Steelcloud Inc – ‘10-K’ for 10/31/01

On:  Tuesday, 1/29/02, at 5:17pm ET   ·   For:  10/31/01   ·   Accession #:  1125282-2-287   ·   File #s:  0-24015, 333-48177   ·   Correction:  This Filing’s “Filed as of” Date was Corrected and “Changed as of” 6/23/04 by the SEC on 6/23/04. ®

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Annual Report   —   Form 10-K
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Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                         46    256K 
 2: EX-10.29    Modification Agreement                                 9     37K 
 3: EX-23.1     Consent of Ernst & Young LLP                           1      6K 

10-K   —   Annual Report
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 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 FORM 10-K

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

For the fiscal year ended October 31, 2001

or

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

 For the transition period from ____________ to ________________

Commission file number 0-24015

 STEELCLOUD, INC
(Exact name of registrant as specified in its charter)

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

1306 Squire Court                                                               
Dulles, Virginia                                                      20166     
-----------------                                                     -----     
(Address of principal executive offices)                            (Zip Code)  

(703) 450-0400
--------------
(Registrant's telephone number, including area code)

Securities registered pursuant to Section 12 (b) of the Exchange Act

Title of each class                         Name of exchange on which registered
-------------------                         ------------------------------------
None.                                                                           

Securities registered pursuant to Section 12 (g) of the Act:

Title of each class                         Name of exchange on which registered
-------------------                         ------------------------------------

Common Stock, $.001                                                             
par value per share                          Nasdaq National Market System  

         Indicate  by check  mark  whether  the  registrant:  (1) has  filed all
reports  required to be filed by Section 13 or 15(d) of the Securities  Exchange
Act of 1934 during the preceding 12 months (or for such shorter  period that the
registrant was required to file such reports),  and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|                        

         Indicate by check mark if there is disclosure  of delinquent  filers in
response  to Item  405 of  Regulation  S-K  contained  herein  and  will  not be
contained,  to the  best of  registrant's  knowledge,  in  definitive  proxy  or
information  statements  incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. |X|                                         

         The aggregate  market value of the voting stock held by  non-affiliates
of the issuer as of January 28, 2002 was $30,017,290.                           

ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS      

         Indicate by check mark whether the  registrant  has filed all documents
and reports  required  to be filed by Section 12, 13 or 15(d) of the  Securities
Exchange Act of 1934 subsequent to the  distribution of securities  under a plan
confirmed by a court. Yes |_| No |_|                                            

APPLICABLE ONLY TO CORPORATE REGISTRANTS

         The number of shares  outstanding  of the  registrant's  Common  Stock,
$.001 par value per share, on January 28, 2002 was 10,214,545.                  

Documents incorporated by reference: None                     

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 STEELCLOUD, INC
 2001 ANNUAL REPORT ON FORM 10-K

 TABLE OF CONTENTS

                                                        [Enlarge/Download Table]

                                     PART I                                                              
                                                                                              Page Number
                                                                                                         
Item 1.           Description of Business                                                            2   
Item 2.           Description of Properties                                                          6   
Item 3.           Legal Proceedings                                                                  7   
Item 4.           Submission of Matters to a Vote of Security Holders                                7   

                                     PART II                                                             

Item 5.           Market for Registrant's Common Equity and Related Stockholder Matters              8   
Item 6.           Selected Financial Data                                                           10   
Item 7.           Management's Discussion and Analysis of Financial Condition and Results of             
                   Operations                                                                       11   
Item 7A.          Quantitative and Qualitative Disclosures About Market Risk                        14   
Item 8.           Financial Statements and Supplementary Data                                       14   
Item 9.           Changes in and Disagreements with Accountants on Accounting and Financial              
                   Disclosures                                                                      14   

                                    PART III                                                             

Item 10.          Directors and Executive Officers of the Registrant                                14   
Item 11.          Executive Compensation                                                                 
Item 12.          Security Ownership of Certain Beneficial Owners and Management                         
Item 13.          Certain Relationships and Related Transactions                                         

         (Part III information is incorporated by reference from portions of the                         
Company's definitive Proxy Statement to be filed pursuant to Regulation 14A)                             

                                     PART IV                                                             

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K                            15   

Signatures                                                                                          18   


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PART I

ITEM 1. DESCRIPTION OF BUSINESS                                                 

General                                                                         

SteelCloud,  Inc.  (formerly Dunn Computer  Corporation)  or (the "Company") was
founded in 1987 as a company that  manufactured  and marketed custom  computers,
primarily to the Federal government.                                            

Today,  the  company is  principally  engaged in the design and  development  of
custom and customized server  appliances for software and technology  companies.
SteelCloud  develops  these  OEM  (original  equipment   manufacturer)  platform
configurations to significantly  reduce the end-users'  implementation  time and
expense.  The Company's  appliance  approach  shortens its OEM  partners'  sales
cycles  while  allowing  them to  increase  their  revenue and  reinforce  their
branding strategies.  SteelCloud sells OEM server appliances to leading software
and  technology  companies  that,  in turn,  distribute  the uniquely  "branded"
products through their own direct sales and distribution channels worldwide.    

The  Company  was  incorporated  as Dunn  Computer  Corporation  in  Virginia on
February  26,  1998 in  connection  with  the  reorganization  of Dunn  Computer
Corporation,  a Delaware Corporation,  which was incorporated on April 22, 1997.
The  Company's  operating  subsidiary,  Dunn  Computer  Operating  Company,  was
incorporated  in Virginia in July 1987.  The Company's  other  subsidiaries  are
International Data Products (IDP), acquired May 1998, STMS, Inc (STMS), acquired
September 1997, and Puerto Rico Industrial  Manufacturing Operations Acquisition
Corporation (PRIMOA), incorporated in Puerto Rico in May 1998.                  

On September 25, 2000, the Company began doing business as ("d/b/a")  SteelCloud
Company.  On October 19, 2000, the Company changed its NASDAQ ticker symbol from
DNCC and began trading as SCLD. On May 15, 2001, the shareholders of the Company
unanimously  approved  the  name  change  of the  Company  to  SteelCloud,  Inc.
effective on that date. Unless the context otherwise requires,  the "Company" or
"Dunn Computer  Corporation"  refers to SteelCloud Inc., its predecessor and its
subsidiaries.  The principal executive offices are located at 1306 Squire Court,
Dulles,  Virginia 20166.  The Company's main telephone number is (703) 450-0400.
Inquiries may also be sent to SteelCloud  at  info@steelcloud.com  for sales and
general information or ir@steelcloud.com for investor relations information.    

Products and Services                                                           

The  Company  offers  network   appliances,   infrastructure   server  products,
outsourced  manufacturing,  and  consulting  services.  The Company  believes it
operates in one segment, information technology.                                

Network  Server  Appliances:  SteelCloud  partners  with  leading  software  and
technology  companies to create uniquely branded,  ready-to-use  turnkey network
server  appliance  solutions  combining  both hardware and software.  SteelCloud
integrates  the  partner's  software  onto a custom  designed  server  platform,
running  Linux or  Microsoft  NT/2000.  This  process  results in an  optimized,
tested,  and certified  appliance,  unique to the OEM partner,  that is ready to
deploy and use when it arrives at the customer  site.  The company has leveraged
its years of  experience,  developing and managing  custom server  platforms for
mission-critical  Department of Defense ("DOD") and security programs, to create
a unique  methodology  for  addressing the OEM market.  The appliance  becomes a
"product" of the  respective  OEM partner,  which in turn markets the  appliance
through  their  normal  distribution  channels.  For  its  appliance  customers,
SteelCloud offers much more than hardware manufacturing. The Company assembles a
package of design, support, and logistical services that are custom tailored for
each particular  software  company,  thereby  augmenting the partner's  internal
capabilities.  In  essence,  SteelCloud  takes  responsibility  for those  tasks
necessary to  successfully  bring an appliance to market,  which are impractical
for its software partners to perform.                                           

The Company  believes that its unique  approach to the server  appliance  market
(collaborating   with  leading  software   manufacturers  and  leveraging  their
significant product marketing and sales efforts) enables it to realize economies
of scale in development, sales, and marketing far greater than its revenue would
indicate under a more traditional strategy. The Company also believes that risks
relating to R&D  (research  and  development)  and  inventory  are also  greatly
reduced through its OEM partnership approach.                                   

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Infrastructure   Products:  The  Company  designs,   develops  and  manufactures
specialized  custom  servers,  which are configured  with single,  dual, or quad
Intel  Pentium III, IV, or Xeon  processors.  These servers are designed to give
data  center  customers  the  highest  level of  performance,  reliability,  and
manageability  available in the market today.  The company combines its hardware
offerings with specialized  software  integration and logistics programs to give
its data center  customers,  unique  solutions  unavailable from the traditional
hardware-only vendors.                                                          

The Company believes that the infrastructure/server  market offers opportunities
for higher profit  margins  compared to other sectors in the industry.  With the
continuing  acceptance  of  Internet  data center and ASP  (application  service
provider) concepts,  this market represents a significant growth opportunity for
the Company.                                                                    

Outsourced  Manufacturing:   Puerto  Rico  Industrial  Manufacturing  Operations
Acquisition  Corporation (PRIMOA)  manufacturers a wide variety of computers and
provides  contract  manufacturing  services for  companies who want to serve the
Puerto Rican Market through a Puerto Rican manufacturer with localized services.
PRIMOA  operates  a 20,000  square  foot,  ISO 9002  manufacturing  facility  in
Guayama,  Puerto Rico,  and as part of the local  community,  PRIMOA's  facility
qualifies  for  incentives  when bidding on Puerto Rican  Government  contracts.
PRIMOA  augments its computer  products with  localized,  bi-lingual IT services
such as training, maintenance, and consulting.                                  

Consulting Services: SteelCloud provides a complete array of consulting services
surrounding the technologies  addressed by its server appliances.  The Company's
consulting   services  include  network  and  security   analysis,   design  and
implementation,  as well as help desk  consulting.  These services are primarily
delivered  in the form of  short-term  (less than three  months)  projects.  The
Company's  consulting  services  are  performed  for a fixed-fee or on an hourly
labor  basis  at the  pre-negotiated  price  and  estimated  levels  of  effort.
SteelCloud acts as a value-added reseller for certain software products that are
delivered  as a part  of its  consulting  services.  In many  cases,  SteelCloud
provides  its  appliance  customers  with  additional  technical  services  that
complement their appliance implementation.                                      

Specific  project-based  services  SteelCloud performs include network analysis,
network design,  systems  implementation,  virus  protection,  network security,
software  migrations,   messaging  system  migrations  and  complete  help  desk
implementation and support. SteelCloud maintains expertise in specific areas and
technologies  rather than general knowledge in many IT (information  technology)
areas.  By  maintaining a rigorous  focus,  SteelCloud  provides  highly skilled
professionals  and services that leverage our experience for maximum  benefit to
the client. Project management is the key component of SteelCloud's strategy and
success in project-based engagements.                                           

SteelCloud  also  provides  network  support  services in the form of fixed-rate
hourly engineering  services.  Client contracts range anywhere from one month to
three years in length.  Staffing services consist of placing one or more network
engineers, user support technicians, or programmers on-site with a client. These
professionals  perform work as a "virtual" employee for the client and typically
work under the direction of the client's  management.  Hourly rates for staffing
engagements are normally lower than for project-based engagements;  however, the
contracts usually have substantially longer periods of performance. SteelCloud's
success in this area is achieved largely due to contract renewals and increasing
staffing requirements from existing customers.                                  

Government Contracts                                                            

In fiscal 2001, the Company derived approximately 14% of its revenues from sales
of hardware and services to the U.S.  Federal  Government  pursuant to contracts
with  the  General  Services   Administration  (GSA)  or  other  agency-specific
contracts.                                                                      

GSA Contract.  The Company has a multiple award schedule  contract with GSA (the
"GSA"  Contract).  The  Company's  GSA contract was awarded in April 1996 and is
valid through March 31, 2002. The GSA contract enables  Government IT purchasers
to acquire all of their requirements from a particular vendor and largely limits
the competition to selected vendors holding GSA contracts. For fiscal year 2001,
the  Company's  GSA  contract had sales of $2.6  million,  which  accounted  for
approximately 9% of the Company's revenues.  The Company expects to have its GSA
contract renewed in 2002.                                                       

In fiscal 2001, the Company derived approximately 14% of its revenues from sales
of hardware and services to the Puerto Rican Government.                        

Commercial Contracts                                                            

In fiscal year 2001,  SteelCloud derived  approximately 86% of its revenues from
sales of hardware and services to the commercial marketplace and state and local
government.  The Company's  commercial customer base consists of several Fortune
500 companies as well as medium-size  local  commercial  customers.  The Company
derived  approximately  51% of its revenues from three  customers  during fiscal
2001. The Company  intends to continue to increase its commercial  customer base
in the upcoming fiscal year. The Company's Appliance Partner program and its own
sales and  marketing  activities  are  concentrated  on expanding  the Company's
commercial customer base. Strategic partnerships with industry leading companies
such as Microsoft,  Cisco, and Intel enable the Company to further diversify its
product mix and attract high quality customers.                                 

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Manufacturing and Production                                                    

The Company's  production  capacity is 100,000  systems per year in its existing
Dulles,  Virginia  facility on a three-shift  basis.  The  Company's  production
capacity  at its  Puerto  Rico  facility  is  100,000  systems  per  year.  Both
facilities are currently operating on a single shift basis.                     

Competition and Marketing                                                       

The markets for the Company's products and services are highly competitive. Many
of the Company's  competitors offer broader product lines and have substantially
greater financial,  technical,  marketing and other resources. These competitors
may benefit from component volume purchasing and product and process  technology
license   arrangements   that  are  more  favorable  in  terms  of  pricing  and
availability than the Company's arrangements.                                   

The Company competes with a large number of computer systems integrators, custom
computer  manufacturers,  resellers,  and IT  services  companies.  The  Company
believes it is likely that these  competitive  conditions  will  continue in the
future.  There  can  be no  assurance  the  Company  will  continue  to  compete
successfully against existing or new competitors that may enter markets in which
the Company operates.                                                           

There has been a consolidation in the industry as a result of acquisitions,  the
failure of many firms, and the decision of firms to focus on other markets.  The
following  companies are significant  competitors of the Company in at least one
of its market segments:                                                         

Company                                                  Type         
-------                                                  ----         
 Sun Microsystems (Cobalt Networks) ..................  Manufacturer
 Avnet ...............................................  Manufacturer
       Pioneer-Standard Electronics ........................  Systems Integrator
 Nokia ...............................................  Manufacturer

Federal Government Market. The emergence of the GSA Schedule, which is a list of
pre-approved  vendors  from which the  Government  and/or  federal  agencies may
purchase goods and services,  as a significant  procurement  vehicle has enabled
traditional  mass-market  commercial computer companies to be more responsive to
government  requirements  and become  more  competitive  with the Company in the
Federal Government Market. The Company believes that the Government's  selection
criteria for vendor selection  consist of price,  quality,  familiarity with the
vendor,  and size and financial  capability of the vendor.  The  government  has
increased the amount of information technology products acquired through the GSA
Schedule. Because the company primarily targets custom computer procurements, it
rarely competes with national  commercial  computer  manufacturers  such as Dell
Computer Corporation and Compaq in the federal market.                          

