UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549




FORM
10-Q




(Mark
one)




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




For the
quarterly period ended January 31, 2009




OR




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




For the
transition period from __________ to ________




Commission
File No. 0-24015







STEELCLOUD,
INC.


(Exact
name of registrant as specified in its charter)




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




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


(703)
674-5500


(Registrant’s
telephone number, including area code)




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




Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.


Yes þ No o




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




Large
Accelerated filer oAccelerated
filer oNon-accelerated filer oSmaller
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
March 1, 2009 there were 14,813,376 shares of the registrant’s common stock
outstanding.





SteelCloud,
Inc.


Form
10-Q Index


for
the Quarterly period ended January 31, 2009




PART
      I. FINANCIAL INFORMATION
                                        1ITEM
      1.
                                        FINANCIAL
      STATEMENTS
                                        1ITEM
      2.
                                        MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
                                        2ITEM
      3.
                                        QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
                                        10ITEM
      4.
                                        CONTROLS
      AND PROCEDURES
                                        11PART
      II. OTHER INFORMATION
                                        12ITEM
      1.
                                        LEGAL
      PROCEEDINGS
                                        12ITEM
      1A.
                                        RISK
      FACTORS
                                        12ITEM
      2.
                                        UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
                                        14ITEM
      3.
                                        DEFAULTS
      UPON SENIOR SECURITIES
                                        14ITEM
      4.
                                        SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS
                                        14ITEM
      5.
                                        OTHER
      INFORMATION
                                        14ITEM
      6.
                                        EXHIBITS
                                        14SIGNATURES
                                        15




i




PART
I. FINANCIAL INFORMATION




ITEM
      1.
            FINANCIAL
      STATEMENTS




Index
to Financial Statements




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




1


STEELCLOUD,
INC.


CONDENSED
CONSOLIDATED BALANCE SHEET




October 31,
                    
                    
                    January 31,2008
                    
                    
                    2009(unaudited)ASSETSCurrent
      assetsCash
      and cash equivalents
                    
                    $
                    752,351
                    
                    
                    $
                    1,187,435Accounts
      receivable, net
                    
                    
                    1,571,673
                    
                    
                    
                    395,356Inventory,
      net
                    
                    
                    521,920
                    
                    
                    
                    440,335Prepaid
      expenses and other current assets
                    
                    
                    130,446
                    
                    
                    
                    117,302Deferred
      contract costs
                    
                    
                    -
                    
                    
                    
                    25,000Total
      current assets
                    
                    
                    2,976,390
                    
                    
                    
                    2,165,428Property
      and equipment, net
                    
                    
                    626,440
                    
                    
                    
                    578,236Equipment
      on lease, net
                    
                    
                    442,099
                    
                    
                    
                    389,089Other
      assets
                    
                    
                    7,020
                    
                    
                    
                    13,344Total
      assets
                    
                    $
                    4,051,949
                    
                    
                    $
                    3,146,097LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesAccounts
      payable
                    
                    $
                    718,316
                    
                    
                    $
                    411,283Accrued
      expenses
                    
                    
                    561,009
                    
                    
                    
                    545,867Notes
      payable, current
                    
                    
                    7,538
                    
                    
                    
                    7,628Unearned
      revenue
                    
                    
                    8,882
                    
                    
                    
                    424,186Total
      current liabilities
                    
                    
                    1,295,745
                    
                    
                    
                    1,388,964Long-term
      liabilitiesNotes
      payable, long-term
                    
                    
                    7,903
                    
                    
                    
                    5,962Other
      long-term
                    
                    
                    132,055
                    
                    
                    
                    131,021Total
      long-term liabilities
                    
                    
                    139,958
                    
                    
                    
                    136,983Stockholders’
      equityPreferred
      stock, $.001 par value: 2,000,000 shares authorized, no shares issued and
      outstanding at October 31, 2008 and January 31, 2009
                    
                    
                    –
                    
                    
                    
                    –Common
      stock, $.001 par value: 50,000,000 shares authorized, 15,138,376 and
      15,213,376 shares issued at October 31, 2008 and January 31, 2009,
      respectively
                    
                    
                    15,138
                    
                    
                    
                    15,213Additional
      paid in capital
                    
                    
                    50,902,172
                    
                    
                    
                    50,909,746Treasury
      stock, 400,000 shares at October 31, 2008 and January 31,
    2009
                    
                    
                    (3,432,500
                    )
                    
                    
                    (3,432,500
                    )Accumulated
      deficit
                    
                    
                    (44,868,564
                    )
                    
                    
                    (45,872,309
                    )Total
      stockholders’ equity
                    
                    
                    2,616,246
                    
                    
                    
                    1,620,150Total
      liabilities and stockholders’ equity
                    
                    $
                    4,051,949
                    
                    
                    $
                    3,146,097




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
                    January
      31,2008
                  
                  
                  2009RevenuesProducts
                  
                  $
                  5,253,027
                  
                  
                  $
                  347,902Services
                  
                  
                  553,445
                  
                  
                  
                  541,008Total
      revenues
                  
                  
                  5,806,472
                  
                  
                  
                  888,910Cost
      of revenuesProducts
                  
                  
                  4,615,803
                  
                  
                  
                  412,424Services
                  
                  
                  440,309
                  
                  
                  
                  446,849Total
      cost of revenues
                  
                  
                  5,056,112
                  
                  
                  
                  859,273Gross
      profit
                  
                  
                  750,360
                  
                  
                  
                  29,637Selling
      and marketing
                  
                  
                  320,244
                  
                  
                  
                  135,974Research
      and product development
                  
                  
                  198,225
                  
                  
                  
                  101,481General
      and administrative
                  
                  
                  914,353
                  
                  
                  
                  722,722Severance
      and restructuring
                  
                  
                  -
                  
                  
                  
                  73,205Loss
      from operations
                  
                  
                  (682,462
                  )
                  
                  
                  (1,003,745
                  )Interest
      income, net
                  
                  
                  6,415
                  
                  
                  
                  –Loss
      before income taxes
                  
                  
                  (676,047
                  )
                  
                  
                  (1,003,745
                  )Provision
      for income taxes
                  
                  
                  –
                  
                  
                  
                  –Net
      loss
                  
                  
                  (676,047
                  )
                  
                  
                  (1,003,745
                  )Loss
      per share (basic and diluted):Basic
      and diluted loss per share
                  
                  $
                  (0.05
                  )
                  
                  $
                  (0.07
                  )Weighted–average
      shares outstanding, basic and diluted
                  
                  
                  14,316,934
                  
                  
                  
                  14,739,200




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


F-2


STEELCLOUD,
INC.


UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS




Three
      Months Ended
                  January
      31,2008
              
              
              2009Operating
      activitiesNet
      loss
              
              $
              (676,047
              )
              
              $
              (1,003,745
              )Adjustments
      to reconcile net (loss) to net cash (used in) provided by operating
      activities:Depreciation
      and amortization
              
              
              137,437
              
              
              
              101,214Stock-based
      compensation
              
              
              63,268
              
              
              
              7,649Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              179,130
              
              
              
              1,176,317Inventory
              
              
              (1,752,124
              )
              
              
              81,585Prepaid
      expenses and other assets
              
              
              18,294
              
              
              
              6,820Deferred
      contract costs
              
              
              12,675
              
              
              
              (25,000
              )Accounts
      payable
              
              
              1,471,130
              
              
              
              (307,033
              )Unearned
      revenue
              
              
              (28,650
              )
              
              
              415,304Accrued
      expenses and other liabilities
              
              
              623,485
              
              
              
              (16,176
              )Net
      cash provided by operating activities
              
              
              48,598
              
              
              
              436,935Investing
      activitiesPurchase
      of property and equipment
              
              
              (2,163
              )
              
              
              –Net
      cash used in investing activities
              
              
              (2,163
              )
              
              
              –Financing
      activitiesPayments
      on notes payable
              
              
              (3,885
              )
              
              
              (1,851
              )Net
      cash used in financing activities
              
              
              (3,885
              )
              
              
              (1,851
              )Net
      increase in cash and cash equivalents
              
              
              42,550
              
              
              
              435,084Cash
      and cash equivalents at beginning of period
              
              
              2,622,654
              
              
              
              752,351Cash
      and cash equivalents at end of period
              
              $
              2,665,204
              
              
              $
              1,187,435Supplemental
      cash flow informationInterest
      paid
              
              $
              4,230
              
              
              $
              1,239Income
      taxes paid
              
              $
              –
              
              
              $
              –




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


F-3


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




1.
            Nature
      of Business and Basis of
Presentation




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




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




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




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




The
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,
are 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 had recurring annual operating losses since its fiscal year ended October
31, 2004.  SteelCloud expects that such losses will continue at least
until its fiscal year ending October 31, 2009.  The report of
SteelCloud’s independent registered public accounting firm on SteelCloud’s
consolidated financial statements for the fiscal year ended October 31, 2008
contains an explanatory paragraph regarding SteelCloud’s ability to continue as
a going concern based upon its history of net losses.




SteelCloud
is dependent upon available cash and operating cash flow to meet its capital
needs.  SteelCloud is considering all strategic options to improve its
liquidity and provide it with working capital to fund its continuing business
operations which include equity offerings, asset sales or debt financing as
alternatives to improve SteelCloud’s cash needs however, there can be no
assurance that SteelCloud will be successful in negotiating financing on terms
agreeable to it or at all.  If adequate funds are not available or are
not available on acceptable terms, SteelCloud 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.  There is no assurance that SteelCloud will be successful in
raising working capital as needed.  Further, there are no assurances
that SteelCloud will have sufficient funds to execute its business plan, pay its
operating expenses and obligations as they become due or generate positive
operating results.


F-4


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




SteelCloud
is in the process of executing on several restructuring initiatives which it as
undertaken since 2008, including:




•
              A
      reorganization in  November 2008 that included personnel terminations
      from all parts of the organization;
 
 •
              Sales
      of certain of our  leased assets to
  customers;
 
 •
              Elimination
      of all non-essential costs; and
 
 •
                Reduction
      of occupancy costs.





While we
believe that these initiatives will better align our costs with our anticipated
revenues going forward, it will take time for these initiatives to have an
impact on our net revenue and operating income.





2.
            Management
      Change




On
January 12, 2009 (the “Agreement Date”) the Company entered into an Amendment to
an Employment Agreement with Robert E. Frick, the Company’s former Chief
Executive Officer and President, pursuant to which the terms of Mr. Frick's
employment agreement, dated August 27, 2007, were amended. Under the terms of
the amended agreement, the parties agreed that Mr. Frick's employment with the
Company terminated effective January 9, 2009 as a result of Mr. Frick's health.
Further, pursuant to the amended agreement, Mr. Frick resigned from the
Company’s Board of Directors. The total compensation of $73,205 for the
severance arrangement, including  health and dental benefits, was
recognized as severance and restructuring expense during the three months ended
January 31, 2009, with the corresponding liability recorded as an accrued
liability as of January 31, 2009.





On
January 14, 2009, the Company’s Board of Directors appointed (i) Brian Hajost, a
former executive officer of the Company, as the Chief Executive Officer,
President and a member of the Board of Directors, and (ii) Kevin Murphy, the
Company’s current Chief Financial Officer and Executive Vice President, as a
member of the Board of Directors.





3.
            Recently
      Issued Accounting Pronouncements




Effective
November 1, 2008, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”) and
Statement of Financial Accounting Standards No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities” (“SFAS No. 159”).  SFAS
157, which defines fair value, establishes a framework for measuring fair value
in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), and
expands disclosures about fair value measurements.  SFAS 157 clarifies
that fair value is an exit price, representing the amount that would be received
to sell asset or paid to transfer a liability in an orderly transaction between
market participants.  SFAS 159 permits an entity to measure certain
financial assets and financial liabilities at fair value with changes in fair
value recognized in earnings each period. For the three month period ended
January 31, 2009, the Company has elected not to use the fair value option
permitted under SFAS 159 for any of its financial assets and financial
liabilities that are not already recorded at fair value.


F-5


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
141 (Revised 2007) “Business Combinations” (“SFAS No. 141R”).  SFAS
No. 141R, which replaces SFAS No. 141, requires that the acquisition method of
accounting (which SFAS No. 141 called the “purchase method”) be used for all
business combinations and for an acquirer to be identified for each business
combination.  SFAS No. 141R also establishes principles and
requirements for how the acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree; recognizes and measures the goodwill
acquired in the business combination or a gain from a bargain purchase; and
determines what information to disclose to enable users of the financial
statements to evaluate the nature and financial effects of the business
combination.  SFAS No. 141R also requires that acquisition-related
costs be recognized separately from the business combination.  SFAS
No. 141R will apply prospectively to business combinations for which the
acquisition date is after fiscal years beginning on or after December 15,
2008.  The Company is in the process of evaluating the effect, if any;
the adoption of SFAS No. 141(R) will have on its financial
statements.




In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160, “Noncontrolling Interests in Consolidated Financial Statements — an
amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires all
entities to report noncontrolling (minority) interests in subsidiaries as equity
in the consolidated financial statements.  Its intention is to
eliminate the diversity in practice regarding the accounting for transactions
between an entity and noncontrolling interests.  This statement is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008.  Earlier adoption is
prohibited.  The Company is in the process of evaluating the effect,
if any; the adoption of SFAS No. 160 will have on its financial
statements.




In
February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB
Statement No. 157” (“FSP 157-2”).  FSP 157-2 deferred the effective
date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to
fiscal years beginning after November 15, 2008.  The Company is in the
process of evaluating the effect, if any; the adoption of FSP 157-2 will have on
its financial statements.




In
October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair
Value of a Financial Asset When the Market for that Asset is not Active” (“FSP
157-3”).  FSP 157-3 provides guidance for determining the fair value
of a financial asset in an inactive market.  The Company is in the
process of evaluating the effect, if any; the adoption of FSP 157-3 will have on
its financial statements.




