receivable has been paid in full, although the Company remains responsible for
indemnification obligations as set forth in the Lease Termination Agreement and
the Letter Agreement.  As a result of these transactions, the Company
recognized a gain on lease settlement of $118,755 in the three- and nine-month
periods ended July 31, 2010.





11.
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,
warrants, convertible debt and convertible preferred stock 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, warrants, convertible debt and convertible preferred stock of
approximately 5,434,000 and 128,000 for the three-month periods ended July 31,
2010 and 2009, respectively, and 2,030,000 and 128,000 for the nine-month
periods ended July 31, 2010 and 2009, respectively. These shares were excluded
from the earnings per share calculation due to their antidilutive effect
resulting from the loss from continuing operations and loss from discontinued
operations.





12. Income
Tax





The
Company accounts for uncertainty in income taxes using a more-likely-than-not
recognition threshold based on the technical merits of the tax position
taken.  Tax positions that meet the more-likely-than-not recognition
threshold should be measured as the largest amount of the tax benefits,
determined on a cumulative probability basis, which is more likely than not to
be realized upon effective settlement in the financial
statements.  The Company has an unrecognized tax benefit of
approximately $61,000 and does not expect any of this amount to reverse in the
next twelve months.  The Company has a valuation allowance against the
full amount of its net deferred tax assets and therefore, the amount of
unrecognized tax benefits that, if recognized, would impact the effective tax
rate is zero.





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, 2006, although carryforward tax attributes that were
generated prior to October 31, 2006 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 July 31,
2010.


F-8





STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





13. Commitments
and Contingencies





On
February 2, 2010, we entered into a Lease Agreement (the “February Lease”) with
Merritt-AB5, LLC (the “Landlord”), pursuant to which we rent approximately 3,461
square feet in the property located at 20110 Ashbrook Place, Suite 130, Ashburn,
Virginia 20147 (the “Ashburn Premises”) for our operations facility. The term of
the February Lease is for one year beginning on February 19, 2010 (the “Term”).
The Term may be extended for two additional successive one year periods. The
monthly rent is $6,489.38, or $77,872.50 for the first year, inclusive of
operating expenses. If we decide to extend the Term, the monthly rent for the
second year will be $6,684.06 or $80,208.68 per year, and the monthly rent for
the third year will be $6,884.58 or $82,614.94 per year.





On May
22, 2009, we entered into a Stipulation/Consent Order with CRP (the
“Stipulation”), pursuant to an Affidavit and Statement of Account (the
“Affidavit”), stating, as declared by a general manager of Jones Lang LaSalle, a
property management company and agent for CRP Holdings A-1, LLC (“CRP”), the
landlord of 14040 Park Center Road, Suite 210, Herndon, Virginia 20171 (the
“Premises”), that CRP, as landlord, was seeking a judgment against us for: (i)
possession of the Premises, and (ii) monetary damages for nonpayment of rent due
under a sublease (the “Sublease”), dated September 28, 2004, by and between us
and NEC America, Inc. (“NEC”), and a subsequent assignment of the Sublease to
CRP from NEC, dated December 15, 2008. In the Stipulation we acknowledged that
the balance due for rent and additional rent for the Premises was $168,638,
together with attorney‘s fees and court expenses of $7,041 through May 22, 2009
(the “Judgment Amount”). Pursuant to the Stipulation, we paid $30,000 (the
“Forbearance Payment”) on May 22, 2009 toward the Judgment Amount. Further we
agreed to, and have, vacated the Premises. CRP agreed to stay enforcement of the
Judgment Amount until the earlier of (a) our receipt of capital in the amount of
at least $500,000, or (b) May 31, 2010. The matter was returned to the court‘s
files pending our compliance with the terms of the Stipulation.  As of
July 31, 2010, we had $168,956 recorded as a liability for this
matter.