Commercial Market. The information  technology  industry is highly  competitive.
Pricing is very  aggressive  in the  industry  and the Company  expects  pricing
pressures to continue.  The industry is also  characterized  by rapid changes in
technology  and  consumer  preferences,  short  product life cycles and evolving
industry standards.                                                             

The  commercial  market for the  Company's  IT products and services is a highly
fragmented  market  served  by  thousands  of small  value-added  resellers  and
specialized manufacturers.  These companies typically service a small geographic
area and resell  national brand computer  and/or network  hardware.  The Company
believes its  consulting  services  group can compete  effectively  in the local
market because it provides  engineering services in conjunction with its turnkey
server  appliances  and  products  from its  strategic  partners;  e.g.,  Cisco,
Microsoft,  and Intel.  The Company  believes  that its ability to integrate its
server systems with networking products also gives its consulting services group
a competitive advantage.                                                        

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In the OEM server appliance  market,  the principal  elements of competition are
product reliability, quality, customization,  price, customer service, technical
support,  value-added  services,  and  product  availability.  There  can  be no
assurance that the Company will, in the future,  be able to compete  effectively
against existing and future competitors.                                        

Marketing.   The  Company   markets  its   products  and  services  to  software
manufacturers,  their  channel  partners,  select  commercial  accounts  and the
federal  government.  The  Company  uses an  in-house  sales  force and  program
managers to market its products and  services.  SteelCloud  markets its products
and services  worldwide;  either directly  through its own sales  personnel,  or
through the  marketing  organizations  of its  appliance  partners.  The Company
believes  that  marketing is important for all of its target  markets,  although
less so in its OEM  appliance  business  because its  success  relies on the OEM
partner's sales and marketing capabilities.                                     

The  Company  strives to build a strong  relationship  with its  customers.  The
Company  believes  that  a  key  to  building  customer  loyalty  is a  team  of
knowledgeable and responsive  account  executives and a knowledgeable  technical
and  support  staff.  The  Company  assigns  each  customer  a  trained  account
executive, to whom subsequent calls to the Company will be directed. The account
executive is augmented with a program manager for SteelCloud's larger customers.
The Company  believes  that these strong  one-on-one  relationships  improve the
likelihood that the customer may consider the Company for future purchases.  The
Company intends to continue to provide its customers with products and technical
services that offer the customer the best value.                                

The Company uses electronic  commerce  technologies in its marketing efforts and
believes  that  its  customers   will  continue  to  expand  and  utilize  these
technologies. The internet is being used by customers to advertise opportunities
and to reference  vendor  information.  The Company  maintains a web site on the
Internet referencing its GSA catalogue and product offerings.  In addition,  the
Company  provides the capability for customers to download  updated software and
drivers that become available.                                                  

Suppliers                                                                       

The Company  devotes  significant  resources  to  establishing  and  maintaining
relationships  with its key suppliers.  The Company,  where possible,  purchases
directly from component  manufacturers such as Intel,  Microsoft and Cisco among
others.  The  Company  also  purchases  multiple  products  directly  from large
national  and  regional  distributors  such as TechData  Corporation  and Ingram
Micro.                                                                          

Certain  suppliers provide the Company with incentives in the form of discounts,
rebates, credits, and cooperative advertising, and market development funds. The
Company  must  continue to obtain  products at  competitive  prices from leading
suppliers in order to provide  competitively  priced products for its customers.
In the  event  the  Company  is  unable to  purchase  components  from  existing
suppliers,  the Company has alternative  suppliers it can rely upon. The Company
believes its  relationships  with its key suppliers to be good and believes that
generally, there are multiple sources of supply available should the need arise.

Patents, Trademarks and Licenses                                                

The Company works closely with computer  product  suppliers and other technology
developers to stay abreast of the latest  developments  in computer  technology.
While the Company does not believe its continued success depends upon the rights
to a patent portfolio,  there can be no assurance that the Company will continue
to have access to existing or new technology for use in its products.           

The Company  conducts its business  under the  trademarks  and service  marks of
"SteelCloud",  "SteelCloud Company", "Dunn Computer Corporation," "International
Data Products," and "IDP." The Company believes its trademarks and service marks
have  significant  value and are an  important  factor in the  marketing  of its
products.                                                                       

Because  most  software  used on the  Company's  computers  is not  owned by the
Company,  the Company has entered  into  software  licensing  arrangements  with
several software manufacturers.                                                 

Employees                                                                       

As of October 31,  2001,  the Company had 90  employees.  Of this total,  4 were
employed  in  an  executive  capacity,   11  in  sales  and  marketing,   18  in
administrative capacities, 29 in technical and/or services and 28 in operations.
As of January  23,  2002,  the Company had 95  employees.  None of  SteelCloud's
employees are covered by a collective bargaining agreement. SteelCloud considers
its relationships with its employees to be good.                                

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The  Company  believes  that its future  success  depends in large part upon its
continued ability to attract and retain highly qualified management,  technical,
and sales personnel. The computer industry's shortage of trained and experienced
technicians  has eased over the past twelve  months.  SteelCloud has an in-house
training  and  mentoring  program to develop its own supply of highly  qualified
technical  support  specialists.  There can be no assurance,  however,  that the
Company will be able to attract and retain the qualified personnel necessary for
its business.                                                                   

ITEM 2. DESCRIPTION OF PROPERTY                                                 

The Company leases  approximately  35,000 square feet at its facility in Dulles,
Virginia,  which is used as its principal  executive offices,  for manufacturing
and administrative  services.  Pursuant to the lease, which expires in February,
2005, the Company pays approximately $27,000 per month in rent.                 

The Company also leases a 20,000 square-foot facility in Guayama, Puerto Rico,  
which is used for manufacturing, technical support, and personal computer board 
level repair. Pursuant to the lease, which expires in 2004, the Company pays    
approximately $4,000 per month in rent. The Company believes that its current   
facilities are adequate for its existing needs and that additional suitable     
space will be available as required.                                            

ITEM 3. LEGAL PROCEEDINGS                                                       

On July 31, 1998, the Company  received  notice from the SBA that it was denying
the request of the U.S. Air Force to waive the  requirement  to terminate  IDP's
Desktop V contract  for the  convenience  of the  Government  upon the change in
control of IDP to the Company. The Company appealed the denial of the SBA to the
SBA's  Office of Hearings and  Appeals.  On August 31, 1999,  the SBA denied the
appeal and ruled  that the U.S.  Air Force  must  terminate-for-convenience  the
Desktop  V  contract.  Prior to this  ruling  by the SBA,  the  U.S.  Air  Force
determined not to exercise any of the remaining option years under the Desktop V
contract  on May 1,  1999.  In  October  1999,  the  U.S.  Air  Force  issued  a
termination-for-convenience     letter     to    the     Company.     Under    a
termination-for-convenience, the government is required generally to reimburse a
contractor  for all costs  incurred  in the  performance  of the  contract.  The
Company is in the process of attempting to recover from the government a portion
or all of unreimbursed costs associated with the Desktop V Contract.            

In November  1998,  IDP  entered  into a  Government  Integrator  Agreement,  as
amended,  with Microsoft  Corporation  (Microsoft)  for the licensing of certain
Microsoft software.  During 1999, Microsoft asserted that IDP owed approximately
$800,000  under this  agreement  due  primarily to amended  billing by Microsoft
concerning  sales by IDP to the U.S. Air Force in conjunction with the Desktop V
contract.  On October 31,  2000,  Microsoft  filed suit  against the Company for
breach of contract.  In  conjunction  with the filing of the lawsuit,  Microsoft
increased  its claim by  asserting  further  amendments  to billing and relating
issues,  resulting in a claim against the Company of approximately $1.3 million.
Subsequent  to October 31, 2000,  the Company  submitted a motion to dismiss the
case and  filed a  counterclaim  of  fraud on  behalf  of IDP in the  amount  of
$500,000. The Company believes that it has meritorious defenses to the claim and
intends to vigorously  defend itself.  The Company cannot  estimate at this time
the amount of the  liability to be  incurred,  if any, but does not believe that
this matter will have a material  adverse  effect upon the  Company's  financial
position  or results of  operations.  The  Company  has  accrued for amounts due
Microsoft based on the original billing terms.                                  

On October  19,  2000,  the  Company  received a cease and  desist  letter  from
LoudCloud,  Inc.  alleging that the use of the "SteelCloud"  mark and name would
constitute an  infringement of LoudCloud's  rights to its  "LoudCloud"  mark and
name and family of "Cloud"  marks,  that use of  "SteelCloud"  would  dilute the
distinctiveness  and fame of the LoudCloud  mark and name and, that such acts by
the Company  violated  federal and state law regarding  unfair  competition.  In
response,  the Company filed a declaratory  judgment action in the U.S. District
Court for the Eastern  District of  Virginia,  seeking a judicial  determination
that its use of the "SteelCloud" mark and name would not violate the proprietary
rights of  LoudCloud  nor dilute the  alleged  fame and  distinctiveness  of the
"LoudCloud" mark and name. In this action,  the Company also alleged a new claim
that  LoudCloud,  Inc.  has  violated  federal  law  through  its  misuse of the
trademark provisions under the Lanham Act as amended in 1988. A hearing has been
held on the LoudCloud motion to dismiss and the court has taken the matter under
advisement.  On January 10, 2001, the US District Court for the Eastern District
of Virginia dismissed the case.                                                 

Other than the above, there are no material claims pending against the Company. 

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There are routine legal claims pending  against the Company,  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.                                                                    

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

There were no matters  submitted to a vote of security holders during the fourth
quarter of the fiscal year covered by this report.                              

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 PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                

Market Information                                                              

Prior to the  quotation of the  Company's  Common  Stock  beginning on April 22,
1997,  there was no established  trading market for the Company's  common stock.
The Company's Common Stock is listed on The Nasdaq Stock Market, Inc.'s National
Market System.  The Company  changed its symbol from "DNCC" to "SCLD" on October
19,  2000.  The  following  table sets forth the high and low selling  prices as
reported by The Nasdaq National Market System for each fiscal quarter during the
fiscal years ended  October 31, 2001 and 2000,  as well as for the first quarter
of fiscal 2002 through January 28, 2002. These quotations  reflect  inter-dealer
prices  without  retail  mark-up,  mark-down or commission and may not represent
actual transactions.                                                            

                                                   Fiscal 2000
                                                   High        Low
                                                    --------------------
First Quarter.....................................        $4.84      $1.00      
Second Quarter....................................        $4.28      $2.00      
Third Quarter.....................................        $2.50      $1.63      
Fourth Quarter....................................        $1.84      $1.00      

                                                   Fiscal 2001
                                                   High        Low
                                                    --------------------
First Quarter.....................................        $1.38      $0.69      
Second Quarter....................................        $1.25      $0.50      
Third Quarter.....................................        $0.75      $0.45      
Fourth Quarter....................................        $1.05      $0.62      

                                                   Fiscal 2002
                                                   High        Low
                                                    --------------------
First Quarter (through January 28, 2002)..........        $3.89      $0.78      

On January 28, 2002 the closing price of the Company's  Common Stock as reported
on The Nasdaq  National  Market was $3.89 per  share.  There were  approximately
5,085 shareholders of the Common Stock of the Company as of such date.          

The Company has not paid cash dividends on its Common Stock and does not intend 
to do so in the foreseeable future.                                             

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Recent Sales of Unregistered Stock                                              

On May 1, 1998, in connection with the IDP acquisition, the Company acquired all
of the issued and outstanding  capital stock of IDP Co. and substantially all of
the net assets of PRIMO. In consideration  for the IDP acquisition,  the Company
paid the former owners an aggregate of $14.9 million in cash and an aggregate of
750,000 shares of Common Stock. In November 1998, the Company  received  350,000
shares of the stock  previously  issued to the former owners of IDP (Fusters) in
connection with a Purchase Price  Adjustment  Agreement.  The shares sold to the
Fusters in the IDP  acquisition  were sold in reliance upon the  exemption  from
registration afforded by Section 4(2) of the Securities Act of 1933, as amended.

In March  2000,  the  Company  sold  3,000  shares of its  Series A  Convertible
Preferred  Stock to one  investor.  In  connection  with the sale,  the  Company
received an aggregate of $3,000,000.  The shares of preferred stock were sold in
reliance upon the exemption from registration  provided by Regulation D Rule 506
of the Securities Act of 1933, as amended.  In August 2001, the Company redeemed
2,620 shares of the Series A Convertible  Preferred Stock which  represented all
of then outstanding Preferred Stock.                                            

In March  2000,  the  Company  issued  225,000  shares  of its  common  stock in
connection with the settlement of a lawsuit with a former  employee.  The shares
of common stock were issued in reliance  upon the  exemption  from  registration
afforded by Section 4(2) of the Securities Act of 1933, as amended.             

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ITEM 6. SELECTED FINANCIAL DATA                                                 

SELECTED CONSOLIDATED FINANCIAL DATA
 (In thousands, except per share data)

The following selected consolidated  financial data of SteelCloud should be read
in conjunction with the consolidated  financial statements and the notes thereto
and "Management's  Discussion and Analysis of Financial Condition and Results of
Operations".  The consolidated statement of operations data set forth below with
respect  to the fiscal  years  ended  October  31,  1999,  2000 and 2001 and the
consolidated  balance sheet data as of October 31, 2000 and 2001 is derived from
and is referenced to the audited consolidated financial statements of SteelCloud
included  elsewhere  in this  Annual  Report  on  Form  10-K.  The  consolidated
statement  of income data set forth below with respect to the fiscal years ended
October 31, 1997 and 1998 and the consolidated  balance sheet data as of October
31,  1997,  1998  and  1999  is  derived  from  audited  consolidated  financial
statements of SteelCloud not included in this annual report.                    

                                                        [Enlarge/Download Table]

                                                                                       Year ended October 31,                     
                                                                   1997(2)     1998(3)        1999         2000           2001    
                                                                  ----------------------------------------------------------------
                                                                                                                                  
Consolidated Statement of Operations Data:                                                                                        
Net revenues.....................................................  $21,766      $66,888      $34,475       $39,766        $30,138 
Costs of revenues................................................   17,549       54,969       27,981        32,636         22,510 
Gross profit.....................................................    4,217       11,919        6,494         7,130          7,628 
Selling, general and administrative, and amortization............    2,198        9,983       37,749         6,716          6,235 
Income (loss) from operations....................................    2,019        1,936     (31,255)           414          1,393 
Other (expense) income, net......................................       98        (270)      (2,911)         (298)          (274) 
Income (loss) before income taxes and extraordinary gain.........    2,117        1,666     (34,166)           116          1,119 
Provision for (benefit from) income taxes........................      795         686         (559)            65            105 
Income (loss) before extraordinary gain..........................    1,322          980     (33,607)            51          1,014 
Extraordinary gain...............................................        -            -            -           750              - 
Cumulative effect of change in accounting principle..............        -            -            -             -          (576) 
Preferred stock dividends........................................        -            -            -         (625)          (112) 
Increase to income available to common stockholders from                                                                          
  repurchase of preferred stock..................................        -            -            -             -            721 
Net income (loss) available to common stockholders...............   $1,322         $980    $(33,607)          $176         $1,047 
Basic earnings (loss) per share(1)...............................    $0.29        $0.14      $(3.57)         $0.02          $0.10 
Earning (loss) per share assuming dilution(1)....................    $0.28        $0.13      $(3.57)         $0.02          $0.08 
Weighted average shares outstanding(1)...........................    4,552        7,231        9,404         9,581         10,111 
Weighted average shares outstanding assuming dilution(1).........    4,679        7,492        9,404         9,581         12,463 
Pro forma basic earnings (loss) per share assuming the                                                                            
  accounting change is applied retroactively.....................    $0.29        $0.14       $(3.57)       $(0.04)         $0.16 
Pro forma earnings (loss) per share assuming the accounting                                                                       
  change is applied retroactively, assuming dilution.............    $0.28        $0.13       $(3.57)       $(0.04)         $0.08 

                                                        [Enlarge/Download Table]

                                                                                          At October 31,                          
                                                                      1997       1998          1999         2000            2001  
                                                                  ----------------------------------------------------------------
                                                                                                                                  
Consolidated Balance Sheet Data:                                                                                                  
Working capital (deficit)........................................    $4,339      $5,773      $(1,422)       $5,733         $7,289 
Total assets.....................................................    18,703      62,965        22,287       23,005         17,135 
Long-term debt...................................................        75          51         2,845        2,598          3,837 
Total liabilities................................................    10,465      24,592        17,470       14,149          9,736 
Stockholders' equity.............................................     8,238      38,373         4,817        8,856          7,398 

-----------                                                                     

(1)      The earnings per share  amounts prior to fiscal 1998 have been restated
         as required to comply with Statement of Financial  Accounting Standards
         No. 128,  Earnings Per Share.  For further  discussion  of earnings per
      share see Note 2 to the Company's consolidated financial statements.