In May
2008, the FASB issued Staff Position No. APB 14-1, “Accounting for Convertible
Debt Instruments that May be Settled in Cash Upon Conversion.” (“APB 14-1”). APB
14-1 requires that the liability and equity components of convertible debt
instruments that may be settled in cash upon conversion (including partial cash
settlement) be separately accounted for in a manner that reflects an issuer’s
nonconvertible debt borrowing rate.  The resulting debt discount is
amortized over the period the convertible debt is expected to be outstanding as
additional non-cash interest expense.  APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years.  Retrospective
application to all periods presented is required except for instruments that
were not outstanding during any of the periods that will be presented in the
annual financial statements for the period of adoption but were outstanding
during an earlier period.  The Company is in the process of evaluating
the effect, if any; the adoption of APB 14-1 will have on its financial
statements.


F-6


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




In May
2008, The FASB issued Statement of Financial Accounting Standards No.162 “The
Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), which
reorganizes the U.S. Generally Accepted Accounting Principles (“GAAP”)
hierarchy.  SFAS 162 is intended to improve financial reporting by
providing a consistent framework for determining what accounting principles
should be used in preparing GAAP financial statements.  With the
issuance of SFAS 162, the FASB concluded that the GAAP hierarchy should be
directed toward the entity and not its auditor, and reside in the accounting
literature established by the FASB as opposed to the American Institute of
Certified Accountants (AICPA) Statement on Auditing Standards No. 69, The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles”.  SFAS 162 will become effective 60 days following the
Securities and Exchange Commission’s (the “SEC”) approval of the Public
Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present
Fairly in Conformity With Generally Accepted Accounting Principles” and is not
expected to have any impact on the Company’s financial statements.




In June
2008, the FASB issued FASB Staff Position EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 states that unvested
share-based payment awards that contain nonforfeitable rights to dividends or
dividend equivalents are “participating securities” as defined in EITF
03-6,  “Participating Securities and the Two-Class Method under FASB
Statement No. 128”,  and therefore should be included in
computing earnings per share using the two-class method. According to FSP EITF
03-6-1, a share-based payment award is a participating security when the award
includes nonforfeitable rights to dividends or dividend equivalents. The rights
result in a noncontingent transfer of value each time an entity declares a
dividend or dividend equivalent during the award’s vesting period. However, the
award would not be considered a participating security if the holder forfeits
the right to receive dividends or dividend equivalents in the event that the
award does not vest. FSP EITF 03-6-1 is effective for financial statements
issued in fiscal years beginning after December 15, 2008, and interim
periods within those years. When adopted, its requirements are applied by
recasting previously reported EPS. The Company is in the process of evaluating
the effect, if any; the adoption of FSP EITF 03-6-1 will have on its financial
statements.




4.
            Significant
      Customers




For the
three month period ended January 31, 2009, 56% of the Company’s revenues were
due from government agencies.  As of January 31, 2009, 11% of the
account receivable balance included amounts due from government
agencies.




5.
            Equity




Stock-based
Compensation




The
Company recognized approximately $7,600 and $63,000 of stock-based compensation
expense during the three month periods ended January 31, 2009 and 2008,
respectively. Stock-based compensation expense for the three-month period ended
January 31, 2009 and 2008 increased the Company’s basic and diluted loss per
share by $0.00 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.


F-7


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




Restricted
Stock




During
the three month period ended January 31, 2009, the Company granted 300,000
shares of restricted common stock, pursuant to its Amended 2007 Stock Option and
Restricted Stock Plan.  Certain recipients of the restricted stock
forfeited 262,500 stock options as a condition of receiving the restricted stock
award. The fair value of the restricted stock was determined based upon the
closing stock price on the date of grant.  The restricted stock grants
vest quarterly over a one year period.  As of January 31, 2009, 75,000
of the restricted stock grants were vested.  The Company’s restricted
stock grants are accounted for as equity awards and is recognized on a
straight-line basis over the requisite service period.  The Company’s
restricted stock agreements do not contain any post-vesting
restrictions.  For the three month period ended January 31, 2009, the
Company recognized $26,250 of stock-based compensation expense associated with
these restricted stock awards.  The Company recognized a credit of
approximately $43,000 due to the reversal of previously recognized stock-based
compensation on unvested stock options forfeited in connection with the
restricted stock awards.




Additional
Paid-in Capital




Additional
paid in capital has increased approximately $7,600 during the three month period
ended January 31, 2009 due to stock-based compensation expense of approximately
$7,600.




6.
            Debt




On March
6, 2008, the Company renewed its bank line of credit that allows the Company to
borrow an amount to the lesser of its collateralized cash on hand or $3.5
million. The line of credit bears interest at the LIBOR Market Index rate plus
1.25%. The line of credit is secured by all assets of the Company and expires on
March 31, 2009. The Company does not plan to renew this line of
credit.  There were no outstanding borrowings on the line of credit at
October 31, 2008 and January 31, 2009.




7.
            Unearned
      Revenue and Deferred Contract Costs




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




8.
            Inventories




Inventories
consisted of the following:




October 31,
                
                
                January
      31,2008
                
                
                2009Raw
      materials
                
                $
                344,898
                
                
                $
                284,055Work
      in
      process
                
                
                -
                
                
                
                32,617Finished
      goods
                
                
                177,022
                
                
                
                123,663$
                521,920
                
                
                $
                440,335




F-8


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




9.
            Earnings
      per Share




Basic
earnings per share is based on the weighted average number of common shares
outstanding during the period and is calculated by dividing the net earnings
(loss) by the weighted average number of common shares outstanding. Diluted
earnings per share is based on the weighted average number of common shares
outstanding plus common stock equivalents associated with stock options and
warrants and is calculated by dividing net earnings by the weighted average
number of common shares outstanding used in the basic earnings per share
calculation plus the common stock equivalent of stock options and warrants. The
dilutive weighted average number of common shares outstanding excluded potential
common shares from stock options of approximately 1,800 and 444,000 for the
three month periods ended January 31, 2009 and 2008, respectively. These shares
were excluded from the earnings per share calculation due to their antidilutive
effect resulting from the loss from operations.




10.
            Income
      Tax




On
November 1, 2007, the Company adopted FASB Interpretation No. 48 “Accounting for
Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition
threshold that a tax position is required to meet before being recognized in the
financial statements and provides guidance on derecognition, measurement,
classification, interest and penalties, accounting in interim periods,
disclosure and transition issues.  The Company has an unrecognized tax
benefit of approximately $61,000 and does not expect any of this amount to
reverse in the next twelve months.  The amount of unrecognized tax
benefits that, if recognized, would impact the effective tax rate is
$0.




The
Company conducts business in the U.S. and is subject to tax in that
jurisdiction. As a result of its business activities, the Company files tax
returns that are subject to examination by the respective federal and state tax
authorities. For income tax returns filed by the Company, the Company is no
longer subject to U.S. federal, or state tax examination by tax authorities for
years before October 31, 2003, although carryforward tax attributes that were
generated prior to October 31, 2003 may still be adjusted upon examination by
tax authorities if they either have been or will be utilized.  The
Company’s accounting policy is to recognize interest and penalties related to
income tax matters in general and administrative expense. The Company had $0
accrued forinterest
and penalties as of January 31, 2009.