On
February 27, 2009, we entered into a lease amendment with the landlord of our
prior operations facility, whereby the lease for that facility, which was
scheduled to expire on August 31, 2014, was amended to provide for (i) the
extension of the lease term for a period of one (1) year and four (4) months
ending on December 31, 2015, and (ii) certain other modifications, including a
reduction in our rent cash payments by approximately $60,000 and $34,000 for the
fiscal years 2009 and 2010, respectively. Monthly rent for the lease was
approximately $21,000 inclusive of operating expenses.   On June 30,
2010, the Company settled its remaining obligations with respect to the lease of
its facility located at 13960-13964 Park Center Road, Herndon, Virginia 20171 by
entering into a Lease Termination Agreement (the “Lease Termination Agreement”)
with the landlord, OTR, an Ohio general partnership, acting as the duly
authorized nominee of the Board of the State Teachers Retirement System of Ohio
(“OTR”).  Under the Lease Termination Agreement, the Company became
obligated to pay $313,654.87 to OTR (the “Settlement Receivable”), and waived
and released its interest in its security deposit, in complete satisfaction of
its obligations under the lease.   On July 1, 2010, Clipper
entered into a Receivable Purchase Agreement with OTR (the “Receivable Purchase
Agreement”), pursuant to which Clipper purchased all of OTR’s rights with
respect to the Settlement Receivable from OTR for $170,000.   On
July 1, 2010, in connection with the closing of the transactions under the
Clipper Preferred Stock Purchase Agreement and the Clipper Note Purchase
Agreement, Clipper entered into a letter agreement with the Company (the “Letter
Agreement”), pursuant to which Clipper, as the new owner of the Settlement
Receivable, agreed to accept $170,000 in complete satisfaction of the Settlement
Receivable.  As a result of the Company’s entry into the Letter
Agreement, the Settlement Receivable has been paid in full, although the Company
remains responsible for indemnification obligations as set forth in the Lease
Termination Agreement and the Letter Agreement.  As a result of these
transactions, the Company recognized a gain on lease settlement of $118,755 in
the three- and nine-month periods ended July 31, 2010.





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.





14. Subsequent
Events





None.


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 . 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 SteelCloud, Inc.’s
(referred to herein as the “Company”, or “SteelCloud”, “we”, “our”, “ours”, and
“us”) ability to obtain financing in the short term; general economic and
business conditions; industry capacity; industry trends; competition; changes in
business strategy or development plans; project performance; and availability of
qualified personnel; and the risks and other factors set forth from time to time
in the reports we file with the Securities and Exchange Commission (the “SEC”).
Statements made herein are as of the date of the filing of this Quarterly Report
on Form 10-Q with the SEC 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 Footnotes thereto included in Part I - 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, 2009 as amended, filed by us with the SEC.




OVERVIEW




Founded
in 1987, we are a developer of mobility appliance and software solutions
primarily for the Research in Motion (“RIM”) BlackBerry market. We design and
integrate our software into specialized server appliances targeted at Department
of Defense, public sector, commercial, and remote hosting customers. In
addition, we are a world-wide provider of RIM hosting
licenses.


SteelWorks®




In
conjunction with RIM, we developed an appliance solution specifically for the
BlackBerry Enterprise Server (“BES”).  We believe the BES appliance
solution is the single best way to implement the BES software
environment.  SteelWorks is an integrated server appliance that
enables virtually any size organization to implement the BES in a fraction of
the time and at a fraction of the cost or resources allocated to this otherwise
time intensive, manual process.  We have filed for three patents for
the appliance related to the technology we created for the installation wizard,
backup and restore features.  These patents are currently pending
approval from the U.S. Patent and Trademark Office.




In
addition, we developed SteelWorks FedMobile, our BES appliance solution
specifically for the Department of Defense (“DoD”) and other related
agencies.  The SteelWorks FedMobile appliance builds upon our
commercial appliance by automating the application of the Defense Information
Systems Agency’s (“DISA”) and DoD’s Security Technical Implementation Guide
(“STIG”) to the BES installation process.  The STIG mandates the
policies for which the DoD and related agencies must operate their wireless
communications.  As a result, our FedMobile appliance allows those
agencies to be STIG compliant in a fraction of the time and at a fraction of the
cost or resources allocated to this otherwise time intensive, manual
process.