(2)      Includes  the  activity  of STMS  from  September  12,  1997  (date  of
acquisition).                                                 

(3)      Includes  the  activity  of IDP and  PRIMO  from May 1,  1998  (date of
acquisition).                                                 

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ITEM7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND        
RESULTS OF OPERATIONS                                         

         Founded  in  1987,  SteelCloud  based  in  Dulles,  Virginia,  designs,
develops and manufactures  custom and customized  server  appliances and network
solutions.  In addition,  the Company  provides  Information  Technology  ("IT")
solutions  support  to  clients  for those  hardware  and  networking  solutions
implemented.                                                                    

         The  following  discussion  should  be read  in  conjunction  with  the
consolidated  financial  statements.  Certain  statements  contained  herein may
constitute   forward-looking  statements  within  the  meaning  of  the  Private
Securities  Litigation Reform Act of 1995. Because such statements include risks
and uncertainties,  actual results may differ materially from those expressed or
implied by such  forward-looking  statements.  Factors  that could cause  actual
results to differ materially  include,  but are not limited to, risks associated
with the integration of businesses  following an acquisition,  competitors  with
broader  product lines and greater  resources,  emergence into new markets,  the
termination  of  any of  the  Company's  significant  contracts,  the  Company's
inability to maintain working capital  requirements to fund future operations or
the  Company's  inability  to attract and retain  highly  qualified  management,
technical and sales personnel.                                                  

Overview of Fiscal 2001                                                         

In fiscal  2001,  the Company  modified  its  business  strategy to focus on the
server appliance  sector.  As a result,  the Company has partnered with software
and  technology  companies in order to design and develop  custom and customized
network server appliances that are delivered to the commercial marketplace.  The
efficiencies  realized on the development and production of these appliances has
enabled the Company to increase its gross margin significantly over fiscal 2000.
The  increase in gross  margins has offset the  decrease  in net  revenues  from
fiscal 2000.  The Company  believes that this trend will continue  during fiscal
2002.                                                                           

In  addition  to the  Company's  modification  of  its  business  strategy,  the
following summarizes significant activity for fiscal 2001.                      

Completion of a significant contract                                            

In fiscal 2000,  the Company  received a contract  award from the  Government of
Puerto Rico for  approximately  $16.5 million.  The contract  commenced in March
2000 and  deliveries  were  completed in January  2001.  The  completion of this
contract  primarily  attributed to the overall  decrease in net revenues.  It is
important to note that the margins realized on this contract were  significantly
lower than the server appliance model and as such the decrease in these revenues
was offset by the increase in gross margin.  During  fiscal 2001,  approximately
$335,000 in revenue was recognized relating to this contract.                   

Redemption of the Company's Series A Convertible Preferred Stock                

In March  2000,  the  Company  sold  3,000  shares of its  Series A  Convertible
Preferred  Stock for net proceeds of  approximately  $2.7 million.  The sale was
executed  in  reliance  upon  the  exemptions  from  registration   provided  by
Regulation D Rule 506  promulgated  by the  Securities  and Exchange  Commission
under the Securities Act of 1933, as amended.  The sale was executed in order to
obtain capital to fund current and future operations.                           

In  July  2001,  the  Company  entered  into an  agreement  with  its  Preferred
Shareholders  to redeem all of its  outstanding  Series A Convertible  Preferred
Stock for $2.5 million in cash. Under the terms of the redemption agreement, the
preferred   shareholders  retained  approximately  247,000  warrants  previously
issued.                                                                         

In August 2001, the Company completed the transaction by delivering $2.5 million
to its preferred  shareholders in exchange for the then outstanding 2,620 shares
of its Series A Convertible Preferred Stock. As a result of this redemption, the
Company had no outstanding preferred shares as of October 31, 2001.             

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Settlement of Malpractice Claim                                                 

In August 2000,  the  Company's  former legal  counsel filed a claim against the
Company for  approximately  $343,087  plus  accrued  interest for legal fees and
costs.  In  response  to the  claim,  the  Company  filed a  counter  claim  for
professional  malpractice  and  breach  of  fiduciary  duty  in  the  amount  of
$1,568,000.                                                                     

In June 2001, the Company  reached a settlement  agreement with its former legal
counsel  whereby both parties agreed to relinquish all claims against the other,
release  each  other from  liability  and waive the  payment of all  outstanding
claims. The Company reversed the liability that had been previously recorded for
this claim,  which reduced  general and  administrative  expenses for the fiscal
year.                                                                           

Fiscal 1999 Termination of a Significant Contract                               

On July 31, 1998, the Company  received  notice from the SBA that it was denying
the request of the U.S. Air Force to waive the  requirement  to terminate  IDP's
Desktop V contract  for the  convenience  of the  Government  upon the change in
control of IDP to the Company. The Company appealed the denial of the SBA to the
SBA's  Office of Hearings and  Appeals.  On August 31, 1999,  the SBA denied the
appeal and ruled  that the U.S.  Air Force  must  terminate-for-convenience  the
Desktop V contract.  On May 1, 1999,  prior to the SBA ruling the U.S. Air Force
determined not to exercise any of the remaining option years under the Desktop V
contract and terminated the contract for all  participating  vendors.  Initially
awarded to IDP,  the  Desktop V contract  was the  Company's  largest  contract.
Management  believed at the date of the IDP  acquisition,  the contract would be
renewed by the government  through fiscal year 2003 and would generate over $100
million in revenues  during that period.  As a result of the termination of this
contract,  the recoverability of the Company's goodwill  associated with the IDP
acquisition was  significantly  impaired.  Accordingly,  management  recorded an
impairment charge of approximately $21 million during fiscal 1999.              

In October 1999, the U.S. Air Force issued a termination-for-convenience  letter
to the Company. Under a termination-for-convenience,  the government is required
generally to reimburse a contractor for all costs incurred in the performance of
the  contract.  The Company is in the process of  attempting to recover from the
government a portion or all of unreimbursed  costs associated with the Desktop V
Contract.                                                                       

Critical Accounting Policies                                                    

The Company believes the following represent its critical accounting policies:  

Revenue Recognition                                                             

The Company recognizes revenue in accordance with SEC Staff Accounting  Bulletin
No. 101,  Revenue  Recognition in Financial  Statements (SAB 101), as amended by
SAB 101A and 101B.  SAB 101 requires that four basic criteria must be met before
revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery  has  occurred  or  services  rendered;   (3)  the  fee  is  fixed  and
determinable;  and (4)  collectibility is reasonably  assured.  Determination of
criteria (3) and (4) are based on  management's  judgments  regarding  the fixed
nature of the fee charged for services  rendered and products  delivered and the
collectibility  of those fees.  Should changes in conditions cause management to
determine  these criteria are not met for certain future  transactions,  revenue
recognized for any reporting period could be adversely affected.                

Hardware  products sold are generally  covered by a warranty for periods ranging
from one to three years.  The Company  accrues a warranty  reserve for estimated
costs to provide warranty  services.  The Company's estimate of costs to service
its warranty  obligations is based on historical  experience and  expectation of
future  conditions.  To the extent the Company  experiences  increased  warranty
claim activity or increased costs  associated  with servicing those claims,  its
warranty accrual will increase resulting in decreased gross profit.             

Legal Contingencies                                                             

We are currently involved in certain legal proceedings.  As discussed in Note 12
of our  consolidated  financial  statements,  as of October  31,  2001,  we have
accrued our estimate of the probable  costs for the  resolution of these claims.
This estimate has been developed in consultation  with outside counsel  handling
our defense in these matters and is based upon an analysis of potential results,
assuming a  combination  of  litigation  and  settlement  strategies.  We do not
believe  these   proceedings   will  have  a  material  adverse  effect  on  our
consolidated financial position. It is possible, however, that future results of
operations  for any  particular  quarterly or annual  period could be materially
affected by changes in our assumptions,  of the effectiveness of our strategies,
related to these proceedings.                                                   

Impairment of Goodwill                                                          

We  periodically   evaluate   acquired   businesses  for  potential   impairment
indicators.  Our judgments regarding the existence of impairment  indicators are
based on legal factors,  market  conditions and  operational  performance of our
acquired  businesses.  Future events could cause us to conclude that  impairment
indicators  exist and that goodwill  associated with our acquired  businesses is
impaired.  Any resulting impairment loss could have a material adverse impact on
our financial condition and results of operations.                              

Results of Operations                                                           

         The  following  table sets forth for the fiscal years ended October 31,
1997, 1998, 1999, 2000 and 2001,  certain income and expense items of SteelCloud
as a percentage of net revenues.                                                

                                                        [Enlarge/Download Table]

                                                     1997     1998     1999     2000     2001  
                                                     ----     ----     ----     ----     ----  
                                                                                               
Net revenues....................................... 100.00%  100.00%  100.00%  100.00%  100.00%
Costs of revenues..................................  80.63%   82.18%   81.16%   82.07%   74.69%
Gross profit.......................................  19.37%   17.82%   18.84%   17.93%   25.31%
Selling, general and administrative and                                                        
  amortization.....................................  10.10%   14.92%  109.50%   16.88%   20.69%
Income (loss) from operations......................   9.27%    2.90%  -90.66%    1.04%    4.62%
Other (expense) income.............................   0.45%   -0.40%   -8.44%    0.75%    0.91%
Income (loss) before income taxes..................   9.72%    2.50%  -99.10%    0.29%    3.71%
Provision for (benefit from) income taxes..........   3.65%    1.03%   -1.62%    0.16%    0.35%
Net income (loss) to common stockholders...........   6.07%    1.47%  -97.48%    0.44%    3.47%

Fiscal Year Ended October 31, 2001 Compared to Fiscal Year Ended October 31,    
2000                                                                            

         Net  revenues  of  SteelCloud  for fiscal  year ended  October 31, 2001
("fiscal 2001") decreased  approximately 24% to $30.1 million from $39.8 million
for fiscal  year ended  October 31,  2000  ("fiscal  2000").  The  decrease  was
primarily due to the completion of a significant  contract with the Puerto Rican
Government  which  represented   approximately  $16.2  million  of  fiscal  2000
revenues.  Excluding the contract with the Puerto Rican Government, net revenues
increased by  approximately  26% to $29.8  million from fiscal 2000  revenues of
$23.6  million  which was the  result of the  Company's  growth  with  their OEM
arrangements,  consulting  services and server  appliance  sales.  During Fiscal
2001,  the  Company  derived  approximately  51%  of  its  revenues  from  three
customers.  During  fiscal  2001,  the  Company's  revenues  from its  reselling
activities  increased to approximately $2.1 million from approximately  $176,000
in fiscal 2000.  The  increase is a result of the  Company's  partnerships  with
certain software companies.                                                     

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         Gross  profit for fiscal 2001  increased  by  approximately  7% to $7.6
million  from  $7.1  million.  The  increase  is the  result  of  the  Company's
successful  efforts in developing and deploying  customized server appliances to
the commercial marketplace.  Gross profit as a percentage of net revenues during
the same periods significantly increased to 25.3% from 17.9% which is the result
of lower sales volume at higher margins.                                        

         Selling and marketing expense  significantly  decreased for fiscal 2001
by 27% to  approximately  $755,000  from  approximately  $1.0 million for fiscal
2000.  During  fiscal  2001,  the  Company  continued  to reduce  its  expensive
marketing  programs  and  increased  its  marketing  efforts  through the use of
cooperative  marketing  dollars  which  resulted  in  an  overall  decrease.  In
addition,  the Company's new business  strategy  relies more heavily on combined
sales and  marketing  efforts by the Company  and the  software  and  technology
partner.                                                                        

         General and administrative expense for fiscal 2001 decreased 4% to $5.1
million  from $5.3 million for fiscal 2000.  As a  percentage  of net  revenues,
general and  administrative  expense slightly increased to 16.9% for fiscal 2001
from 13.3% for fiscal 2000. This was due to the reduced revenue base compared to
the relatively  stable general and  administrative  cost structure.  The overall
decrease  from fiscal 2000  resulted  primarily  from the  Company's  efforts to
manage  general and  administrative  costs relative to its net revenue and gross
margin.                                                                         

         Other  expense,  including  interest,  for  fiscal  2001  decreased  to
approximately $274,000 from approximately $299,000 for fiscal 2000. This was the
result a continual decrease in the short-term  borrowing rates throughout fiscal
2001.  In addition,  the Company  sold  certain  assets in fiscal 2000 for which
gains of $228,000 were recognized.                                              

         Cumulative  Effect of  Accounting  Change.  During  2001,  the  Company
implemented  Emerging  Issues Task Force Issue No.  00-27,  Application  of EITF
Issue  No.  98-5,   "Accounting  for  Convertible   Securities  with  Beneficial
Conversion  Features or Contingently  Adjustable  Conversion Ratios," to Certain
Convertible  Instruments  (EITF  00-27).  Issue 1 of  EITF  00-27  modified  the
calculation  of  beneficial   conversion   feature   discounts  for  convertible
securities  issued with detachable  instruments for all transactions  subject to
EITF Issue No. 98-5. As a result of implementation of EITF 00-27, the beneficial
conversion  feature discount  associated with the Company's Series A Convertible
Preferred Stock  increased by $576,001.  This non-cash item has been recorded by
the  Company  as a  cumulative  effect of a change in  accounting  principle  in
accordance with EITF 00-27.                                                     

         Net income available to common  shareholders  includes certain one-time
and  non-recurring  increase  to  income  available  to common  stockholders  of
$721,816 relating to the Series A Convertible  Preferred Stock private placement
with Briarcliff  Investors LLC, which closed in March 2000 and the redemption of
those preferred shares in August 2001 for $2.5 million.  Net income available to
common  shareholders  is also comprised of the  accumulating 5% dividends on the
Series  A  Convertible   Preferred  Stock  for  the  period  those  shares  were
outstanding.  For fiscal 2000,  dividends to preferred  stockholders  included a
non-cash  deemed  dividend of $529,411  for the  beneficial  conversion  feature
discount  associated  with the  private  placement  of the  preferred  stock and
$95,417 for the 5% dividend on the  convertible  preferred  stock for the period
those  shares were  outstanding.  Net income  available  to common  shareholders
increased  approximately  495% to  $1,047,041  in fiscal  2001 from  $175,837 in
fiscal 2000. The increase is  attributable  to the growth in gross margins which
resulted from the Company  moving away from its low margin  legacy  business and
increasing its focus on the customized server appliance market. In addition, the
Company has managed its selling,  general and  administrative  costs relative to
its net revenues and gross margin thereby increasing net income in fiscal 2001. 