11.
            Commitments
      and Contingencies




The
Company has accrued approximately $59,000 pertaining to payroll taxes and
related interest resulting from the failure to report certain employee
reimbursements as compensation.  The Company intends to file the
necessary returns to resolve the contingency.




F-9


STEELCLOUD,
INC.


NOTES
TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




12.
            Subsequent
      Events




On
February 5, 2009, the Company entered into an Executive Retention Agreement (the
“2009 Agreement”) with Brian Hajost, the Company’s President and Chief Executive
Officer, effective as of January 16, 2009.  Pursuant to the terms of
the 2009 Agreement, as compensation for Mr. Hajost serving as the Company’s
President and Chief Executive Officer, Mr. Hajost receives (a) a semi-monthly
salary of $8,333.33 (or $200,000 annually); (b) a stock grant of 156,000 shares
of the Company’s common stock, which will vest ratably over 12 months; and (c) a
stock option grant of 300,000 shares of the Company’s common stock, which will
vest ratably over a three year term and have a five year exercise
period.  The 2009 Agreement further provides that in the event the
Company terminates Mr. Hajost’s employment without cause (other than due to Mr.
Hajost’s request), or if Mr. Hajost terminates his employment for good reason,
Mr. Hajost will be entitled to (a) if the termination takes place within three
months from the date of the 2009 Agreement, two months salary, (b) if the
termination takes place between three and six months from the date of the 2009
Agreement, three months salary, (c) if the termination takes place between six
months and one year from the date of the 2009 Agreement, six months salary, (d)
if the termination takes place after the first year anniversary of the 2009
Agreement, 12 months salary.  In the event that a majority of the
Company’s stock or a substantial portion of the Company’s assets are acquired,
the acquisition closes while Mr. Hajost is employed by the Company, and Mr.
Hajost’s employment with the Company is terminated without cause (other than due
to Mr. Hajost’s request) within 30 days of the acquisition, Mr. Hajost will be
entitled to severance pay equal to the lesser of (a) 24 months salary based on
Hajost’s annual rate of pay for the calendar year before the calendar year of
termination from service, or (b) two times the IRS limit for qualified plans
provided for in 26 U.S.C. § 401(a)(17) for the calendar year of termination of
service.




On
February 28, 2009, the Company entered into an Employment Agreement Amendment
(the “Amended Agreement”) with Kevin Murphy, the Company’s current Chief
Financial Officer, pursuant to which the terms of Mr. Murphy’s employment
agreement, dated June 8, 2004, as amended on October 26, 2007 and December 31,
2008, were amended. Under the terms of the Amended Agreement, Mr. Murphy’s
annual base salary was reduced to $193,500, from $215,000 and Mr. Murphy’s
monthly general business allowance was reduced to $500, from $1,000. The terms
of the Amended Agreement further provide that (a) Mr. Murphy agrees to forfeit
options to purchase an aggregate of 225,000 shares of the Company’s common
stock, $0.001 par value per share (the “Common Stock”), (b) Mr. Murphy shall
enter into a separate Incentive Stock Option agreement with the Company,
pursuant to which Mr. Murphy shall be granted an option to purchase 150,000
shares of Common Stock, which shall vest quarterly in arrears over a one year
period, and (c) Mr. Murphy shall enter into a separate Restricted Stock
Agreement with the Company, pursuant to which Mr. Murphy shall receive 90,000
shares of restricted stock which shall vest ratably over 12 months, or 7,500
shares per month, so long as Mr. Murphy is employed by the Company on the last
day of each month.




On
February 27, 2009, the Company entered into a lease amendment with the landlord
or one of its operation facilities whereby the current lease, which is presently
scheduled to expire on August 31, 2014, has been 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 the Company’s  rent cash payments by approximately
$60,000 and $34,000 for the fiscal years 2009 and 2010,
respectively.  The Company’s monthly straight-line rent expense will
be reduced by approximately $1,000 a month for the length of the
lease.


F-10


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




Certain
statements contained herein may constitute forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. The words or
phrases “would be,” “will allow,” “intends to,” “will likely result,” “are
expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or
similar expressions are intended to identify “forward-looking statements.”
Because such statements include risks and uncertainties, actual results may
differ materially from those expressed or implied by such forward-looking
statements. Factors that could cause actual results to differ materially
include, but are not limited to, risks associated with the integration of
businesses following an acquisition, competitors with broader product lines and
greater resources, emergence into new markets, the termination of any of our
significant contracts, our inability to maintain working capital requirements to
fund future operations, or our inability to attract and retain highly qualified
management, technical and sales personnel. Statements made herein are as of the
date of the filing of this Quarterly Report on Form 10-Q with the Securities and
Exchange Commission (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 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, 2008 as amended, filed by us with the SEC.




OVERVIEW




Founded
in 1987, we are a manufacturer of embedded integrated computing solutions for
the federal marketplace and for Independent Software Vendors
(“ISV”s).  We design, manufacture and integrate specialized servers
for federal market prime contractors (“federal integrators”) and ISVs who use
the specialized server appliances to deliver application software to their
clients.




Federal
Systems Integrator




Federal
integrators outsource their specialized requirements to us and consider us to be
an integral part of their product and service delivery capability.  We
design and manufacture specialized embedded and integrated computing systems
that are the foundation upon which the integrators develop and deliver their
application software.  SteelCloud’s specialized service allows our
customers to outsource computer system integration in order that they may
concentrate on their core application software and services.  As a
result, integrators improve customer satisfaction, shorten time to delivery and
lower overall development costs.




We
complement our embedded integrated computing systems, which are often designed
to withstand harsh environmental conditions, with software integration, quality
testing and program lifecycle management services.  We also provide
configuration management, logistics and support services that are unavailable
from traditional computer vendors.


2




Independent
Software Vendors (ISV)




For our
ISV customers, we are their “virtual hardware engineering
division.”  Similar to our federal integrator business, we create a
unique product for the ISV by integrating the ISV’s software onto a specialized
appliance platform running Linux, FreeBSD, or one of Microsoft’s operating
systems.




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




Our
specialized servers and appliances are engineered and developed according to New
Product Realization procedures which are compliant with our ISO 9001:2000
Certified Quality Management System.




BlackBerry®
Enterprise Server Solution (SteelWorks® Mobile)




As an
extension of our ISV business, we developed an appliance solution specifically
for the BlackBerry Enterprise Server (“BES”).  Developed in
conjunction with Research in Motion (“RIM”), we believe the BES appliance
solution is the single best way to implement the BlackBerry Enterprise Server
software environment.  SteelWorks Mobile is an integrated server
appliance that enables virtually any size organization to implement the BES at a
fraction of the cost, time, and resource commitment.  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 BlackBerry Enterprise Server
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 DoD
organizations to implement a STIG compliant BES infrastructure in a fraction of
the time, cost, or resources necessary to what is otherwise a time intensive and
manual STIG process.