In
January 2010, we announced the availability of SteelWorks FLEX+.  This
offering combines the standard commercial SteelWorks appliance with BES hosting
licensing.  SteelWorks FLEX+ allows our BES hosting
partners to install and manage a complete solution, including infrastructure and
licensing, at a customer site.  FLEX+ provides SteelCloud
with the ability to recognize revenue from both the appliance sale and the BES
licensing.


Hosting
Licenses




From
October to December of 2009, we entered into six agreements with RIM, or with
RIM international subsidiaries, to distribute and manage BES hosted licensing to
RIM Alliance Members in the U.S. and 105 countries worldwide.  As of
July, 31, 2010, we had agreements with 140 domestic and international BES
hosting providers to supply and manage hosting licenses.  Revenue from
hosting licenses are billed and recognized on a monthly basis. We anticipate
that hosting license revenue will increase throughout the 2010 fiscal year as
the current BES hosters enter into agreements with us and new hosters are
developed.


4


Professional
Services





We
provide information technology consulting for our clients.  Our
consultants are subject matter experts in mobility technology.





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 nine months ended July
31, 2010, we incurred research and development costs of approximately
$240,000.  We will continue to incur costs for product development in
the future.


CRITICAL
ACCOUNTING POLICIES AND ESTIMATES




The
preparation of financial statements in conformity with US Generally Accepted
Accounting Principles (“GAAP”) 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.


In
simultaneous transactions with the same investors, the Company issued
convertible preferred stock with warrants to purchase common stock and also
issued debt.  The proceeds received were allocated to the debt,
preferred stock and warrants based on their relative fair values.  The
resulting discount associated with the debt is amortized to interest expense
over the term of the debt.


No other
changes to our critical accounting policies have taken place since our Annual
Report on Form 10-K for the fiscal year October 31, 2009, as amended (the
“Annual Report”).


New
Accounting Pronouncements




There
have been no recent accounting pronouncements or changes in accounting
pronouncements during the nine months ended July 31, 2010, as compared to the
recent accounting pronouncements described in the Annual Report that we have
implemented, or that are of significance, or potential significance, to
us.


5


RESULTS
OF OPERATIONS




For
the Three and Nine Months Ended July 31, 2010 Compared to the Three and Nine
Months Ended July 31, 2009:




Revenue
Discussion:




Revenues
increased approximately 97%, or $272,716, to $554,421 for the three-month period
ended July 31, 2010 as compared to $281,705 for the same period in fiscal
2009.  The increase was due to the increase in hosting license
revenue, which more than offset the decline in our professional service
revenue.


Revenues
increased by approximately 19%, or $215,113, to $1,375,377 for the nine-month
period ended July 31, 2010, as compared to $1,160,264 for the same period in
fiscal 2009.  The increase was primarily attributable to the increase
in hosting license revenue, which more than offset a decrease in our
professional service revenue.




Gross
Profit Discussion:




Gross
profit increased $76,243, or approximately 64%, to $195,449 for the three-month
period ended July 31, 2010 as compared to $119,206 for the same period in fiscal
2009.  The increase was primarily attributable to the gross margins
generated from the new business related to Hosting Licenses offset by reduced
gross margins attributable to lower service and product
sales.


Gross
profit increased by approximately 60%, or $198,476, to $530,959 for the
nine-month period ended July 31, 2010 as compared to $332,483 for the same
period in fiscal 2009.  The increase was primarily attributable to
improved margins on a professional services contract begun in November 2009 as
well as the gross margins generated from the new business related to Hosting
Licenses.




Operating
Expense Discussion:




The
following table summarizes our operating expenses for the three months ended
July 31, 2009 and 2010 in dollars and as a percentage of net
revenues.