Fiscal Year Ended October 31, 2000 Compared to Fiscal Year Ended October 31,    
1999                                                                            

         Net  revenues  of  SteelCloud  for fiscal  year ended  October 31, 2000
("fiscal 2000") increased  approximately 16% to $39.8 million from $34.5 million
for fiscal  year ended  October 31,  1999  ("fiscal  1999").  The  increase  was
primarily  due to the  contract  award with the Puerto  Rican  Government  which
represented  approximately  $16.2 million of fiscal 2000 revenues.  In addition,
the  Company  experienced  a  significant  growth  with their OEM  arrangements,
consulting  services  and server  appliance  sales  which  offset the decline in
government  sales which was a result of (a) a loss of a  significant  government
contract in 1999 and (b) the Company's focus to the commercial environment.     

         Gross  profit for fiscal 2000  increased by  approximately  10% to $7.1
million from $6.5 million.  The increase is in  proportion  with the increase in
net  revenues.  Gross  profit as a percentage  of net  revenues  during the same
periods  slightly  decreased  to 17.9% from 18.8%  which is the result of higher
sales volume at slightly lower margins.                                         

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         Selling and marketing expense  significantly  decreased for fiscal 2000
by 55% to  approximately  $1 million from $2.3  million for fiscal 1999.  During
fiscal 2000, the Company reduced expensive  marketing  programs while increasing
their marketing  efforts through the use of cooperative  marketing dollars which
resulted in a significant decrease.                                             

         General and  administrative  expense for fiscal 2000  decreased  63% to
$5.3  million  from  $14.1  million  for fiscal  1999.  As a  percentage  of net
revenues,  general and administrative expense decreased to 13.3% for fiscal 2000
from 40.9% for fiscal 1999. This decrease resulted  primarily from the Company's
efforts to manage general and  administrative  costs relative to its net revenue
and gross  margin.  It should be noted  that the  Company  incurred  significant
non-recurring   general  and   administrative   costs  in  fiscal  1999.   These
non-recurring expenses consisted of costs associated with the termination of the
DTV  contract,   termination  of  certain  benefit  plans,  and  legal  expenses
associated with all of these factors.                                           

         Other  expense,  including  interest,  for  fiscal  2000  decreased  to
approximately  $298,000  from  approximately  $2.9 million for fiscal 1999.  The
reduction  primarily relates to the settlement  agreement with a former employee
and the Company's significant debt reduction.  In addition, the company recorded
gains on the sales of certain leased assets.                                    

         Net income  available to common  shareholders  increased  approximately
100% to $175,837 in fiscal 2000 from a loss of  $33,607,145  in fiscal 1999. The
increase is attributable to the Company's efforts to manage its selling, general
and  administrative  costs  relative to its net revenues and gross  margins.  In
addition, the Company recorded an impairment charge of approximately $21 million
in fiscal  1999  related  to the  impairment  of  goodwill  associated  with the
acquisition of IDP.                                                             

Liquidity and Capital Resources                                                 

         In fiscal 2001,  the Company  generated  approximately  $2.1 million in
cash flow from  operations.  The  Company  generated  cash from the  significant
reduction of  receivables  of  approximately  $4.6 million and the collection of
income tax receivables of approximately $233,000. The cash generated was used to
reduce  accounts  payable by  approximately  $4.6 million,  accrued  expenses by
approximately  $384,000 and increase  inventory by approximately  $261,000.  The
Company's  investing  activities  consisted of the  purchases  of  approximately
$519,000 for property and equipment,  primarily for lease  transactions with its
customers.                                                                      

         The Company's financing  activities during fiscal 2001 were provided by
the  Company's  bank line of credit with First  Union  Bank.  The line of credit
expires on March 31, 2003 and currently bears interest at the lower of (a) prime
or (b) the LIBOR Market Index Rate plus two and one-half percent. As of December
31,  2001,  the  Company  had an  outstanding  balance  on the line of credit of
approximately  $3.3 million and available  borrowing  capacity of  approximately
$1.7 million.                                                                   

         In fiscal  2001,  the  Company  redeemed  2,620  shares of its Series A
Convertible  Preferred Stock, which represented all of its outstanding preferred
shares, for $2.5 million. As a result, there are no preferred shares outstanding
at October 31, 2001.                                                            

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         In fiscal 1999, SteelCloud's subsidiary,  IDP, had borrowing agreements
with  Deutsche  Financial  Services  (DFS) for an aggregate of $25 million.  The
outstanding  balance as of October 31, 1999 was approximately  $4.7 million.  In
fiscal  2000,  the  Company  executed an  agreement  terminating  the  borrowing
arrangement  whereby $3.25 million was repaid to DFS prior to December 31, 1999.
Of the remaining outstanding balance,  approximately $832,000 was converted to a
24 month note  accruing  interest at the prime rate and $750,000 was forgiven by
DFS. The Company  recorded the  $750,000 as an  extraordinary  gain on the early
extinguishment  of debt in fiscal 2000.  As of October 31, 2001,  the balance on
the note  payable was  approximately  $103,000.  The balance was paid in full on
January 1, 2002.                                                                

         As  of  October  31,   2001,   the  Company  had  working   capital  of
approximately  $7.3 million.  The Company  believes the bank facility,  together
with cash on hand,  projected  cash  generated  from  operations  and income tax
refunds due will provide sufficient  financial  resources to finance the current
operations of the Company through fiscal 2002.                                  

         The Company has obligations  under its operating  lease  commitments of
approximately  $687,000 for fiscal 2002.  In addition,  the Company will receive
approximately  $375,000 in rental  income which will be used to offset its lease
commitments.                                                                    

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

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK             

         The  Company is  exposed to market  risk  related  to  fluctuations  in
interest  rates on its  debt.  Increases  in  prevailing  interest  rates  could
increase the Company's  interest payment  obligations  relating to variable rate
debt.  For example,  a 100 basis point increase in interest rates would increase
annual interest expense by 38,000.                                              

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                             

Financial Statements of SteelCloud, Inc.                                        

                                                                Page
                                                                ----
Report of Ernst & Young LLP, Independent Auditors...............       F-1      
Consolidated Balance Sheets.....................................       F-2      
Consolidated Statements of Operations...........................       F-3      
Consolidated Statements of Stockholders' Equity.................       F-4      
Consolidated Statements of Cash Flows...........................       F-5      
Notes to the Consolidated Financial Statements..................       F-6      

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND        
FINANCIAL DISCLOSURE                                          

None.                                                         

PART III

         The  Notice  and  Proxy  Statement  for  the  2001  Annual  Meeting  of
Stockholders  to be filed  pursuant to Regulation  14A under the  Securities and
Exchange Act of 1934,  as amended,  which is  incorporated  by reference in this
Annual Report on Form 10-K  pursuant to General  Instruction G (3) of Form 10-K,
will  provide  the  information  required  under  Part  III,  including  Item 10
(directors  and  executive   officers  of  the  Company),   Item  11  (Executive
Compensation),  Item 12  (security  ownership of certain  beneficial  owners and
management), and Item 13 (certain relationships and related transactions), which
will be filed  within 120 days after the end of the fiscal year  covered by this
Form 10-K.                                                                      

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 PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K      

(a)      The following documents are filed as part of this report               

1.       Financial Statements                                                   

SteelCloud, Inc.                                              

Report of Ernst & Young LLP, Independent Auditors             

Consolidated Balance Sheets                                   

Consolidated Statements of Operations                         

Consolidated Statements of Stockholders' Equity               

Consolidated Statements of Cash Flows                         

Notes to Consolidated Financial Statements                    

2.       Financial Statement Schedules                                          

Schedule II Valuation and Qualifying Accounts                 

         Statements  not listed  above have been  omitted  because  they are not
applicable  or the  information  required to be set forth therein is included in
the Consolidated Financial Statements or the notes thereto under Item 8.        

3.       Exhibits.                                                              

Exhibit                                                                         
Number                         Description                                      
------                         -----------                                      

       3.1    Articles of Incorporation of the Company, dated February 25, 1998,
              and  effective as of February  26, 1998.  (Filed as Exhibit 3.1 to
              the Company's Registration Statement on Form S-1, Amendment No. 1,
              dated April 23, 1998 (File No. 333-47631) and hereby  incorporated
by reference.)                                      

       3.2    By-laws of the Company,  effective as of March 5, 1998.  (Filed as
              Exhibit 3.2 to the Company's  Registration  Statement on Form S-1,
              Amendment  No. 2, dated  April 23, 1998 (File No.  333-47631)  and
hereby incorporated by reference.)                  

       4.1    Specimen  common  stock  certificate  for the  Company.  (Filed as
              Exhibit 4.1 to the Company's  Registration  Statement on Form S-1,
              Amendment  No. 2, dated  April 23, 1998 (File No.  333-47631)  and
hereby incorporated by reference.)                  

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       10.8   Employment  Agreement  by and  between  Dunn and  Thomas P.  Dunne
              (Filed as Exhibit  99.2 to Dunn's  Registration  Statement on Form
              SB-2,  Amendment 2, dated April 4, 1997 (File No.  333-19635)  and
hereby incorporated by reference).                  

       10.10  Deed of Lease,  dated February 7, 1997, between APA Properties No.
              6 L.P. and STMS, Inc. and First Amendment thereto,  dated July 23,
              1997 (Filed as Exhibit 10.10 to Dunn's Form 10-KSB,  dated January
              30, 1998 (File No. 0-22263) and hereby incorporated by reference).

       10.11  1997 Stock Option Plan, as amended. (Filed as Exhibit 10.11 to the
              Company's  Registration  Statement on Form S-1,  Amendment  No. 2,
              dated April 23, 1998 (File No. 333-47631) and hereby  incorporated
by reference.)                                      

       10.12  General Service  Administration  Schedule for  International  Data
              Products,   Corp.   (Filed  as  Exhibit  10.12  to  the  Company's
              Registration  Statement on Form S-1,  Amendment No. 2, dated April
              23,  1998  (File  No.   333-47631)  and  hereby   incorporated  by
reference.)                                         

       10.13  Agreement,  dated May 5, 1997, by and between  International  Data
              Products,  Corp.  and the U.S. Air Force,  the Desktop V Contract.
              (Filed as Exhibit 10.13 to the Company's Registration Statement on
              Form  S-1,  Amendment  No.  2,  dated  April  23,  1998  (File No.
333-47631) and hereby incorporated by reference.)   

       10.16  Deed of Lease, dated July 15, 1994, between Puerto Rico Industrial
              Development  Company  and  Puerto  Rico  Industrial  Manufacturing
              Operations,  Corp.  (Filed  as  Exhibit  10.16  to  the  Company's
              Registration  Statement on Form S-1,  Amendment No. 2, dated April
              23,  1998  (File  No.   333-47631)  and  hereby   incorporated  by
reference.)                                         

10.22  Employee Stock Purchase Plan.                              

       10.25  Termination agreement, Promissory Note, dated December 29, 1999 by
and between Dunn and Deutsche Financial Services.   

       10.26  Loan and  Security  Agreement,  dated May 27,  1999 by and between
Dunn and First Union Commercial Corporation.        

       10.27  Modification  Agreement,  dated  February  11, 2000 by and between
Dunn and First Union National Bank.                 

       10.29  Modification  Agreement,  dated  January  18,  2002 by and between
SteelCloud, Inc. and First Union National Bank.     

*21.1  List of Subsidiaries.                                      

*23.1  Consent of Ernst & Young LLP, Independent Auditors.        

-----------                                                                     

*        Filed herewith                                                         

(b) Reports on Form 8-K                                                         

         On August 8, 2001,  the Company  filed a report on Form 8-K pursuant to
Item 5 Other Events.                                                            

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SIGNATURES

         Pursuant to the  requirements  of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.                       

STEELCLOUD, INC.
Date: January 29, 2002          By:                                             

                                           /s/ Thomas P. Dunne
                                               -----------------------
                                               Thomas P. Dunne
                                               Chief Executive Officer

         Pursuant to and in accordance  with the  requirements of the Securities
Exchange Act of 1934,  this report has been signed by the  following  persons on
behalf of the registrant and in the capacities and on the dates indicated.      

                                                        [Enlarge/Download Table]

                   Name                                      Title                              Date        
                   ----                                      -----                              ----        
                                                                                                            
         /s/ Thomas P. Dunne                                                                                
-----------------------------------------                                                                   
             Thomas P. Dunne               Chief Executive Officer and Director             January 29, 2002

            /s/ Edward Spear                                                                                
-----------------------------------------                                                                   
               Edward Spear                President, Chief Operating Officer and Director  January 29, 2002

        /s/ VADM E. A. Burkhalter                                                                           
-----------------------------------------                                                                   
    VADM E. A. Burkhalter USN (Ret.)       Director                                         January 29, 2002

             /s/ James Bruno                                                                                
-----------------------------------------                                                                   
               James Bruno                 Director                                         January 29, 2002

         /s/ Jay Kaplowitz                                                                                  
-----------------------------------------                                                                   
             Jay Kaplowitz                 Director                                         January 29, 2002

         /s/ Benjamin Kreiger                                                                               
-----------------------------------------                                                                   
           Benjamin Kreiger                Director                                         January 29, 2002

          /s/ Richard Prins                                                                                 
-----------------------------------------                                                                   
             Richard Prins                 Director                                         January 29, 2002


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 Index to Financial Statements

                                                        [Enlarge/Download Table]
                                                                                                                       
 SteelCloud, Inc (a Virginia Corporation)                                                                              
Report of Ernst & Young LLP, Independent Auditors.................................................................. F-1
Consolidated Balance Sheets as of October 31, 2000 and 2001........................................................ F-2
Consolidated Statements of Operations for the three years ended October 31, 2001................................... F-3
Consolidated Statements of Stockholders' Equity for the three years ended October 31, 2001......................... F-4
Consolidated Statements of Cash Flows for the three years ended October 31, 2001                                    F-5
Notes to Consolidated Financial Statements......................................................................... F-6


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 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors                                                              
SteelCloud, Inc.                                                                

We have audited the accompanying consolidated balance sheets of SteelCloud, Inc.
(a  Virginia  Corporation)  as of October  31,  2000 and 2001,  and the  related
consolidated  statements of operations,  stockholders' equity and cash flows for
each of the three years in the period ended October 31, 2001. These consolidated
financial  statements are the  responsibility of the Company's  management.  Our
responsibility  is  to  express  an  opinion  on  these  consolidated  financial
statements based on our audits.                                                 

We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to  obtain  reasonable  assurance  about  whether  the  consolidated   financial
statements are free of material misstatement.  An audit includes examining, on a
test basis,  evidence supporting the amounts and disclosures in the consolidated
financial statements. An audit also includes assessing the accounting principles
used and  significant  estimates made by  management,  as well as evaluating the
overall financial statement  presentation.  We believe that our audits provide a
reasonable basis for our opinion.                                               