Professional
Services




We
provide information technology (“IT”) consulting and contract staffing solutions
for our commercial and government clients.  Our consultants are
subject matter experts in network infrastructure complexities and security
technologies including firewalls, content inspection, intrusion detection, spam
and vulnerability scanning.  For our contract staffing solutions, our
personnel function as “virtual” employees, performing work directly under the
auspices of client management and serve as an extension of the client’s in-house
staff resources.




Research
and Product Development




By
investing in product development, we believe we will have more control over the
functionality and marketing of our products.  We also believe that the
resulting intellectual property will increase the competitiveness of our
offerings and improve product margins.  For the three months ended
January 31, 2009, we incurred research and development costs of approximately
$101,000.  We will continue to incur costs for product development in
the future.




We invest
in intellectual property in the form of proprietary hardware and software
products such as SteelWorks®.  SteelWorks® is appliance management
software that provides self-management and self-maintenance functionality to our
appliance servers and allows our customers to quickly create a fully integrated
turnkey appliance.  Our SteelWorks® Mobile product is a plug-and-play
appliance for RIM’s BlackBerry Enterprise Server.  It is a fully
integrated hardware and software solution that speeds installation, lowers cost
of ownership, and improves reliability and availability for the BlackBerry
Enterprise Server.


3


GSA
Contract




We have a
multiple award schedule contract with the U.S. General Services Administration
(the “GSA Contract”).  The GSA Contract was originally awarded in
April 1996.  It was renewed in fiscal years 2002 and 2007, and is
valid through March 31, 2012.  In August 2006, GSA Contract auditors
awarded us an “Outstanding” rating for our management and execution of the GSA
Contract.  The GSA Contract enables government IT purchasers to
acquire all of their needed goods and services from a particular vendor and
largely limits the competition to selected vendors holding GSA
Contracts.  For the three months ended January 31, 2009, our GSA
Contract had sales of approximately $259,000, which accounted for approximately
29% of our net revenues.




CRITICAL
ACCOUNTING POLICIES AND ESTIMATES




The
preparation of financial statements in conformity with US Generally Accepted
Accounting Principles requires management to make certain judgments, estimates
and assumptions that could affect the reported amounts of assets and liabilities
at the date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. We based our estimates and assumptions on
historical experience and on various other assumptions believed to be
applicable, and evaluated them on an on-going basis to ensure they remained
reasonable under current conditions. Actual results could differ significantly
from those estimates. No changes to our critical accounting policies have taken
place since October 31, 2008.





Recently
Issued Accounting Pronouncements




Effective
November 1, 2008, we adopted the provisions of Statement of Financial Accounting
Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”) and Statement of
Financial Accounting Standards No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities” (“SFAS No. 159”).  SFAS 157, which
defines fair value, establishes a framework for measuring fair value in
accordance with U.S. Generally Accepted Accounting Principles (“GAAP”), and
expands disclosures about fair value measurements.  SFAS 157 clarifies
that fair value is an exit price, representing the amount that would be received
to sell asset or paid to transfer a liability in an orderly transaction between
market participants.  SFAS 159 permits an entity to measure certain
financial assets and financial liabilities at fair value with changes in fair
value recognized in earnings each period. For the three month period ended
January 31, 2009, we have elected not to use the fair value option permitted
under SFAS 159 for any of our financial assets and financial liabilities that
are not already recorded at fair value.


4




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




In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160, “Noncontrolling Interests in Consolidated Financial Statements — an
amendment of ARB No. 51” (“SFAS No. 160”).  SFAS No. 160 requires all
entities to report noncontrolling (minority) interests in subsidiaries as equity
in the consolidated financial statements.  Its intention is to
eliminate the diversity in practice regarding the accounting for transactions
between an entity and noncontrolling interests.  This statement is
effective for fiscal years, and interim periods within those fiscal years,
beginning on or after December 15, 2008.  Earlier adoption is
prohibited.  We are in the process of evaluating the effect, if any,
the adoption of SFAS No. 160 will have on our financial statements.




In
February 2008, the FASB issued Staff Position No. 157-2, “Effective Date of FASB
Statement No. 157” (“FSP 157-2”).  FSP 157-2 deferred the effective
date of FAS 157 for all nonfinancial assets and nonfinancial liabilities to
fiscal years beginning after November 15, 2008.  We are in the process
of evaluating the effect, if any; the adoption of FSP 157-2 will have on our
financial statements.




In
October 2008, the FASB issued Staff Position No. 157-3, “Determining the Fair
Value of a Financial Asset When the Market for that Asset is not Active” (“FSP
157-3”).  FSP 157-3 provides guidance for determining the fair value
of a financial asset in an inactive market.  We are in the process of
evaluating the effect, if any; the adoption of FSP 157-3 will have on our
financial statements.




In May
2008, the FASB issued Staff Position No. APB 14-1, “Accounting for Convertible
Debt Instruments that May be Settled in Cash Upon Conversion.” (“APB 14-1”). APB
14-1 requires that the liability and equity components of convertible debt
instruments that may be settled in cash upon conversion (including partial cash
settlement) be separately accounted for in a manner that reflects an issuer’s
nonconvertible debt borrowing rate.  The resulting debt discount is
amortized over the period the convertible debt is expected to be outstanding as
additional non-cash interest expense.  APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years.  Retrospective
application to all periods presented is required except for instruments that
were not outstanding during any of the periods that will be presented in the
annual financial statements for the period of adoption but were outstanding
during an earlier period.  We are in the process of evaluating the
effect, if any; the adoption of APB 14-1 will have on our financial
statements.




In May
2008, The FASB issued Statement of Financial Accounting Standards No.162 “The
Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”), which
reorganizes the GAAP hierarchy.  SFAS 162 is intended to improve
financial reporting by providing a consistent framework for determining what
accounting principles should be used in preparing GAAP financial
statements.  With the issuance of SFAS 162, the FASB concluded that
the GAAP hierarchy should be directed toward the entity and not its auditor, and
reside in the accounting literature established by the FASB as opposed to the
American Institute of Certified Accountants Statement on Auditing Standards No.
69, The Meaning of Present Fairly in Conformity With Generally Accepted
Accounting Principles”.  SFAS 162 will become effective 60 days
following the SEC’s approval of the Public Accounting Oversight Board amendments
to AU Section 411, “The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles” and is not expected to have any impact on our
financial statements.


5




In June
2008, the FASB issued FASB Staff Position EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 states that unvested
share-based payment awards that contain nonforfeitable rights to dividends or
dividend equivalents are “participating securities” as defined in EITF
03-6,  “Participating Securities and the Two-Class Method under FASB
Statement No. 128”,  and therefore should be included in
computing earnings per share using the two-class method. According to FSP EITF
03-6-1, a share-based payment award is a participating security when the award
includes nonforfeitable rights to dividends or dividend equivalents. The rights
result in a noncontingent transfer of value each time an entity declares a
dividend or dividend equivalent during the award’s vesting period. However, the
award would not be considered a participating security if the holder forfeits
the right to receive dividends or dividend equivalents in the event that the
award does not vest. FSP EITF 03-6-1 is effective for financial statements
issued in fiscal years beginning after December 15, 2008, and interim
periods within those years. When adopted, its requirements are applied by
recasting previously reported EPS. We are in the process of evaluating the
effect, if any; the adoption of FSP EITF 03-6-1 will have on our financial
statements.