Three Months Ended July 31,2009
                        
                        
                        2010
                        
                        
                        Increase (decrease)% of Net
                        
                        
                        
                        
                        
                        % of NetDollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        PercentageSelling
      and marketing
                        
                        $
                        153,412
                        
                        
                        
                        54
                        %
                        
                        $
                        138,770
                        
                        
                        
                        25
                        %
                        
                        $
                        (14,642
                        )
                        
                        
                        (10
                        )%Research
      and product development
                        
                        
                        53,637
                        
                        
                        
                        19
                        %
                        
                        
                        89,184
                        
                        
                        
                        16
                        %
                        
                        
                        35,547
                        
                        
                        
                        66
                        %General
      and administrative
                        
                        
                        591,397
                        
                        
                        
                        210
                        %
                        
                        
                        328,564
                        
                        
                        
                        59
                        %
                        
                        
                        (262,833
                        )
                        
                        
                        (44
                        )%Total
      operating expenses
                        
                        $
                        798,446
                        
                        
                        
                        283
                        %
                        
                        $
                        556,518
                        
                        
                        
                        100
                        %
                        
                        $
                        (241,928
                        )
                        
                        
                        (30
                        )%





The
increase in research and product development for the three months ended July 31,
2010 compared to the three months ended July 31, 2009 is the result of our
continued investment in our core products.




The
decrease in general and administrative expenses for the three months ended July
31, 2010 compared to the three months ended July 31, 2009 is primarily
attributable to reductions in personnel costs which were partially offset by an
increase in stock-based compensation expense to our Board of
Directors.





The
following table summarizes our operating expenses for the nine months ended July
31, 2009 and 2010 in dollars and as a percentage of net
revenues.


Nine Months Ended July 31,2009
                        
                        
                        2010
                        
                        
                        Increase (decrease)% of Net
                        
                        
                        
                        
                        
                        % of NetDollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        PercentageSelling
      and marketing
                        
                        $
                        369,276
                        
                        
                        
                        32
                        %
                        
                        $
                        356,776
                        
                        
                        
                        26
                        %
                        
                        $
                        (12,500
                        )
                        
                        
                        (3
                        )%Research
      and product development
                        
                        
                        151,869
                        
                        
                        
                        13
                        %
                        
                        
                        239,917
                        
                        
                        
                        17
                        %
                        
                        
                        88,048
                        
                        
                        
                        58
                        %General
      and administrative
                        
                        
                        1,886,485
                        
                        
                        
                        163
                        %
                        
                        
                        1,594,446
                        
                        
                        
                        116
                        %
                        
                        
                        (292,039
                        )
                        
                        
                        (15
                        )%Severance
      and restructuring
                        
                        
                        73,205
                        
                        
                        
                        6
                        %
                        
                        
                        -
                        
                        
                        
                        0.0
                        %
                        
                        
                        (73,205
                        )
                        
                        
                        (100.00
                        )%Total
      operating expenses
                        
                        $
                        2,480,835
                        
                        
                        
                        214
                        %
                        
                        $
                        2,191,139
                        
                        
                        
                        159
                        %
                        
                        $
                        (289,696
                        )
                        
                        
                        (12
                        )%




6


The
increase in research and product development for the nine months ended July 31,
2010 compared to the nine months ended July 31, 2009 is the result of our
continued investment in our core products.  We believe that research
and product development expenses will fluctuate from quarter to quarter as we
develop and introduce new products into the marketplace.




The
decrease in general and administrative expenses for the nine months ended July
31, 2010 compared to the nine months ended July 31, 2009 is primarily
attributable to reductions in personnel costs offset by the impairment of
leasehold improvements and an increase in legal expenses related to our S-1
registration statement.




The
decrease in severance and restructuring costs for the nine months ended July 31,
2010 compared to the nine months ended July 31, 2009 is the result of incurring
severance payments in the amount of $73,205 associated with the termination of
our former CEO and President’s employment agreement during the three months
ended January 31, 2009.