In our opinion, the consolidated  financial statements referred to above present
fairly,  in all  material  respects,  the  consolidated  financial  position  of
SteelCloud,  Inc. as of October 31, 2000 and 2001, and the consolidated  results
of its  operations  and its cash flows for each of the three years in the period
ended October 31, 2001,  in  conformity  with  accounting  principles  generally
accepted in the United States.                                                  

As discussed in Note 2 of the Notes to the Consolidated Financial Statements, in
2001 the Company  changed its method of accounting  for  convertible  securities
with beneficial conversion features.                                            

                         /s/ ERNST & YOUNG LLP

December 21, 2001, except for Note 5                                            
as to which the date is January 18, 2002                                    
McLean, Virginia                                                                

F-1 

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STEELCLOUD, INC.
 CONSOLIDATED BALANCE SHEETS

                                                        [Enlarge/Download Table]

                                                                                        OCTOBER 31,              
                                                                            -------------------------------------
                                                                                  2000               2001        
                                                                            ------------------ ------------------
                                                                                                                 
ASSETS                                                                                                           
Current assets:                                                                                                  
   Cash and cash equivalents                                                   $     363,958      $     313,054  
   Accounts receivable, net of allowance for doubtful                                                            
    accounts of $100,000 and $112,000 as of October 31, 2000 and 2001,                                           
    respectively                                                                  10,851,270          6,201,621  
   Inventory, net                                                                  4,318,936          5,099,436  
   Deferred tax asset                                                              1,326,745                  -  
   Income tax receivable                                                             230,681          1,400,424  
   Prepaid expenses and other current assets                                         191,897            173,695  
                                                                            ------------------ ------------------
Total current assets                                                              17,283,487         13,188,230  

Property and equipment, net                                                          819,798            319,944  
Equipment on lease, net                                                            1,443,704            597,202  
Goodwill and other intangible assets, net                                          3,164,789          2,770,572  
Investments                                                                          150,000            150,000  
Other assets                                                                         143,193            108,599  
                                                                            ------------------ ------------------

Total assets                                                                     $23,004,971        $17,134,547  
                                                                            ================== ==================

LIABILITIES AND STOCKHOLDERS' EQUITY                                                                             
Current liabilities:                                                                                             
   Accounts payable                                                              $  7,886,342      $  3,293,030  
   Accrued expenses                                                                 2,753,361         2,277,993  
   Accrued litigation costs                                                           343,087                 -  
   Notes payable, current portion                                                     431,597           114,985  
   Unearned revenue                                                                   135,690           213,385  
                                                                             ----------------- ------------------
Total current liabilities                                                          11,550,077         5,899,393  

Notes payable, long-term portion                                                      115,290                 -  
Line of credit, long term                                                           2,483,203         3,836,754  

Stockholders' equity:                                                                                            
Preferred stock $.001 par value; 2,000,000 shares authorized, 3,000 and 0                                        
    shares issued and outstanding at October 31, 2000 and 2001,                                                  
    respectively; aggregate liquidation preference of $2,945,417 at                                              
    October 31, 2000                                                                        3                 -  
Common stock, $.001 par value; 20,000,000 shares authorized, 9,806,962 and                                       
   10,214,545 shares issued and outstanding at October 31, 2000 and                                              
   2001, respectively                                                                   9,807            10,215  
Additional paid-in capital                                                         41,584,844        39,079,397  
Treasury stock, 400,000 shares at October 31, 2000 and 2001, respectively          (3,432,500)       (3,432,500) 
Accumulated deficit                                                               (29,305,753)      (28,258,712) 
                                                                             ----------------- ------------------
Total stockholders' equity                                                          8,856,401         7,398,400  
                                                                             ----------------- ------------------

Total liabilities and stockholders' equity                                       $ 23,004,971      $ 17,134,547  
                                                                             ================= ==================

See accompanying notes.                                                         

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STEELCLOUD, INC.
 CONSOLIDATED STATEMENTS OF OPERATIONS

                                                        [Enlarge/Download Table]

                                                                YEARS ENDED OCTOBER 31,           
                                                     -------------------------------------------- 
                                                         1999            2000           2001      
                                                     ------------    ------------    ------------ 
                                                                                                  
Net revenues                                         $ 34,475,297    $ 39,766,393    $ 30,138,379 
Costs of revenues                                      27,981,691      32,636,410      22,509,978 
                                                     ------------    ------------    ------------ 
Gross profit                                            6,493,606       7,129,983       7,628,401 

Selling and marketing                                   2,311,091       1,035,698         755,184 
General and administrative                             14,112,227       5,285,767       5,086,460 
Amortization of goodwill                                  675,743         394,216         394,216 
Impairment of goodwill                                 20,649,335              --              -- 
                                                     ------------    ------------    ------------ 

Income (loss)  from operations                        (31,254,790)        414,302       1,392,541 

Other income (expense):                                                                           
   Interest income                                         27,998          34,276          88,485 
   Interest expense                                      (962,004)       (654,329)       (336,128)
   Settlement of litigation                            (2,000,000)             --              -- 
   Gain on sale of assets                                 193,516         228,062              -- 
   Other, net                                            (170,621)         93,354         (26,396)
                                                     ------------    ------------    ------------ 
Income (loss) from operations before income taxes,                                                
   and extraordinary gain                             (34,165,901)        115,665       1,118,502 

Provision for (benefit from) income taxes                (558,756)         65,000         104,776 
                                                     ------------    ------------    ------------ 
Income (loss) before extraordinary gain               (33,607,145)         50,665       1,013,726 
Extraordinary gain - early extinguishment of debt              --         750,000              -- 
                                                     ------------    ------------    ------------ 
Net income (loss)                                    $(33,607,145)   $    800,665    $  1,013,726 

Dividends to preferred stockholders                            --        (624,828)       (112,500)
Cumulative effect of change in accounting principle            --              --        (576,001)
Increase to income available to common stockholders                                               
   from repurchase of preferred stock                          --              --         721,816 
                                                     ------------    ------------    ------------ 

Net income (loss) available to common stockholders   $(33,607,145)   $    175,837    $  1,047,041 
                                                     ============    ============    ============ 
Earnings (loss) per share, basic                                                                  
Earnings (loss) before extraordinary gain            $      (3.57)   $       (.06)   $        .10 
Extraordinary gain                                             --             .08              -- 
                                                     ------------    ------------    ------------ 

Net earnings (loss) per share                        $      (3.57)   $        .02    $        .10 
                                                     ============    ============    ============ 
Earnings (loss) per share, fully diluted                                                          
Earnings (loss) before extraordinary gain                   (3.57)           (.06)   $        .08 
Extraordinary gain                                             --             .08              -- 
                                                     ------------    ------------    ------------ 
Net earnings (loss) per share                        $      (3.57)   $        .02    $        .08 
                                                     ============    ============    ============ 

Pro forma amounts assuming the accounting change                                                  
  is applied retroactively:                                                                       
Net income (loss) to common stockholders             $(33,607,145)   $   (400,164)   $  1,623,042 
                                                     ============    ============    ============ 

Net earnings (loss) per share, basic                 $      (3.57)   $      (0.04)   $       0.16 
                                                     ============    ============    ============ 

Net earnings (loss) per share, fully diluted         $      (3.57)   $      (0.04)   $       0.08 
                                                     ============    ============    ============ 

See accompanying notes                                                          

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STEELCLOUD, INC.
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

                                                        [Enlarge/Download Table]


                                                  Preferred Stock                        Common Stock           
                                          ------------------------------      -----------------------------     
                                             Shares             Amount            Shares          Amount        
                                          ------------      ------------      ------------     ------------     
                                                                                                                
Balance at October 31, 1998                                                      9,391,493     $      9,392     
  Issuance of common stock under                                                                                
     employee stock purchase plan                                                   28,016               28     
  Net loss                                                                              --               --     
                                          ------------      ------------      ------------     ------------     

Balance at October 31, 1999                                                      9,419,509            9,420     

Issuance of Common Stock in connection                                                                          
with exercise of employee incentive                                                                             
stock option plan                                   --                --             4,900                5     

Issuance of Series A Convertible                                                                                
Preferred Stock                                  3,000                 3                --               --     

Issuance of Common Stock                            --                --           225,000              225     

Paid in Capital and Deemed Dividend on              --                --                --               --     
Preferred Stock                                                                                                 

Conversion of Series A Convertible                                                                              
Preferred Stock                                   (150)               --           153,150              153     

Conversion of Preferred Stock dividends                                                                         
to shares of Common Stock                           --                --             4,403                4     

Dividend Declared on Series A                                                                                   
Convertible Preferred Stock                                                                                     

Net Income                                          --                --                --               --     
                                          ------------      ------------      ------------     ------------     

Balance at October 31, 2000                      2,850                 3         9,806,962            9,807     

Conversion of Series A Convertible                (230)               --           390,267              391     
Preferred Stock                                                                                                 

Conversion of Preferred  Stock dividends            --                --            17,316               17     
payable to shares of Common Stock                                                                               

Dividend Declared on Series A                                                                                   
Convertible Preferred Stock                         --                --                --               --     

Cumulative effect of change in                      --                --                --               --     
accounting principle                                                                                            

Redemption of Preferred Stock                   (2,620)               (3)               --               --     

Net Income                                          --                --                --               --     
                                          ------------      ------------      ------------     ------------     
Balance at October 31, 2001                         --                --        10,214,545     $     10,215     
                                          ============      ============      ============     ============     


                                                                                   Retained                     
                                              Additional                           Earnings                     
                                               Paid-In           Treasury        (Accumulated                   
                                               Capital             Stock            Deficit)           Total    
                                             ------------      ------------      ------------      ------------ 
                                                                                                                
Balance at October 31, 1998                  $ 37,670,245     $  (3,432,500)     $  4,125,555      $ 38,372,692 
  Issuance of common stock under                                                                                
     employee stock purchase plan                  51,504                --                --            51,532 
  Net loss                                             --                --       (33,607,145)      (33,607,145)
                                             ------------      ------------      ------------      ------------ 

Balance at October 31, 1999                    37,721,749        (3,432,500)      (29,481,590)        4,817,079 

Issuance of Common Stock in connection                                                                          
with exercise of employee incentive                                                                             
stock option plan                                  15,308                --                --            15,313 

Issuance of Series A Convertible                                                                                
Preferred Stock                                 2,716,711                --                --         2,716,714 

Issuance of Common Stock                          597,420                --                --           597,645 

Paid in Capital and Deemed Dividend on            529,411                --          (529,411)               -- 
Preferred Stock                                                                                                 

Conversion of Series A Convertible                                                                              
Preferred Stock                                      (153)               --                --                   

Conversion of Preferred Stock dividends                                                                         
to shares of Common Stock                           4,398                --                --             4,402 

Dividend Declared on Series A                                                         (95,417)          (95,417)
Convertible Preferred Stock                                                                                     

Net Income                                             --                --           800,665           800,665 
                                             ------------      ------------      ------------      ------------ 

Balance at October 31, 2000                    41,584,844        (3,432,500)      (29,305,753)        8,856,401 

Conversion of Series A Convertible                   (391)               --                --                -- 
Preferred Stock                                                                                                 

Conversion of Preferred  Stock dividends           10,019                --                --            10,036 
to shares of Common Stock                                                                                       

Dividend Declared on Series A                                                                                   
Convertible Preferred Stock                            --                --          (112,500)         (112,500)

Cumulative effect of change in                    576,001                --          (576,001)               -- 
accounting principle                                                                                            

Redemption of Preferred Stock                  (3,091,076)               --           721,816        (2,369,263)

Net Income                                             --                --         1,013,726         1,013,726 
                                             ------------      ------------      ------------      ------------ 
Balance at October 31, 2001                  $ 39,079,397      $ (3,432,500)     $(28,258,712)     $  7,398,400 
                                             ============      ============      ============      ============ 


See accompanying notes.                                                         

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 STEELCLOUD, INC
 CONSOLIDATED STATEMENTS OF CASH FLOWS

                                                        [Enlarge/Download Table]

                                                                           YEARS ENDED OCTOBER 31,           
                                                            ------------------------------------------------ 
                                                                1999              2000              2001     
                                                            ------------      ------------      ------------ 
                                                                                                             
Operating activities                                                                                         

Net income (loss)                                           $(33,607,145)     $    800,665      $  1,013,726 
Adjustments to reconcile net income (loss) to net cash                                                       
  provided by (used in) operating activities:                                                                
   Depreciation and amortization of property and equipment     2,779,926         2,841,210         1,346,129 
   Amortization of goodwill and other intangibles                675,743           394,216           394,216 
   Impairment of goodwill                                     20,649,335                --                -- 
   Gain on sale of assets                                       (193,516)         (228,062)               -- 
   Gain on settlement of litigation                                   --          (495,709)         (343,087)
   Gain on redemption of preferred stock                              --                --                   
   Extraordinary debt extinguishment gain                             --          (750,000)               -- 
   Changes in operating assets and liabilities:                                                              
     Accounts receivable, net                                 11,801,135        (5,788,229)        4,649,649 
     Income tax receivable                                        11,556           355,088           234,378 
     Investment in sales-type leases                           3,099,342                --                -- 
     Inventory                                                 5,431,102         1,178,698          (261,317)
     Prepaid expenses and other assets                           175,823           (71,375)           52,796 
     Accounts payable                                         (7,328,184)        3,063,363        (4,593,312)
     Accrued expenses                                           (211,112)         (416,865)         (384,355)
     Deferred tax asset (credit)                                (652,695)          (44,050)          (77,376)
     Unearned revenue and other liabilities                   (2,296,764)         (956,772)           77,695 
                                                            ------------      ------------      ------------ 
Net cash provided by (used in) operating activities              334,546          (117,822)        2,109,142 

Investing activities                                                                                         
Purchases of property and equipment                           (2,532,509)         (509,737)         (518,956)
Acquisitions, net of cash acquired                              (652,231)               --                -- 
Proceeds from sale of assets                                     740,023           784,838                -- 
                                                            ------------      ------------      ------------ 
Net cash (used in) provided by investing activities           (2,444,717)          275,101          (518,956)

Financing activities                                                                                         
Proceeds from issuance of preferred stock                             --         2,716,714                -- 
Payments made to redeem preferred stock                               --                --        (2,562,739)
Proceeds from issuance of common stock                            51,532                --                   
Proceeds from exercise of common stock options                        --            15,313                -- 
Payments on notes payable                                        (46,248)         (323,296)         (431,902)
Payments on notes payable to related parties                    (905,960)               --                -- 
Proceeds from (repayments on) lines of credit, net             3,666,297        (2,857,502)        1,353,551 
                                                            ------------      ------------      ------------ 
Net cash provided by (used in) financing activities            2,765,621          (448,771)       (1,641,090)

Net increase (decrease) in cash and cash equivalents             655,450          (291,492)          (50,904)
Cash and cash equivalents at beginning of year                        --           655,450           363,958 
                                                            ------------      ------------      ------------ 
Cash and cash equivalents at end of year                    $    655,450      $    363,958      $    313,054 
                                                            ============      ============      ============ 

Supplemental cash flow information                                                                           
Interest paid                                               $    962,004      $    654,329      $    336,128 
                                                            ------------      ------------      ------------ 
Income taxes paid                                           $    223,850      $    116,630      $    185,210 
                                                            ============      ============      ============ 

See accompanying notes                                                          

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 OCTOBER 31, 1999, 2000 AND 2001

1.  Organization                                                                

Dunn Computer  Corporation  was  incorporated on July 27, 1987 under the laws of
the Commonwealth of Virginia. On January 3, 1997, Dunn Computer  Corporation,  a
Delaware  corporation,  was  formed as a holding  company  for the stock of Dunn
Computer  Corporation,  the Virginia  corporation.  On February  26, 1998,  Dunn
Computer  Corporation  was  incorporated  in  Virginia  in  connection  with the
reorganization  of Dunn  Computer  Corporation,  the Delaware  Corporation.  The
Company's  subsidiaries  are  International  Data Products  ("IDP") acquired May
1998,  STMS,  Inc (STMS)  acquired  September  1997 and Puerto  Rico  Industrial
Manufacturing  Operations  Acquisition  Corporation,  (PRIMOA),  incorporated in
Puerto Rico on May 1, 1998. Unless the context otherwise requires, the "Company"
or "Dunn Computer  Corporation"  refers to SteelCloud,  its  predecessor and its
subsidiaries.                                                                   

On September  25, 2000 the Company  began doing  business as ("dba")  SteelCloud
Company.  On October 19, 2000, the Company changed its NASDAQ ticker symbol from
DNCC and began trading as SCLD.                                                 

On May 15,  2001,  the  shareholders  approved  an  amendment  to the  Company's
articles  of  incorporation  to change  the  corporate  name from Dunn  Computer
Corporation to SteelCloud,  Inc. The name change became effective as of July 30,
2001  pursuant  to a  certificate  of  amendment  issued by the  Virginia  State
Corporation Commission.                                                         

The  Company is engaged in the design  and  development  of  original  equipment
manufacturer  (OEM) server  appliances  for software and  technology  companies.
SteelCloud  augments the  capabilities  of its OEM customers by providing them a
quick  and  cost-effective   approach  to  introducing  new  appliances  to  the
marketplace. The Company also works with major integrators to address the custom
hardware needs of its public sector customers. In addition, the Company provides
Information  Technology  (IT)  support  and  consulting  services  to  both  the
commercial  and  public  sector  clients.  Although  SteelCloud  operates  in  a
competitive environment subject to technological change and the emergence of new
technologies,  the Company believes that its products and services are, or would
be, compatible or upgradeable to new technologies.                              