RESULTS
OF OPERATIONS




For
the three months ended January 31, 2009 compared to the three months ended
January 31, 2008:




The
overall economic downturn has impacted virtually every area of our
business.  There were reductions in quantities ordered from our
commercial and government clients as well as continued delays of anticipated
program awards that were originally planned for late fiscal 2008 and early
fiscal 2009.




Net
Revenue Discussion:




The
following table summarizes our net revenue for the three months ended January
31, 2008 and 2009 in dollars and as a percentage of net revenues.




Three
      Months Ended January 31,2008
                
                
                2009
                
                
                Increase
      (decrease)%
      of Net
                
                
                
                
                
                %
      of NetDollars
                
                
                Revenues
                
                
                Dollars
                
                
                Revenues
                
                
                Dollars
                
                
                PercentageProducts
                
                $
                5,253,027
                
                
                
                90.47
                %
                
                $
                347,902
                
                
                
                39.14
                %
                
                $
                (4,905,125
                )
                
                
                (93.38
                )%Services
                
                
                553,445
                
                
                
                9.53
                %
                
                
                541,008
                
                
                
                60.86
                %
                
                
                (12,437
                )
                
                
                (2.25
                )%Total  net
      revenues
                
                $
                5,806,472
                
                
                
                100.00
                %
                
                $
                888,910
                
                
                
                100.00
                %
                
                $
                (4,917,562
                )
                
                
                (84.69
                )%





The
decrease in product revenue is primarily attributable to our exiting of the
reseller business and continued program delays with our integrator business. Due
to the current economic decline, we experienced a significant reduction in our
Integrator and ISV opportunities. Our ISV opportunities also declined as our
customers merged and/or were acquired resulting in lower demand for our
products.  As a result of these mergers, we anticipate our ISV revenue
to continue at this level in the near future.  For our integrator
business, based on customer discussions and past performance, we anticipate
future contract awards, originally slated for our first quarter to occur later
in fiscal year 2009.




The
decrease in service revenue for the three-month period ended January 31, 2009 as
compared to the same period in fiscal 2008 is the result of us completing a
large services contract in December 2008.  We anticipate service
revenues to fluctuate in the near future due to the current state of the U.S.
economy.


6




Gross
Profit Discussion:




The
following table summarizes our gross profit for the three months ended January
31, 2008 and 2009 in dollars, as a percentage of gross profit and as a
percentage of net revenues.




Three
      Months Ended January 31,2008
                    
                    
                    2009
                    
                    
                    Increase
      (decrease)%
      of Gross
                    
                    
                    
                    
                    
                    %
      of GrossDollars
                    
                    
                    Profit
                    
                    
                    Dollars
                    
                    
                    Profit
                    
                    
                    Dollars
                    
                    
                    PercentageProducts
                    
                    $
                    637,224
                    
                    
                    
                    84.92
                    %
                    
                    $
                    (64,522
                    )
                    
                    
                    (217.71
                    )%
                    
                    $
                    (701,746
                    )
                    
                    
                    (110.13
                    )%Products
      - GM%
                    
                    
                    12.13
                    %
                    
                    
                    
                    
                    
                    
                    (18.55
                    )%Services
                    
                    
                    113,136
                    
                    
                    
                    15.08
                    %
                    
                    
                    94,159
                    
                    
                    
                    317.71
                    %
                    
                    $
                    (18,977
                    )
                    
                    
                    (16.77
                    )%Services
      – GM%
                    
                    
                    20.44
                    %
                    
                    
                    
                    
                    
                    
                    17.40
                    %Total
      gross profit
                    
                    $
                    750,360
                    
                    
                    
                    100.00
                    %
                    
                    $
                    29,637
                    
                    
                    
                    100.00
                    %
                    
                    $
                    (720,723
                    )
                    
                    
                    (96.05
                    )%Total
      – GM%
                    
                    
                    12.92
                    %
                    
                    
                    
                    
                    
                    
                    3.33
                    %





The
decrease in gross profit percentage for the three months ended January 31, 2009
as compared to the same period in fiscal 2008 is primarily due to the allocation
of our fixed cost.  Although we were able to align our variable
expenses with our revenue, we were not able to significantly reduce our fixed
facility expenses during the three months ended January 2009.  As a
result of the reduced volume of revenue and corresponding production activity
that occurred during the three months ended January 31, 2009, we included
abnormal amounts of idle facility expense in our cost of goods sold for the
three months ended January 31, 2009 compared to the same period in
2008.  We are taking measures to reduce our fixed expenses for future
periods as evidenced by our recent restructuring of one of our leases, as
discussed in Footnote 12 “Subsequent Events” of the Footnotes to our
Consolidated Financial Statements, although we can give no assurances that we
will be successful.  We expect gross profit as a percentage of net
revenues to continue to fluctuate from quarter to quarter as product lines
expand, new products are brought to market, start up costs are incurred, new
discounts, incentives and rebates become available and the reduction of fixed
and variable overhead production costs occur.




The
decrease in services gross profit for the three months ended January 31, 2009 as
compared to the same period in fiscal 2008 is consistent with prior
years.  We anticipate gross profit for services to fluctuate in future
quarters as we continue to realign and grow the services
division.


7




Operating
Expense Discussion:




The
following table summarizes our operating expenses for the three months ended
January 31, 2008 and 2009 in dollars and as a percentage of net
revenues.




Three
      Months Ended January 31,2008
                    
                    
                    2009
                    
                    
                    Increase
      (decrease)%
      of Net
                    
                    
                    
                    
                    
                    %
      of NetDollars
                    
                    
                    Revenues
                    
                    
                    Dollars
                    
                    
                    Revenues
                    
                    
                    Dollars
                    
                    
                    PercentageSelling
      and marketing
                    
                    $
                    320,244
                    
                    
                    
                    5.52
                    %
                    
                    $
                    135,974
                    
                    
                    
                    15.30
                    %
                    
                    $
                    (184,270
                    )
                    
                    
                    (57.54
                    )%Research
      and product development
                    
                    
                    198,225
                    
                    
                    
                    3.41
                    %
                    
                    
                    101,481
                    
                    
                    
                    11.42
                    %
                    
                    
                    (96,744
                    )
                    
                    
                    (48.81
                    )%General
      and administrative
                    
                    
                    914,353
                    
                    
                    
                    15.75
                    %
                    
                    
                    722,722
                    
                    
                    
                    81.30
                    %
                    
                    
                    (191,631
                    )
                    
                    
                    (20.96
                    )%Severance
      and restructuring
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    73,205
                    
                    
                    
                    8.24
                    %
                    
                    
                    73,205
                    
                    
                    
                    100.00
                    %Total
      operating expenses
                    
                    $
                    1,432,822
                    
                    
                    
                    24.68
                    %
                    
                    $
                    1,033,382
                    
                    
                    
                    116.25
                    %
                    
                    $
                    (399,440
                    )
                    
                    
                    (27.88
                    )%





The
decrease in selling and marketing expense is the result of aligning expenses to
our current and future business models. For the three months ended January 31,
2009 compared to the three months ended January 31, 2008, marketing activities
and expense associated with selling and marketing personnel decreased as a
result of cost cutting efforts. We will continue to evaluate our costs relative
to our revenues and gross margins.