Interest
Expense Discussion:




For the
three-month period ended July 31, 2010, the Company incurred interest expense of
$41,619 on its notes payable of which $5,139 represented amortization of the
discount on its notes payable.




In the
nine-month period ended July 31, 2010, the Company incurred interest expense of
$153,078 on its notes payable of which $82,221 represented amortization of the
discount on its notes payable.




Other
Income (Expense) Discussion:


Legal settlement




In
December 2007 the Company was notified that there was a class action lawsuit
settlement with defendants which may have affected entities who directly
purchased Dynamic Random Access Memory (“DRAM”) during the period of April 1,
1999 through June 30, 2002.  As a purchaser of DRAM from one of the
defendants during that period, the Company submitted a claim of approximately
$1.4 million.  In December 2009 the Company received a payment of
$155,757 as a result of this settlement.




Royalties




In the
three-month and nine-month periods ended July 31, 2010, the Company earned
$25,084 and $82,441, respectively, of royalties associated with the July 2009
sale of the Integration Business.


Sale
of Professional Services Assets


On
January 11, 2010, the Company entered into a Purchase and Sale Agreement
(referred to herein as “Agreement”) with Global Technology Partners, Inc., a
Maryland Corporation (referred to herein as “Purchaser”).  Pursuant to
the Agreement the Company sold to the Purchaser a large portion of its
professional services assets, consisting of certain consulting contracts and
related agreements, and assigned all of its rights to employment and independent
contractor contracts for certain of the Company’s contractors and employees
engaged in the consulting business (referred to herein as
“Assets”).  As consideration for the sale of the Assets, the Purchaser
agreed to pay a base price of one hundred forty thousand dollars ($140,000) of
which (a) seventy thousand dollars ($70,000) was paid upon the execution of the
Agreement, and (b) seventy thousand dollars ($70,000) of which was paid on
January 15, 2010.


Extinguishment
of debt




On March
31, 2010, the Company recognized a loss on extinguishment of debt of $30,000 due
to a modification of the Caledonia notes which was accounted for as an
extinguishment of debt due to the addition of conversion
privileges.


Lease
settlement


On June
30, 2010, the Company settled its remaining obligations with respect to the
lease of its facility located at 13960-13964 Park Center Road, Herndon, Virginia
20171 by entering into a Lease Termination Agreement (the “Lease Termination
Agreement”) with the landlord, OTR, an Ohio general partnership, acting as the
duly authorized nominee of the Board of the State Teachers Retirement System of
Ohio (“OTR”).  Under the Lease Termination Agreement, the Company
became obligated to pay $313,654.87 to OTR (the “Settlement Receivable”), and
waived and released its interest in its security deposit, in complete
satisfaction of its obligations under the lease.  On July 1, 2010, in
connection with the closing of the Clipper Transaction, Clipper entered into a
Receivable Purchase Agreement with OTR (the “Receivable Purchase Agreement”),
pursuant to which Clipper purchased all of OTR’s rights with respect to the
Settlement Receivable from OTR for $170,000.  On July 1, 2010, in
connection with the closing of the Clipper Transaction, Clipper entered into a
letter agreement with the Company (the “Letter Agreement”), pursuant to which
Clipper, as the new owner of the Settlement Receivable, agreed to accept
$170,000 in complete satisfaction of the Settlement Receivable.  As a
result of the Company’s entry into the Letter Agreement, the Settlement
Receivable has been paid in full, although the Company remains responsible for
indemnification obligations as set forth in the Lease Termination Agreement and
the Letter Agreement.  As a result of these transactions, the Company
recognized a gain on lease settlement of $118,755 in the three- and nine-month
periods ended July 31, 2010.