2.  Significant Accounting Policies                                             

Use of Estimates                                                                

The  preparation of the  consolidated  financial  statements in conformity  with
generally accepted  accounting  principles requires management to make estimates
and assumptions  that affect the reported  amounts of assets and liabilities and
disclosure of contingent  assets and liabilities at the date of the consolidated
financial  statements and the reported  amounts of revenues and expenses  during
the reporting period. Actual results could differ from those estimates.         

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  Significant Accounting Policies (continued)                                 

Principles of Consolidation                                                     

The consolidated  financial  statements  include the accounts of the Company and
its  wholly-owned  subsidiaries.   All  significant  intercompany  accounts  and
transactions have been eliminated.                                              

Cash and Cash Equivalents                                                       

The Company  maintains demand deposits with several financial  institutions.  At
times,  deposits  exceed  federally  insured  limits,  but  management  does not
consider this a significant  concentration of credit risk. The Company considers
all highly  liquid  investments  with a maturity of three  months or less at the
time of purchase to be cash equivalents.                                        

Financial Instruments                                                           

The carrying  value of the Company's  financial  instruments  including cash and
cash equivalents,  accounts receivable,  accounts payable,  accrued liabilities,
notes payable and its line of credit approximates fair value.                   

Investments                                                                     

At October 31, 2000 and 2001, investments consisted of shares of common stock of
a privately-held  internet company,  Worldwide Internet Solutions Network,  Inc.
("WIZnet"),  with a  cost  basis  of  approximately  $150,000.  The  Company  is
accounting  for this  investment  using  the cost  method  since  the  Company's
investment  represents less than 20% of the  privately-held  internet  company's
outstanding  stock and the Company  does not exert  significant  influence  over
WIZnet's operations. The Company is not aware of any factors that would indicate
its investment is permanently impaired.                                         

Inventory                                                                       

Inventory is stated at the lower of cost or market as determined by the first-in
first-out  (FIFO)  method.  The Company  periodically  evaluates  its  inventory
obsolescence reserve to ensure inventory is recorded at net realizable value.   

Impairment of Long-Lived Assets                                                 

Each year, management determines whether any property and equipment or any other
assets have been  impaired  based on the  criteria  established  in Statement of
Financial  Accounting  Standards  No.  121  (SFAS  121),   "Accounting  for  the
Impairment of Long-Lived  Assets and  Long-Lived  Assets to be Disposed of." The
carrying amount of a long-lived asset is considered  impaired when the estimated
undiscounted cash flow from each asset is less than its carrying amount. In that
event,  the  Company  records a loss equal to the  amount by which the  carrying
amount exceeds the fair value of the long-lived asset.  During fiscal year 1999,
management  determined  that  goodwill  associated  with the purchase of IDP was
impaired. The fair value of the IDP goodwill was estimated using discounted cash
flows.  Accordingly,  the Company recorded an impairment charge of approximately
$20.6  million (see Note 4).  During  fiscal 2000 and 2001,  the Company made no
adjustments to the carrying values of the long-lived assets.                    

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  Significant Accounting Policies (continued)                                 

Goodwill and Other Intangible Assets                                            

Goodwill and other intangibles  represent the unamortized  excess of the cost of
acquiring  subsidiary  companies  over the fair  values of such  companies'  net
tangible assets at the dates of acquisition.  Goodwill  related to the Company's
acquisitions as described in Note 4 is being amortized on a straight-line  basis
over periods  ranging from five to twenty years.  Other  intangibles,  including
contracts, are being amortized on a straight-line basis over a five year period.

Acquisition-Related Liabilities                                                 

During fiscal year 1998, the Company recorded $1,376,000 of  acquisition-related
liabilities  in connection  with the IDP  Acquisition.  These  liabilities  were
recorded after certain actions had been  identified,  quantified and approved by
management  of the Company  having  authority to commit the Company to the plan.
Those certain actions included closing the IDP facility in Maryland, integrating
IDP and the Company's production, warehouse, sales, marketing and administrative
functions,  eliminating  duplicative  jobs and expanding  space in the Company's
office  space in  Virginia.  During  fiscal  year 1999,  $894,000  of costs were
charged against the liability. The acquisition-related  liabilities remaining at
October 31, 2000 and 2001 amounted to $250,000.                                 

Stock Compensation                                                              

Statement of Financial Accounting Standards No. 123 (SFAS 123),  "Accounting for
Stock-Based   Compensation"   allows   companies  to  account  for   stock-based
compensation  under  either  the  provisions  of SFAS 123 or the  provisions  of
Accounting  Principles  Board  Opinion  No. 25 (APB 25),  "Accounting  for Stock
Issued to Employees," but requires pro forma  disclosure in the footnotes to the
consolidated  financial statements as if the measurement  provisions of SFAS 123
had  been  adopted.   The  Company  continues  accounting  for  its  stock-based
compensation in accordance with the provisions of APB 25.                       

Revenue Recognition                                                             

In December 1999, the SEC released Staff Accounting  Bulletin No, 101,  "Revenue
Recognition in Financial  Statements"  (SAB101) as amended by SAB 101A and 101B.
SAB 101  requires  that four basic  criteria  must be met before  revenue can be
recognized:  (1) persuasive  evidence of an arrangement exists; (2) delivery has
occurred or services  rendered;  (3) the fee is fixed and determinable:  and (4)
collectibility  is reasonably  assured.  The Company  adopted SAB 101 during the
fourth quarter of fiscal year 2001.  The adoption has not had a material  effect
on the Company's financial position, results of operations or cash flows.       

The Company  derives its revenue from the following  sources:  Product  revenue,
information  technology  support services,  software license and support revenue
and software training and customization revenue.                                

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  Significant Accounting Policies (continued)                                 

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

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

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  Significant Accounting Policies (continued)                                 

Revenue Recognition (continued)                                                 

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

During the years ended October 31, 1999, 2000 and 2001, the Company had revenues
from the Federal government,  which represented 12%, 27%, and 18%, respectively,
of total  revenue.  As of October 31, 2000 and 2001,  accounts  receivable  from
agencies of the Federal  government  represented 56%, and 8%,  respectively,  of
total  accounts  receivable.  In  addition,  the Company had  revenues  from two
commercial  customers  that  represents 11% and 51% of fiscal year 2000 and 2001
revenues, respectively and 7% and 61% of accounts receivable at October 31, 2000
and 2001, respectively.                                                         

Advertising Expenses                                                            

The Company expenses  advertising costs as incurred.  Advertising costs amounted
to  approximately  $130,000,  $41,000 and $67,000 during fiscal 1999,  2000, and
2001, respectively.                                                             

Income Taxes                                                                    

The Company provides for income taxes in accordance with the liability method.  

Change in Accounting Principle                                                  

During 2001, the Company implemented Emerging Issues Task Force Issue No. 00-27,
Application of EITF Issue No. 98-5,  "Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios," to
Certain Convertible  Instruments ("EITF 00-27").  Issue 1 of EITF 00-27 modified
the calculation of beneficial  conversion  features for  convertible  securities
issued with detachable  instruments for all  transactions  subject to EITF Issue
No. 98-5. In accordance  with the transition  provision of EITF 00-27  companies
are  required  to report any  changes in a  beneficial  conversion  feature as a
result of applying  Issue 1 of EITF 00-27 as a cumulative  effect of a change in
accounting  principle  at the  time of  implementation  in  accordance  with APB
Opinion No. 20, "Accounting  Changes". As a result of the implementation of EITF
00-27, the Company has recorded a charge  representing an additional  allocation
of value to the beneficial  conversion feature, of $576,001, or $0.06 per share,
as a cumulative effect of a change in accounting principle.                     

Supplemental Information of Non-Cash Investing and Financing Activities:        

                                                        [Enlarge/Download Table]


                                                                             Year Ended October 31,               
                                                               ---------------------------------------------------
                                                                    1999             2000              2001       
                                                               --------------- ------------------ ----------------
                                                                                                                  
Common stock issued in connection with legal settlement                     -          $ 597,645                - 
                                                               =============== ================== ================
Deemed dividend on preferred stock                                          -          $ 529,411        $ 112,500 
                                                               =============== ================== ================
Increase to income to common shareholders for repurchase of                                                       
preferred stock                                                             -                  -        $ 721,816 
                                                               =============== ================== ================
Conversion of preferred stock and accrued dividends to common                                                     
stock                                                                       -             $4,404  $        10,036 
                                                               =============== ================== ================
Cumulative effect of change in accounting principle                         -                  -        $ 576,001 
                                                               =============== ================== ================

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.  Significant Accounting Policies (continued)                                 

Earnings Per Share                                                              

The  Company  follows  the  provisions  of  Statement  of  Financial  Accounting
Standards No. 128, Earnings Per Share ("SFAS 128") which requires the Company to
present basic and fully diluted earnings per share.  Basic earnings per share is
based on the weighted  average  shares  outstanding  during the period.  Diluted
earnings per share  increases the shares used in the basic share  calculation by
the dilutive effect of stock options,  warrants and convertible preferred stock.
For fiscal years 1999 and 2000,  the Company's  common stock  equivalent  shares
outstanding  from stock options,  warrants and  convertible  preferred stock are
excluded  from the diluted  earnings  per share  calculation  as their effect is
antidilutive to net income (loss) to common  stockholders  before  extraordinary
items.                                                                          

Financial Instruments and Concentration of Credit Risk                          

Financial  instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash, investments and accounts receivable.  The
cash is held  by  high  credit  quality  financial  institutions.  For  accounts
receivable,  the Company performs  ongoing credit  evaluations of its customers'
financial  condition  and  generally  does not require  collateral.  The Company
maintains  reserves  for credit  losses.  The  concentration  of credit  risk is
mitigated  by the  amount of  receivables  due by the  Federal  government.  The
carrying amount of the receivables approximates their fair value.               

Recent Pronouncements                                                           

In June 2001,  the FASB  issued  SFAS No. 141,  "Business  Combinations",  which
requires the purchase method of accounting for business  combinations  initiated
after June 30, 2001 and eliminates the pooling-of-interests  method.  Currently,
the Company  does not believe the  adoption of SFAS No. 141 will have any impact
on its financial statements                                                     

In June 2001,  the FASB  issued  SFAS No. 142,  "Goodwill  and Other  Intangible
Assets", effective for fiscal years beginning after December 15, 2001. Under the
new rules,  goodwill and intangible  assets deemed to have indefinite lives will
no longer be  amortized  but will be  subject  to annual  impairment  tests.  In
addition,  the statement includes provisions for the reclassification of certain
existing recognized intangibles to goodwill, reassessment of the useful lives of
existing recognized intangibles,  reclassification of certain intangibles out of
previously  reported  goodwill and the  identification  of  reporting  units for
purposes of assessing  potential  future  impairments of goodwill.  Goodwill and
other  intangibles,  acquired  prior to July 1, 2001,  are  amortized  until the
adoption  of the  statement.  The  Company is required to apply the new rules on
accounting  for  goodwill  and other  intangible  assets  beginning in the first
quarter of the fiscal year ending  October 31,  2003.  The Company is  currently
assessing,  but  has not yet  determined,  the  impact  of SFAS  No.  142 on its
financial position and results of operations.                                   

In August 2001, the FASB issued SFAS No. 144,  "Accounting for the Impairment or
Disposal of  Long-Lived  Assets",  effective  for fiscal years  beginning  after
December 15, 2001.  The new rules on asset  impairment  supersede FASB Statement
No.  121 and  provide  a single  accounting  model for  long-lived  assets to be
disposed  of.  Although  retaining  many  of  the  fundamental  recognition  and
measurement  provisions of Statement 121, the new rules significantly change the
criteria that would have to be met to classify an asset as held-for-sale.  Under
SFAS No.  144,  assets to be  disposed  of are stated at the lower of their fair
values or carrying amounts and depreciation is no longer  recognized.  Statement
144 also  supersedes  the  provisions of APB Opinion 30 with regard to reporting
the effects of a disposal of a segment of a business and require expected future
operating  losses from  discontinued  operations to be displayed in discontinued
operations in the period(s) in which the losses are incurred  (rather than as of
the measurement date as presently required by APB 30). In addition, the criteria
for  discontinued  operation  presentation  is  changed  to a  component  of the
business rather than a segment of the business. The Company is required to adopt
Statement 144 in the first  quarter of the fiscal year ending  October 31, 2003.
The Company is currently assessing,  but has not determined,  the impact of SFAS
No. 144 on its financial position and results of operations.                    

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3.  Property and Equipment and Equipment on Lease                               

Property and equipment,  including leasehold  improvements,  are stated at cost.
Property and equipment are  depreciated  and amortized  using the  straight-line
method  over the  estimated  useful  lives  ranging  from  three to five  years.
Leasehold  improvements  are amortized over the lesser of the related lease term
or the useful life.                                                             

Property and equipment consisted of the following:                              

                                                                [Download Table]


                                                            October 31,             
                                                ------------------------------------
                                                       2000              2001       
                                                ------------------------------------
                                                                                    
Computer and office equipment                      $ 1,577,145        $ 1,610,335   
Furniture and fixtures                                 302,741            304,600   
Leasehold improvements                                 491,059            492,936   
Other                                                  412,766            411,256   
                                                ------------------------------------
                                                     2,783,711          2,819,127   
Less accumulated depreciation and amortization      (1,963,913)        (2,499,183)  
                                                ------------------------------------
                                                     $ 819,798          $ 319,944   
                                                ====================================

The Company owns equipment  that is currently at customer sites under  operating
lease agreements (See Note 2 Revenue Recognition). The cost of the equipment was
$6,309,864  and  $6,345,508  at October  31,  2001 and 2000,  respectively.  The
related accumulated  depreciation on the equipment was $5,712,662 and $4,901,804
at October 31, 2001 and 2000, respectively.                                     