The
decrease in research and product development for the three months ended January
31, 2009 compared to the three months ended January 31, 2008 is the result of
our aligning expenses to our current and future business models.  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 three months ended
January 31, 2009 compared to the three months ended January 31, 2008 is
primarily attributable to cost cutting efforts. The cost reductions continue to
include curtailing expenses related to non-revenue generating activities,
terminating non-essential employees, and instituting an across the board
departmental expense reductions. Although we continue to manage our costs
relative to our revenues and gross margins, additional resources may be required
in order to invest in our core federal integrator and ISV business.




The
increase in severance and restructuring costs for the three months ended January
31, 2009 compared to the three months ended January 31, 2008 is the result of
incurring severance payments, as described in Note 2 “Management Change” of the
Footnotes to the Consolidated Financial Statements, 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.


8




Other
Income (Expense) Discussion:




The
following table summarizes our other income (expense) for the three months ended
January 31, 2008 and 2009 in dollars and as a percentage of net
revenues.




Three
      Months Ended January 31,2008
                        
                        
                        2009
                        
                        
                        Increase
      (decrease)%
      of Net
                        
                        
                        
                        
                        
                        %
      of NetDollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        PercentageInterest
      income
                        
                        $
                        6,415
                        
                        
                        
                        0.11
                        %
                        
                        $
                        0.00
                        
                        
                        
                        0.00
                        %
                        
                        $
                        (6,415
                        )
                        
                        
                        (100.00
                        )%Total
      interest income
                        
                        $
                        6,415
                        
                        
                        
                        0.11
                        %
                        
                        $
                        0.00
                        
                        
                        
                        0.00
                        %
                        
                        $
                        (6,415
                        )
                        
                        
                        (100.00
                        )%





The decrease in net interest income for
the three-month period ended January 31, 2009 is attributable to recording a
fixed tax expense accrual during fiscal year 2009, offsetting lower interest
earned as a result of lower cash balances compared to the same period in fiscal
year 2008.




Net
(Loss) Discussion:




The
following table summarizes our net (loss) for the three months ended January 31,
2008 and 2009 in dollars and as a percentage of net revenues.




Three
      Months Ended January 31,2008
                        
                        
                        2009
                        
                        
                        Increase
      (decrease)%
      of Net
                        
                        
                        
                        
                        
                        %
      of NetDollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        Revenues
                        
                        
                        Dollars
                        
                        
                        PercentageNet
      (loss)
                        
                        $
                        (676,047
                        )
                        
                        
                        (11.64
                        )%
                        
                        $
                        (1,003,745
                        )
                        
                        
                        (112.92
                        )%
                        
                        $
                        327,698
                        
                        
                        
                        48.47
                        %





The
increase in net loss for the three months ended January 31, 2009 as compared to
the same period in fiscal 2008 is a result of lower revenues and corresponding
gross margin dollars.  We continue to manage our costs relative to our
revenue.  We plan for revenue to grow while keeping expenses in
alignment with our revenue and gross margins.




LIQUIDITY
AND CAPITAL RESOURCES




We have
experienced recurring losses from operations and negative cash
flows.  For the three months ended January 31, 2009, we incurred a net
loss of $1,003,745 and an accumulated deficit of $45,872,309 as of that
date.  The report from our independent registered public accounting
firm on our audited financial statements at October 31, 2008 contains an
explanatory paragraph regarding doubt as to our ability to continue as a going
concern as a result of our net loss from operations.  Despite our
history of revenues, we can give no assurance that we will be able to maintain
or increase our revenues in fiscal 2009 or that we will be successful in
reaching profitability or generate positive cash flows from our
operations.  We are considering all strategic options to improve our
liquidity and provide us with working capital to fund our continuing business
operations including equity offerings, asset sales and debt financing as
alternatives to improve our cash needs however; we can give no assurances that
we will be successful in 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.




Our
consolidated financial statements for the three months ended January 31, 2009 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.


9


As of
January 31, 2009, we had cash and cash equivalents of approximately $1.2 million
and working capital of approximately $776,000,
which management believes is sufficient to maintain our operations for 90 days
fromMarch 17, 2009.  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.  Additional capital may be needed to fund
acquisitions of additional companies or assets, although we are not a party to
any pending agreements at this time and, accordingly, cannot estimate the amount
of capital which may be necessary, if any, for acquisitions.  We
believe cash on hand together with cash generated from operations will provide
sufficient financial resources to finance our current operations through the end
of fiscal 2009 although we can provide no assurance we will be able to do
so.




For the
three months ended January 31, 2009, we generated $437,000 in cash from
operating activities. Our primary use of cash was to finance our operating loss.
A decrease in accounts receivable generated approximately $1.2 million of cash.
The use and availability of our cash is affected by the timing, pricing, and
magnitude of orders for our products, and the timing of cash outflows relating
to these orders.




We
generated approximately $435,000 from our operating, investing and financing
activities for the three months ended January 31, 2009.




On March
6, 2008, we renewed our bank line of credit that allows us to borrow an amount
equal to the lesser of our collateralized cash on hand or $3.5 million. The line
of credit bears interest at the LIBOR Market Index rate plus 1.25%. The line of
credit is secured by all of our assets and expires on March 31, 2009. We do not
plan to renew this line of credit.  There were no outstanding
borrowings on the line of credit at October 31, 2008 and January 31,
2009.




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




Off-Balance
Sheet Arrangements




Contractual
Obligations and Commercial Commitments




We have
significant contractual obligations for fiscal year 2009 and beyond for our
operating leases and an employment agreement.  Our total obligation
for our headquarters and operations facilities, expiring in August 2009 and
August 2014 respectively, is approximately $43,000 a month.  We are
currently in negotiations with the landlord of our headquarters facility to
reduce this monthly expense and may consolidate our facilities prior to the
lease termination date, potentially reducing rent expense by approximately
$20,000 a month.  In addition, as discussed in the Note 12 “Subsequent
Events” of the Footnotes to our Consolidated Financial Statements in February
2009, we amended our lease for our operations facilities, reducing cash payments
by approximately $60,000 and $34,000 for the fiscal years 2009 and 2010,
respectively, and reducing our monthly straight-line rent expense by
approximately $1,000 a month for the term of the lease.




As of
January 31, 2009 the total obligation of our employment agreement for fiscal
year 2009 is approximately $161,000 and does not include applicable employment
taxes and potential bonuses.  As of March 17, 2009 we have amended our
employment agreement with our Chief Financial Officer and entered into an
employment agreement with our Chief Executive Officer as discussed in the Note
12 “Subsequent Events” of the Footnotes to the Consolidated Financial
Statements.