7


LIQUIDITY
AND CAPITAL RESOURCES




We have
experienced recurring losses from operations and negative cash flows. For the
nine months ended July 31, 2010, we incurred a net loss of $1,344,843 and an
accumulated deficit of $49,949,971 as of that date. The report from our
independent registered public accounting firm on our audited financial
statements at October 31, 2009 contains an explanatory paragraph regarding doubt
as to our ability to continue as a going concern as a result of our history of
net losses from operations, net working capital deficit and uncertainty
regarding the our ability to satisfy obligations as they become due in the near
future. Despite our history of revenues, we can give no assurance that we will
be able to maintain or increase our revenues in fiscal 2010 or that we will be
successful in reaching profitability or generating positive cash flows from our
operations. As a result of the Clipper Transaction and the Caledonia Transaction
described in Notes 4 and 5 to our Consolidated Financial Statements set forth
above in Part I, Item I, we have improved our short-term liquidity and working
capital resources.




On July
16, 2010, we filed a Form RW with the SEC seeking its permission to terminate
our offering of up to 16,000,000 shares of our common stock together with
16,000,000 common stock purchase warrants on a best efforts basis at a fixed
price between $0.07 and $0.30 per share and an exercise price per warrant equal
to 150% of the final offering share price, pursuant to a Form S-1 Registration
Statement filed with the SEC on April 20, 2009, which we subsequently amended on
Forms S-1/A filed on June 25, 2009, July 23, 2009, August 13, 2009, August 27,
2009, October 23, 2009, October 29, 2009, December 30, 2009, February 24, 2010
and March 16, 2010 (as so amended, the “Registration Statement”) and declared
effective by the SEC on March 16, 2010.  We took this action in
response to the failure to raise any significant interest in the
offering.  We sold no common stock or warrants pursuant to the
Registration Statement.  The SEC granted our request on September 1,
2010, and, as a result, the Registration Statement is no longer
effective.




We will
continue to consider all strategic options to improve our liquidity and to
obtain working capital to fund our continuing business operations including
equity offerings, asset sales and debt financing as alternatives to improve our
cash needs as required; however; we can offer no assurance that we will be
successful in identifying, obtaining or negotiating financing terms. If adequate
funds are not available or are not available on terms acceptable to us, we will
likely not be able to take advantage of unanticipated opportunities, develop or
enhance services or products, respond to competitive pressures, or continue as a
going concern.


As of
July 31, 2010, we had cash and cash equivalents of $1,406,441 and working
capital of $842,766. As of September 8, 2010, we have approximately $1,002,000
of cash on hand, which management believes is adequate for the next twelve
months of operations. We do not have any working capital commitments nor do we
presently have any external sources of working capital. Historically, our
revenues have not been sufficient to fund our operations and we have relied on
capital provided through the sale of equity securities. Our working capital
needs in future periods will depend primarily on the rate at which we can
increase our revenues while controlling our expenses and decreasing the use of
cash from operations.


For the
nine months ended July 31, 2010, we used $963,660 in cash for operating
activities. Our primary use of cash was to finance our operating loss. 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 along with corporate, sales and marketing and research and development
expenditures.


We used
$36,549 from our investing activities and generated $2,346,000 from financing
activities for the nine months ended July 31, 2010.




Our
consolidated financial statements for the nine months ended July 31, 2010 do not
give effect to any adjustments to recorded amounts and their classifications,
which would be necessary should we be unable to continue as a going concern and
therefore, be required to realize our assets and discharge our liabilities in
other than the normal course of business and at amounts different from those
reflected in the consolidated financial statements.


8


COMMITMENTS




On
February 2, 2010, we entered into a Lease Agreement (the “February Lease”) with
Merritt-AB5, LLC (the “Landlord”), pursuant to which we rent approximately 3,461
square feet in the property located at 20110 Ashbrook Place, Suite 130, Ashburn,
Virginia 20147 (the “Ashburn Premises”) for our operations facility. The term of
the February Lease is for one year beginning on February 19, 2010 (the “Term”).
The Term may be extended for two additional successive one year periods. The
monthly rent is $6,489.38, or $77,872.50 for the first year, inclusive of
operating expenses. If we decide to extend the Term, the monthly rent for the
second year will be $6,684.06 or $80,208.68 per year, and the monthly rent for
the third year will be $6,884.58 or $82,614.94 per year.