4.  Goodwill and Other Intangible Assets                                        

Goodwill and other intangible assets were comprised of:                         

                                                                [Download Table]

                                           October 31,              
                               -------------------------------------
                                      2000              2001        
                               -------------------------------------
                                                                    
Goodwill                            $3,485,855         $3,485,855   
Contracts                              600,000            600,000   
Less accumulated amortization         (921,066)        (1,315,283)  
                               -------------------------------------
                                    $3,164,789         $2,770,572   
                               =====================================

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

4.  Goodwill and Other Intangible Assets (continued)                            

Impairment of Goodwill                                                          

Statement of Financial  Accounting  Standards No. 121 (SFAS 121) "Accounting for
the  Impairment of Long-Lived  Assets and for  Long-Lived  Assets to Be Disposed
Of," requires that long-lived assets and certain identifiable  intangibles to be
held and used by an entity be reviewed for impairment whenever events or changes
in  circumstances  indicate  that the  carrying  amount  of an asset  may not be
recoverable.                                                                    

In May 1999, the U.S. Government determined not to exercise the remaining option
years  on  one of the  Company's  significant  contracts.  This  contract  was a
significant   component  of  the  Company's  acquisition  of  IDP.  The  Company
anticipated   that  the  contract  would  have  generated   future  revenues  of
approximately  $65 million  had all option  years been  renewed.  The former IDP
operations have been substantially  curtailed as a result of this contract loss.
In addition,  significant future business is not expected from IDP operations as
the majority of its sales force has separated from the Company.                 

The Company  determined that these factors indicated that the carrying amount of
goodwill  associated with the IDP and PRIMO  acquisition may not be recoverable.
The Company  performed an analysis of the goodwill in  accordance  with SFAS 121
and determined that the fair value of the remaining  goodwill  (estimated  using
the present value of expected future cash flows) was approximately  $1.1 million
at the time of the  analysis.  Accordingly,  the Company  recorded an impairment
charge of approximately $20.6 million during fiscal year 1999.                  

5.  Bank Lines of Credit and Notes Payable                                      

IDP Line of Credit                                                              

In conjunction  with the purchase of IDP, the Company  assumed a credit facility
of $25,000,000  secured by inventory and accounts receivable of IDP. On November
8, 1999,  the Company  executed an agreement  with the financial  institution to
terminate  this facility.  Under the terms of the agreement,  the Company repaid
approximately  $3.0  million of the  principal  outstanding  at October 31, 1999
prior  to  December  31,  1999.  In  addition,  outstanding  principal  totaling
approximately  $832,000 was  converted  to a term note  bearing  interest at the
prime  rate  (5.5% at October  31,  2001) and  maturing  in  January  2002.  The
outstanding  balance on this term note at  October  31,  2001 was  approximately
$103,000.  The remaining  amount of  approximately  $750,000 was forgiven by the
financial  institution and has been reflected as an extraordinary  gain on early
extinguishment of debt in fiscal year 2000.                                     

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STEELCLOUD, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.  Bank Lines of Credit and Notes Payable (continued)                          

Operating Line of Credit                                                        

The Company has a line of credit agreement,  as amended, with a bank that allows
the Company to borrow an amount  limited to the minimum of its borrowing base or
$5 million.  The interest rate is the prime rate and the line of credit  expires
on February 28, 2002.                                                           

As of October 31, 2000 and 2001, the Company's borrowing base, which is based on
certain   percentages   of  total  accounts   receivable   and  inventory,   was
approximately $3.2 million and $4.7 million, respectively.                      

As of October 31, 2000 and 2001,  the Company had  borrowed  approximately  $2.5
million and $3.8 million, respectively, against this line of credit facility and
had an  unused  borrowing  capacity  of  approximately  $600,000  and  $800,000,
respectively. The line of credit is secured by all assets of the Company and its
subsidiaries.  In January 2002, the Company amended its line of credit agreement
whereby the maximum  availability  under the line of credit  increased from $5.0
million to $7.5 million. Under the terms of the amendment,  the Company may make
advances  against their eligible  receivables.  The interest rate of the amended
line of credit is the lower of (a) the prime rate or (b) the LIBOR  Market Index
Rate plus two and  one-half  percent.  The line of credit  expires  on March 31,
2003. The Company has classified  this line of credit as long-term  based on the
amended maturity date.                                                          

Notes Payable                                                                   

Notes payable consisted of the following:                                       

                                                        [Enlarge/Download Table]

                                                                                      October 31,           
                                                                             -------------------------------
                                                                                  2000            2001      
                                                                             -------------------------------

                                                                                                            
Bank term note, bearing interest at the prime rate; payable in monthly                                      
  installments of $34,652 plus accrued interest, due in January 2002.             $519,119        $103,233  

Asset loans, bearing interest at annual interest rates ranging from 7.9% to                                 
  10.46%; due in aggregate monthly payments of $1,303 and $139 due through                                  
  August 2002 and January 2002, respectively, secured by certain assets of                                  
  the Company                                                                       27,768          11,752  
                                                                             -------------------------------
                                                                                   546,887         114,985  

Less current portion                                                               431,597         114,985  
                                                                             -------------------------------
Notes payable, long-term                                                          $115,290   $           -  
                                                                             ===============================

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.  Bank Lines of Credit and Notes Payable (continued)                          

Receivable Financing Program                                                    

In December 1999, the Company entered a Short Term Accounts Receivable Financing
Program  with one of its  vendors.  Under the terms of the  program,  the vendor
extended  credit  to the  Company  for  specific  pre-approved  sales  orders in
exchange for the  assignment of the associated  receivable  once the product was
delivered to the  customer.  During fiscal 2000 and 2001,  the Company  assigned
approximately $1.56 million and $0,  respectively of specific  receivables under
the  program.  As of  October  31,  2000 and 2001  there  were  $112,000  and $0
uncollectible receivables assigned under this agreement.                        

6.  Commitments                                                                 

Operating Leases                                                                

The  Company  leases  office  space  for  its  corporate  headquarters  under  a
noncancelable  operating  lease  agreement.  The lease  agreement was renewed in
October  1999 and expires in February  2005.  Additionally,  the Company  leases
various office equipment and other office space under  non-cancelable  operating
leases. Rent expense under all leases was approximately  $321,000,  $330,147 and
$284,000 for the years ended October 31, 1999, 2000, and 2001, respectively.    

Future minimum lease payments under  noncancelable  operating leases,  including
the leases assumed in the STMS and IDP acquisitions,  at October 31, 2001 are as
follows:                                                                        

         2002                                                686,804
         2003                                                628,546
         2004                                                401,259
         2005                                                 91,554
                                                        ------------------
         Total                                            $1,808,163
                                                        ==================

The Company will receive  $749,661 in aggregate  sublease  income through fiscal
2003.                                                                           

7.  Employment Agreements                                                       

The Company has an  employment  agreement  with Thomas P. Dunne,  the  Company's
Chairman and Chief Executive Officer.  The agreement for Mr. Dunne has a term of
three years  commencing April 1997 and  automatically  renews for additional one
year terms unless terminated by either the Company or the employee.             

All other  employment  agreements  the company had with  certain key  executives
expired in September 2000.                                                      

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8.  Stockholders' Equity                                                        

Equity Transactions                                                             

On March 3, 2000, the Company executed a settlement for a judgment in favor of a
former  employee  relating  to an  employment  contract.  Under the terms of the
settlement,  the Company paid $1 million and issued 225,000 shares of its common
stock to the former employee.                                                   

On March 13, 2000,  the Company  sold 3,000  shares of its Series A  Convertible
Preferred  Stock in a  private  placement,  which is  exempt  from  registration
provided by Regulation D Rule 506  promulgated  by the  Securities  and Exchange
Commission  under the Securities Act of 1933, as amended.  The Company  received
net proceeds of approximately  $2.7 million,  which was used to fund current and
future  operations.  In addition,  the Company issued  warrants to the preferred
investor and the broker of the  transaction  in the amount of 247,525 and 75,000
to purchase  shares of the Company's  common stock at $3.64 and $4.57 per share,
respectively. The warrants expire on March 13, 2005.                            

The holders of the preferred shares were entitled to cumulative  dividends of 5%
of the  liquidation  preference  of $1,000  per share  plus  accrued  but unpaid
dividends  whether or not  declared.  For fiscal  year 2000 and 2001 the Company
accrued  dividend of $95,417 and $112,500,  respectively and $91,000 and $0 were
accrued and unpaid as of October 31, 2000 and 2001, respectively. Each holder of
preferred  shares was entitled to voting rights equal to the number of shares of
common stock into which such preferred shares were convertible.                 

The Series A Convertible  Preferred Stock were  convertible at the  shareholders
option into common  stock at the price equal to the lesser of 85% of the average
of the three lowest closing bid prices of the common stock for the 25 days prior
to the conversion  date or $3.64.  In fiscal year 2000,  the Company  recorded a
non-cash deemed dividend of $529,411 for the beneficial  conversion feature. The
transaction  was  reported  as  "Dividend  to  Preferred  Stockholders"  on  the
Company's 2000 Consolidated Statement of Operations.                            

In  August  2001,  the  Company  completed  a  transaction  with  its  Preferred
Shareholders  to redeem all of its  outstanding  Series A Convertible  Preferred
stock for  $2,500,000 in cash.  Under the  redemption  agreement,  the Preferred
Shareholders  retained  approximately  247,000 warrants  previously issued. As a
result of the transaction,  the Company recorded an increase to income available
to common  stockholders  of  $721,816,  representing  the excess of the carrying
value of the preferred  stock plus the beneficial  conversion  feature  discount
over the repurchase price.                                                      

Stock Options                                                                   

On January 6, 1997,  the Company  adopted the 1997 Stock Option Plan (the Option
Plan)  which  permits the  Company to grant up to 600,000  options to  officers,
directors and employees who contribute materially to the success of the Company.
In September  1997,  the Company  increased the number of options  available for
grant  under the plan to  2,200,000.  In June 1999,  the Company  increased  the
number of options available for grant under the plan to 2,500,000. Stock options
are generally granted at prices which the Company's Board of Directors  believes
approximates the fair market value of its common stock at the date of grant. The
options vest ratably over a stated period of time not to exceed four years.  The
contractual term of the options is five years.                                  

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8.  Stockholders' Equity (continued)                                            

Stock Options (continued)                                                       

Common stock option activity was as follows:                                    

                                                                [Download Table]

                                                    Weighted-Average   
                                      Shares         Exercise Price    
                                  -------------------------------------
                                                                       
 Outstanding at October 31, 1998       2,495,817        $6.70          
   Options granted                       413,000         2.87          
   Options canceled or expired        (1,026,384)        5.56          
                                  -------------------------------------
 Outstanding at October 31, 1999       1,882,433        $5.22          
   Options granted                     1,147,000         1.26          
   Options exercised                      (4,900)        3.13          
   Options canceled or expired          (582,600)        2.74          
                                  -------------------------------------
 Outstanding at October 31, 2000       2,441,933        $3.95          
   Options granted                       984,000         0.74          
   Options canceled or expired          (387,599)        3.20          
                                  -------------------------------------
Outstanding at October 31, 2001        3,038,334         3.01          
                                  -------------------------------------
 Exercisable at October 31, 2001       1,126,167        $1.10          
                                  =====================================

The total options  outstanding include 600,000 options granted to the former IDP
stockholders that are not included in the Option Plan.                          

As of October 31, 2001,  there were 61,666  options  available for future grants
under the Option Plan.                                                          

During  fiscal 1999,  the Company  repriced  certain  stock  options  granted to
certain  executives in accordance with their  employment  agreements,  of which,
approximately  547,000 remain  outstanding at October 31, 2001. No  compensation
expense has been  recognized as the exercise price for the repriced  options was
at or  above  fair  market  value  of the  underlying  stock  at the end of each
reporting period subsequent to June 30, 2000.                                   

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8.  Stockholders' Equity (continued)                                            

Stock Options (continued)                                                       

The following  table  summarizes  information  about  fixed-price  stock options
outstanding at October 31, 2001:                                                

                                                                [Download Table]

                                                     Average        Weighted-    
                                                    Remaining        Average     
Range of Exercise Prices         Number            Contractual       Exercise    
                               Outstanding            Life            Price      
                          -------------------------------------------------------
                                                                                 
$0.55-$1.75                       1,736,500           4.50             $0.97     
$2.00-$4.50                         701,834           5.92              3.16     
$5.00-$8.75                         600,000           7.00              8.75     
                          -------------------------------------------------------
$0.55-$8.75                       3,038,334           4.99             $3.01     
                          =======================================================

Had  compensation  expense related to the stock options been determined based on
the fair  value at the grant date for  options  granted  during the years  ended
October 31, 1999, 2000, and 2001 consistent with the provisions of SFAS 123, the
Company's net income and earnings per share would have been as follows:         

                                                        [Enlarge/Download Table]

                                                        Year ended October 31,                  
                                         ------------------------------------------------------ 
                                               1999               2000              2001        
                                         -------------------------------------------------------
                                                                                                
Net income (loss)  - pro forma             $(34,865,823)        $(491,904)          $503,444    
Net income (loss) per share - pro forma         $ (3.71)           $(0.05)             $0.05    
Net income (loss) per share - assuming                                                          
 dilution pro forma                             $ (3.71)          $ (0.05)           $ (0.01)   


The effect of applying  SFAS 123 on pro forma net income as stated  above is not
necessarily  representative  of the  effects on  reported  net income for future
years due to, among other  things,  the vesting  period of the stock options and
the fair value of additional options in the future years.                       

The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes  option-pricing  fair  value  model with the  following  weighted-
average  assumptions  used for grants in 1999, 2000 and 2001:  dividend yield of
0%, expected  volatility of .86, 1.59 and 1.52 respectively;  risk-free interest
rates of 6.70%,  6.01% and 4.50%  respectively;  and expected life of the option
term of five years.  The weighted  average fair values of the options granted in
1999,  2000 and 2001 with a stock  price equal to the  exercise  price is $2.02,
$1.26 and $0.74 respectively.                                                   

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9.  Income Taxes                                                                

Deferred  income  taxes  reflect  the net tax effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and the amounts used for income tax purposes.                          