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 the information under
this item.


10




ITEM
      4T.
            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 January 31, 2009, our Principal
Executive and Principal 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) are effective at such
date.




Changes
in Internal Control Over Financial Reporting




There
were no changes in our internal control over financial reporting during our
fiscal quarter ended January 31, 2009 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.


11




PART
II. OTHER INFORMATION




ITEM
      1.
            LEGAL
      PROCEEDINGS




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




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




ITEM
      1A.
            RISK
      FACTORS




RISKS RELATED TO OUR BUSINESS




Our auditors have expressed doubt
regarding our ability to continue as a going concern.





The report of our independent registered public
accounting firm on our consolidated financial statements for the fiscal year
ended October 31, 2008 contains an explanatory paragraph regarding our ability
to continue as a going concern based upon our history of net losses.  We
have had recurring annual operating losses since our fiscal year ended October
31, 2004.  We expect that such losses will continue at least until our
fiscal year ending October 31, 2009.





We cannot offer
assurances that any of the strategic options that we are considering to improve
our liquidity and provide us with working capital will occur or be
successful.





We are considering a variety of strategic options to
improve our liquidity and provide us with working capital to fund our continuing
business operations.  These options include equity offerings, asset
sales, debt financing and merger and acquisition transactions as alternatives to
improve our cash needs.  However, there can be no assurance that we will be
successful in negotiating or concluding any of these transactions.  If
we are unable to consummate one or more of these transactions, and adequate
funds are not available to us or are not available on acceptable terms, we will
likely not be able to continue as a going concern.





We may not be able to continue our operations without
additional funding.





As of January 31, 2009, we had cash and cash equivalents
of approximately $1.2 million and working capital of approximately $776,000,
which management believes is sufficient to maintain our operations for 90 days
fromMarch 17, 2009.  We require additional financing, which we
may obtain through issuance of debt and/or equity. Such financing, may not be
forthcoming. As widely reported, the domestic financial markets have been
extremely volatile in recent months.  If such conditions and
constraints continue, we may not be able to acquire additional funds either
through credit markets or through equity markets. Even if additional financing
is available, it may not be available on terms we find favorable. At this time,
there are no anticipated sources of additional funds in place. Failure to secure
the needed additional financing will have an adverse effect on our ability to
remain in business.





We may not be able to compete successfully against
current and future competitors.





The market for our products and services is highly
competitive. Many of our competitors offer broader product lines and have
substantially greater financial, technical, marketing and other resources than
we do, which could seriously harm our net sales and results of operation.
Additionally, our competitors may receive beneficial prices from purchasing
component parts in large quantities and may be party to product and process
technology license arrangement that are more favorable in terms of pricing and
availability than our arrangements. As a result, we may have difficulty
increasing our market share.


12




We are dependent on significant customers and the
government market.




For the three month period ended January 31, 2009, 56%
of our revenues were due from government agencies.  As of January 31,
2009, 11% of our account receivable balance included amounts due from government
agencies.Future revenues and results of operations, and our
ability to remain in business could be adversely affected, should these
government agencies reduce their purchases, eliminate product lines or choose
not to continue to buy products and services from us.




If we are unable to continue to participate in
government contract programs or if government contracting policies are changed,
our business and results of operations could be harmed. Additionally, most
government contracts are subject to modification or termination in the event of
changes in funding and our contractual costs and revenues are subject to
adjustment as a result of governmental audits. A significant amount of our
revenues are derived from sales made through major procurement programs awarded
by the government. If we are unable to renew or replace those contracts our
results of operations and ability to remain in business could be materially
adversely affected.




RISKS RELATED TO OUR COMMON STOCK




Our stock may be subject to substantial price and volume
fluctuations due to a number of factors, many of which are beyond our control
that may prevent our stockholders from reselling our common stock at a
profit.




The securities markets have experienced significant
price and volume fluctuations in recent months and the market price of our
common stock has been volatile. This market volatility, as well as general
economic, market or political conditions, has, and could continue to, reduce the
market price of our common. In addition, our operating results could be below
the expectations of public market analysts and investors, and in response the
market price of our common stock could decrease significantly. Investors may be
unable to resell their shares of our common stock for a profit. The decline in
the market price of our common stock and market conditions generally may
adversely affect our ability to raise additional capital.




If our common stock is delisted from the Nasdaq Capital
Market, the market price of our common stock could decrease
significantly.




If we are unable to satisfy the Nasdaq Capital Market
continued listing criteria in the future, our common stock may be delisted from
the Nasdaq Capital Market. If this occurs, trading, if any, in our common stock
would thereafter be conducted in the over-the-counter market on the “pink
sheets” or the Over-the-Counter Bulletin Board. If our common stock is delisted
from the Nasdaq Capital Market, a shareholder may find it more difficult to
dispose of, or to obtain quotations as to the price of our common stock.
Additionally, if our common stock is delisted from the Nasdaq Capital Market,
the market price of our common stock could decrease
significantly.




Wemay issue more
shares in connection with a merger or acquisition; this would result in
substantial dilution.




Any merger or acquisition effected by us may result in
the issuance of additional securities without stockholder approval and may
result in substantial dilution in the percentage of our common stock held by our
then existing stockholders. Moreover, the common stock issued in any such merger
or acquisition transaction may be valued on an arbitrary or non-arm’s-length
basis by our management, resulting in an additional reduction in the percentage
of common stock held by our then existing stockholders. Our Board of Directors
has the power to issue any or all of such authorized but unissued shares without
stockholder approval. To the extent that additional shares of Common Stock or
Preferred Stock are issued in connection with a business transaction,
combination or otherwise, dilution to the interests of our stockholders will
occur and the rights of the holders of Common Stock might be materially
adversely affected.


13




We may issue additional shares and dilute your ownership
percentage.




Some events over which you have no control could result
in the issuance of additional shares of our common stock. We may issue
additional shares of common stock or preferred stock to raise additional
capital, which may dilute your ownership percentage.




Future sales of our common stock in the public market
may adversely affect our stock price.




Future sales of substantial amounts of our common stock
in the public market, could adversely affect the market price of our common
stock.




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




Not
applicable.




ITEM
      3.
            DEFAULTS
      UPON SENIOR SECURITIES




Not
applicable.




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




Not
applicable.




ITEM
      5.
            OTHER
      INFORMATION




Not
applicable.




ITEM
      6.
            EXHIBITS




Exhibit
      11.1
              Statement
      of computation of earnings per share.Exhibit
      31.1
              Certification
      of Chief Executive Officer and President Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.Exhibit
      31.2
              Certification
      of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.Exhibit
      32.1
              Certification
      Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes – Oxley Act of 2002.Exhibit
      32.2
              Certification
      Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes – Oxley Act of
2002.


14




SIGNATURES




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




March
      17, 2009
              STEELCLOUD,
      INC.By:
              /s/ Brian H.
    HajostName:
      Brian H. HajostTitle:
      Chief Executive Officer and PresidentBy:
              /s/ Kevin
  MurphyName:
      Kevin MurphyTitle:
      Chief Financial Officer


15