On May
22, 2009, we entered into a Stipulation/Consent Order with CRP (the
“Stipulation”), pursuant to an Affidavit and Statement of Account (the
“Affidavit”), stating, as declared by a general manager of Jones Lang LaSalle, a
property management company and agent for CRP Holdings A-1, LLC (“CRP”), the
landlord of 14040 Park Center Road, Suite 210, Herndon, Virginia 20171 (the
“Premises”), that CRP, as landlord, was seeking a judgment against us for: (i)
possession of the Premises, and (ii) monetary damages for nonpayment of rent due
under a sublease (the “Sublease”), dated September 28, 2004, by and between us
and NEC America, Inc. (“NEC”), and a subsequent assignment of the Sublease to
CRP from NEC, dated December 15, 2008. In the Stipulation we acknowledged that
the balance due for rent and additional rent for the Premises was $168,638,
together with attorney‘s fees and court expenses of $7,041 through May 22, 2009
(the “Judgment Amount”). Pursuant to the Stipulation, we paid $30,000 (the
“Forbearance Payment”) on May 22, 2009 toward the Judgment Amount. Further we
agreed to, and have, vacated the Premises. CRP agreed to stay enforcement of the
Judgment Amount until the earlier of (a) our receipt of capital in the amount of
at least $500,000, or (b) May 31, 2010. The matter was returned to the court‘s
files pending our compliance with the terms of the Stipulation.  As of
July 31, 2010, we had $168,956 recorded as a liability for this
matter.


On
February 27, 2009, we entered into a lease amendment with the landlord of our
prior operations facility, whereby the lease for that facility, which was
scheduled to expire on August 31, 2014, was amended to provide for (i) the
extension of the lease term for a period of one (1) year and four (4) months
ending on December 31, 2015, and (ii) certain other modifications, including a
reduction in our rent cash payments by approximately $60,000 and $34,000 for the
fiscal years 2009 and 2010, respectively. Monthly rent for the lease was
approximately $21,000 inclusive of operating expenses.   On June 30,
2010, the Company settled its remaining obligations with respect to the lease of
its facility located at 13960-13964 Park Center Road, Herndon, Virginia 20171 by
entering into a Lease Termination Agreement (the “Lease Termination Agreement”)
with the landlord, OTR, an Ohio general partnership, acting as the duly
authorized nominee of the Board of the State Teachers Retirement System of Ohio
(“OTR”).  Under the Lease Termination Agreement, the Company became
obligated to pay $313,654.87 to OTR (the “Settlement Receivable”), and waived
and released its interest in its security deposit, in complete satisfaction of
its obligations under the lease.   On July 1, 2010, Clipper
entered into a Receivable Purchase Agreement with OTR (the “Receivable Purchase
Agreement”), pursuant to which Clipper purchased all of OTR’s rights with
respect to the Settlement Receivable from OTR for $170,000.   On
July 1, 2010, in connection with the closing of the transactions under the
Clipper Preferred Stock Purchase Agreement and the Clipper Note Purchase
Agreement, Clipper entered into a letter agreement with the Company (the “Letter
Agreement”), pursuant to which Clipper, as the new owner of the Settlement
Receivable, agreed to accept $170,000 in complete satisfaction of the Settlement
Receivable.  As a result of the Company’s entry into the Letter
Agreement, the Settlement Receivable has been paid in full, although the Company
remains responsible for indemnification obligations as set forth in the Lease
Termination Agreement and the Letter Agreement.  As a result of these
transactions, the Company recognized a gain on lease settlement of $118,755 in
the three- and nine-month periods ended July 31, 2010.


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.




ITEM
      3.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK




We are a
smaller reporting company as defined by Rule 12b-2 of the Securities Exchange
Act of 1934, as amended, and are not required to provide information in response
to this item.


9


ITEM
      4.
            CONTROLS
      AND PROCEDURES




Disclosure
Controls and Procedures




We have
established disclosure controls and procedures to ensure that material
information relating to our Company is made known to the officers who certify
our financial reports and to other members of our senior management and our
Board of Directors.




A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met.
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 a company have been detected. Our disclosure controls and
procedures are designed to provide reasonable assurance of achieving our
objectives.


Based
upon their evaluation as of July 31, 2010, our Chief Executive Officer and Chief
Financial and Accounting Officer have concluded that our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934) were not effective as of the end of the fiscal quarter
ended July 31, 2010.  In making this evaluation, our Chief Executive
Officer and Chief Financial Officer considered, among other matters, the
material weakness in our internal control over financial reporting described in
our Annual Report on Form 10-K for the fiscal year ended October 31, 2009, as
filed with the SEC on February 5, 2010, as amended.




Changes
in Internal Control Over Financial Reporting




There
have been no significant changes in our internal controls over financial
reporting during the quarter ended July 31, 2010 that have altered our
conclusion as to the ineffectiveness of such controls.


10


PART
II. OTHER INFORMATION




ITEM
      1.
            LEGAL
      PROCEEDINGS




On May
22, 2009, we entered into a Stipulation/Consent Order with CRP, referred to as
the “Stipulation,” pursuant to an Affidavit and Statement of Account, referred
to as the “Affidavit,” stating, as declared by a general manager of Jones Lang
LaSalle, a property management company and agent for CRP Holdings A-1, LLC,
referred to as “CRP,” the landlord of 14040 Park Center Road, Suite 210,
Herndon, Virginia 20171, referred to as the “Premises,” that CRP, as landlord,
was seeking a judgment against us for: (i) possession of the Premises, and (ii)
monetary damages for nonpayment of rent due under a sublease, referred to as the
“Sublease,” dated September 28, 2004, by and between us and NEC America, Inc.,
referred to as “NEC,” and a subsequent assignment of the Sublease to CRP from
NEC, dated December 15, 2008.  In the Stipulation we acknowledged that
the balance due for rent and additional rent for the Premises was $168,637.96,
together with attorney’s fees and court expenses of $7,041.00 through May 22,
2009, referred to as the “Judgment Amount.”  Pursuant to the
Stipulation, we paid $30,000, referred to as the “Forbearance Payment,” on May
22, 2009 toward the Judgment Amount.  Further we agreed to, and have,
vacated the Premises.  CRP agreed to stay enforcement of the Judgment
Amount until the earlier of (a) our receipt of capital in the amount of at least
$500,000, or (b) May 31, 2010.  The matter was returned to the court’s
files pending our compliance with the terms of the Stipulation.  As of July
31, 2010, we had $168,956 recorded as a liability for this matter.




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 to any other material
legal proceedings.




ITEM
      1A.
            RISK
      FACTORS




Not
applicable.




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





Not
applicable.




ITEM
      3.
            DEFAULTS
      UPON SENIOR SECURITIES




Not
applicable.




ITEM
      4.
            REMOVED
      AND RESERVED




Not
applicable.




ITEM
      5.
            OTHER
      INFORMATION




Not
applicable.




ITEM
      6.
            EXHIBITS




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.Exhibit
      99.1
                Form
      RW filed with the Securities and Exchange Commission on July 16, 2010 and
      incorporated herein by
reference.


11


SIGNATURES




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




September
      14, 2010
              STEELCLOUD,
      INC.By:
              /s/ Brian H. HajostName:
      Brian H. HajostTitle:
      Chief Executive Officer and PresidentBy:
              /s/ Steven SnyderName:
      Steven SnyderTitle:
      Chief Financial Officer, Principal Accounting Officer and
      Controller




12