Components of the Company's net deferred tax asset balance are as follows:      

                                                                [Download Table]

                                                 October 31,             
                                     ------------------------------------
                                           2000              2001        
                                     ------------------------------------
                                                                         
Deferred tax asset:                                                      
   Accrued expenses                     $   776,714      $   401,752     
   Net operating loss carryforwards       4,834,470        3,052,019     
   Depreciation                              26,469          540,680     
   Asset reserves                           648,318          284,617     
   Other                                     52,339           69,539     
                                     ------------------------------------
Total deferred tax asset                  6,338,310        4,348,607     
                                     ------------------------------------
Deferred tax credit:                                                     
   Acquisition of intangible assets               -                -     
   Depreciation                                   -                -     
   Valuation allowance                   (5,011,565)      (4,348,607)    
                                     ------------------------------------
Net deferred tax asset                   $1,326,745      $         -     
                                     ====================================

As of October  31,  2001,  the  Company had  approximately  $7.9  million in net
operating loss carryforwards  which expire between 2012 and 2020.  Approximately
$1.3 million of those net operating  loss  carryforwards  relate to STMS and IDP
and may be  significantly  limited  under  Section 382 of the  Internal  Revenue
Service  Code and the SRLY  rules.  The Company  has  recorded a full  valuation
allowance for the deferred tax assets because  realizability  of those assets is
uncertain.                                                                      

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9.  Income Taxes (continued)                                                    

The components of the provision for income taxes are as follows:                

                                                        [Enlarge/Download Table]

                                                              Years ended October 31,              
                                                 --------------------------------------------------
                                                      1999            2000             2001        
                                                 --------------------------------------------------
                                                                                                   
Current tax expense (benefit):                                                                     
  Federal                                              $(974,781)    $        -      $    27,400   
  State                                                 (213,975)             -                -   
                                                 --------------------------------------------------
                                                      (1,188,756)             -           27,400   

Deferred tax expense:                                                                              
  Federal                                                535,500         49,000           58,032   
  State                                                   94,500         16,000           19,344   
                                                 --------------------------------------------------
                                                         630,000         65,000           77,376   
                                                 --------------------------------------------------
Total provision for (benefit from) income taxes        $(558,756)    $   65,000      $   104,776   
                                                 ==================================================

The reconciliation of income tax from the Federal statutory rate of 34% is:     

                                                        [Enlarge/Download Table]

                                                         Years ended October 31,                
                                          ------------------------------------------------------
                                                   1999              2000              2001     
                                          ------------------------------------------------------
                                                                                                
Tax at statutory rates:                       $(11,536,368)       $  49,089        $  380,291   
Non-deductible expenses                          7,277,936           68,966           145,641   
Valuation allowance and other                    4,278,322          (69,097)         (492,621)  
State income tax, net of federal benefit          (578,646)          16,042            71,465   
                                          ------------------------------------------------------
                                                 $(558,756)       $  65,000        $  104,776   
                                          ======================================================

In September 1997 and in May 1998, respectively,  the Company acquired the stock
of STMS and IDP in tax-free exchanges. The stock acquisitions were accounted for
using the purchase method.  Deferred tax assets include  differences between the
assigned values and tax bases of the assets and liabilities acquired, as well as
net operating  loss  carryforwards  acquired.  To the extent these  deferred tax
assets are subsequently  realized,  the resulting tax benefit will be applied to
reduce goodwill  recorded in connection with the  acquisitions and there will be
no impact on income tax expense.                                                

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10.  Retirement Plans                                                           

401(k) Plans                                                                    

The Company maintains a 401(k) (the "Plan") for all current employees. Under the
Plan,  employees are eligible to participate after completing 90 days of service
and  attaining  the age of 18.  Employees  can defer up to 15% of  compensation.
Employee contributions are subject to Internal Revenue Service limitations.  All
employees  who  contributed  to the Plan are eligible to share in  discretionary
Company  matching  contributions.  Company  contributions  vest over 5 years. In
fiscal 2000 and 2001, the Company contributed  approximately $18,000 and $60,000
to the participants of the 401(k), respectively.                                

Defined Benefit Plan                                                            

On October 31, 1999,  the Company  amended and  terminated  its Defined  Benefit
Plan. Under the termination,  no additional  benefits accrued to participants in
the Plan after that date.  In addition,  all existing  participants  in the Plan
became 100%  vested in their  accrued  benefits in the Plan as of that date.  No
gain or loss was recognized as a result of the  termination of the Pension Plan.
The Company  began to  distribute  the vested  benefits to the  participants  in
fiscal year 2000 and completed the distributions is fiscal 2001.                

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11.  Earnings Per Share                                                         

The following table sets forth the computation of basic and diluted earnings per
share:                                                                          

                                                        [Enlarge/Download Table]

                                                                Years ended October 31,                 
                                                 -------------------------------------------------------
                                                        1999              2000               2001       
                                                 -------------------------------------------------------
                                                                                                        
Numerator:                                                                                              
   Net income (loss) before extraordinary gain       $(33,607,145)        $50,665         $1,013,726    
   Preferred Stock dividends                                    -        (624,828)          (112,500)   
   Redemption of preferred stock                                -               -            721,816    
   Cumulative effect of change in accounting                                                            
     principle                                                  -               -           (576,001)   
                                                 -------------------------------------------------------
   Net (loss) income available to common                                                                
     stockholders before extraordinary gain           (33,607,145)       (574,163)         1,047,041    
                                                 =======================================================

Denominator:                                                                                            
Denominator for basic earnings per share-                                                               
  weighted-average shares                               9,403,775       9,580,112         10,111,364    
Effect of dilutive securities:                                                                          
   Employee stock options                                       -               -             36,899    
   Convertible preferred stock                                  -               -          2,314,969    
                                                 -------------------------------------------------------
   Dilutive potential common shares                             -               -          2,351,868    
                                                 -------------------------------------------------------
 Denominator for diluted earnings per share -                                                           
   adjusted weighted-average shares and assumed                                                         
   conversions                                          9,403,775       9,580,112         12,463,232    
                                                 -------------------------------------------------------

Earnings per share before extraordinary gain,                                                           
  basic:                                                  $ (3.57)        $ (0.06)            $ 0.10    
                                                 =======================================================

Earnings per share before extraordinary gain,                                                           
  diluted:                                                $ (3.57)        $  (.06)            $ 0.08    
                                                 =======================================================

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12.  Contingencies                                                              

IDP Acquisition                                                                 

On July 31,  1998 the Company  received  notice from the SBA that it was denying
the request of the U.S. Air Force to waive the  requirement  to terminate  IDP's
Desktop V contract  for the  convenience  of the  Government  upon the change in
control of IDP to the Company. The Company appealed the denial by the SBA to the
SBA's  Office of Hearings and  Appeals.  On August 31, 1999,  the SBA denied the
appeal and ruled  that the U.S.  Air Force  must  terminate-for-convenience  the
Desktop V contract.  Under a  termination-for-convenience,  the Government shall
reimburse the Company for all costs incurred in the performance of the contract.
The  Company  expects to  recover  from the  Government  a portion or all of its
unreimbursed costs. The Company is currently in negotiations with the Government
regarding this matter.                                                          

Microsoft Licensing Agreement                                                   

In November  1998,  IDP  entered  into a  Government  Integrator  Agreement,  as
amended,  with Microsoft  Corporation  (Microsoft)  for the licensing of certain
Microsoft software.  During 1999, Microsoft asserted that IDP owed approximately
$800,000  under this  agreement  due  primarily to amended  billing by Microsoft
concerning  sales by IDP to the U.S. Air Force in conjunction with the Desktop V
contract. On October 31, 2000, Microsoft filed suit against the Company, and its
subsidiary  IDP, for breach of contract.  In conjunction  with the filing of the
claim,  Microsoft  further  amended the original  billings,  which resulted in a
claim against the Company of approximately  $1.3 million.  Subsequent to October
31,  2000,  the  Company  submitted  a motion  to  dismiss  the case and filed a
counterclaim  of fraud on behalf of IDP in the amount of  $500,000.  The Company
believes that it has meritorious defenses to the claim and intends to vigorously
defend  itself.  The  Company  cannot  estimate  at this time the  amount of the
liability to be incurred,  if any. In the event the Company is not successful in
its defense and a judgment is entered on behalf of Microsoft for the full amount
sought,  the payment  would have a material  adverse  effect upon the  Company's
financial  position  and  results of  operations.  The  Company  has accrued for
amounts due Microsoft based on the original billing terms. On February 20, 2001,
the Court ruled in favor of SteelCloud  thereby  dismissing that entity from the
claim. The Company will continue to vigorously  defend its subsidiary,  IDP, for
which it believes to have meritorious defenses.                                 

Trademark Infringement                                                          

On October  19,  2000,  the  Company  received a cease and  desist  letter  from
LoudCloud,  Inc.  alleging that the use of the "SteelCloud"  mark and name would
constitute an  infringement of LoudCloud's  rights to its  "LoudCloud"  mark and
name and family of "Cloud"  marks,  that use of  "SteelCloud"  would  dilute the
distinctiveness  and fame of the LoudCloud  mark and name and, that such acts by
the Company  violated  federal and state law regarding  unfair  competition.  In
response,  the Company filed a declaratory  judgment action in the U.S. District
Court for the Eastern  District of  Virginia,  seeking a judicial  determination
that its use of the "SteelCloud" mark and name would not violate the proprietary
rights of  LoudCloud  nor dilute the  alleged  fame and  distinctiveness  of the
"LoudCloud" mark and name. In this action,  the Company also alleged a new claim
that  LoudCloud,  Inc.  has  violated  federal  law  through  its  misuse of the
trademark provisions under the Lanham Act as amended in 1988. A hearing has been
held on the LoudCloud motion to dismiss and the court has taken the matter under
advisement.  On  January  10,  2001,  the U.S.  District  Court for the  Eastern
District of Virginia dismissed the case. The Company has appealed such decision.
The  Company  cannot  estimate  at this time the amount of the  liability  to be
incurred,  if any,  but does not  believe  that this matter will have a material
adverse effect upon the Company's financial position or results of operations.  

Professional Services Malpractice Claim                                         

In August of 2000, the Company's  former legal counsel filed a claim against the
Company for  approximately  $343,087  plus  accrued  interest for legal fees and
costs.  In  response  to the  claim,  the  Company  filed a  counter  claim  for
professional  malpractice  and  breach  of  fiduciary  duty  in  the  amount  of
$1,568,000.  In June 2001, the Company  reached a settlement  agreement with its
former  legal  counsel  whereby  both parties  agreed to  relinquish  all claims
against the other,  release each other from  liability  and waive the payment of
outstanding  claims.  The Company  reversed the  liability  that was  previously
accrued  for the legal  fees and  costs,  reducing  general  and  administrative
expenses for fiscal 2001 by $343,087.                                           

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

13.       Quarterly Financial Information (unaudited)                           

Quarterly  financial  information  for fiscal 2001 and 2000 is  presented in the
following tables:                                                               

                                                        [Enlarge/Download Table]

                                          Previously     Restated                                                  
                                           Reported        1st            2nd             3rd            4th       
                                         1st Quarter    Quarter(1)      Quarter         Quarter        Quarter     
                                         ------------- ------------- --------------- -------------- ---------------
                                                                                                                   
2001                                                                                                               
----                                                                                                               
Revenue                                    $7,188,899    $7,188,899      $7,328,384     $7,203,426      $8,417,670 
Gross Profit                                1,748,338     1,748,338       1,808,880      1,904,110       2,167,073 
Net income (loss) available to common                                                                              
shareholders                                   69,722      (506,279)        129,590        506,330         917,400 

Per Share Data                                                                                                     
--------------                                                                                                     
Net income (loss)                                                                                                  
Basic                                            0.01         (0.05)           0.01           0.05            0.09 
Diluted                                          0.01         (0.05)           0.01           0.04            0.02 

2000                                                                                                               
----                                                                                                               
Revenue                                    $7,128,063                   $10,602,548    $10,328,950     $11,706,832 
Gross Profit                                1,481,318                     2,007,347      1,797,071       1,844,247 

(Loss) income before extraordinary item      (589,298)                     (240,744)       228,065         171,154 
Extraordinary item                            750,000                             -              -               - 
Net income (loss) available to common                                                                              
shareholders                                  160,702                      (288,667)       190,565         113,237 

Per Share Data                                                                                                     
--------------                                                                                                     
Loss (income) before extraordinary item         (0.06)                        (0.03)          0.02            0.01 
Net income (loss), basic and diluted             0.02                         (0.03)          0.02            0.01 

(1)      The Company has restated its results for the quarter ended  January 31,
         2001 to reflect  the implementation of  Emerging Issues  Task Force No.
         00-27 as of  November 1, 2000. As discussed in  Note 2 to the financial
         statements, the  implementation of  Issue 1 of EITF 00-27  modified the
         calculation of the  beneficial conversion  feature discount  associated
         with   the   Company's  Series  A  Convertible  Preferred  Stock.   The
         implementation of  EITF 00-27 resulted in a charge of $576,001 or $0.06
         per share,  reflected as a cumulative effect of a  change in accounting
         principle.  The restatement had  no effect  on income  from operations,
         cash flows or  net stockholders' equity as of and for the quarter ended
January 31, 2001.                                             

F-24

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REPORT OF ERNST & YOUNG, LLP, INDEPENDENT AUDITORS

The Board of Directors                                                          
SteelCloud, Inc.                                                                

We have audited the  consolidated  financial  statements of SteelCloud,  Inc. (a
Virginia corporation) as of October 31, 2000 and 2001, and for each of the three
years in the period  ended  October 31, 2001 and have issued our report  thereon
dated  December 21, 2001,  except for Note 5 as to which the date is January 18,
2002  (included  elsewhere  in this Form  10-K).  Our audits also  included  the
consolidated  financial  statement schedule listed in Item 14 of this Form 10-K.
The  schedule  is  the   responsibility   of  the  Company's   management.   Our
responsibility is to express an opinion based on our audits.                    

In our opinion, the consolidated financial statement schedule referred to above,
when considered in relation to the basic consolidated financial statements taken
as a whole, presents fairly in all material respects,  the information set forth
herein.                                                                         

 /s/ Ernst & Young LLP

McLean, Virginia                                                                
December 21, 2001                                                               

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 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
STEELCLOUD, INC.

                                                        [Enlarge/Download Table]

                                                                Balance at                               Balance  
                                                               Beginning of                             at End of 
Classification                                                     Year      Additions   Deductions        Year   
--------------                                                     ----      ---------   ----------        ----   
                                                                                                                  
Allowance for doubtful accounts:                                                                                  
Year ended October 31, 1999...................................      $46,000  $1,400,000  $1,346,000(1)    $100,000
Year ended October 31, 2000...................................     $100,000          $0          $0       $100,000
Year ended October 31, 2001...................................     $100,000     $12,000          $0       $112,000

Inventory reserve:                                                                                                
Year ended October 31, 1999...................................     $250,000  $2,241,000    $362,000(2)  $2,129,000
Year ended October 31, 2000...................................   $2,129,000          $0    $575,000(2)  $1,554,000
Year ended October 31, 2001...................................   $1,554,000    $120,000    $466,438(2)  $1,207,562


-----------                                                                     

(1)      Write-offs of accounts receivable                                      

(2)      Write-offs of inventory                                                

S-1 

Dates Referenced Herein   and   Documents Incorporated by Reference

				Referenced-On Page
This ‘10-K’ Filing		Date		First		Last			Other Filings
		3/13/05		36
Changed as of / Corrected on:		6/23/04
		10/31/03		31					10-K,  4
		3/31/03		15		34
		3/31/02		4
		2/28/02		34					DEF 14A
Filed on:		1/29/02		19
		1/28/02		1		9
		1/23/02		6
		1/18/02		18		45
		1/1/02		16
		12/31/01		15
		12/21/01		21		45
		12/15/01		31
For Period End:		10/31/01		1		46
		8/8/01		18					8-K
		7/30/01		26
		7/1/01		31
		6/30/01		31
		5/15/01		3		26			DEF 14A,  PRE 14A
		2/20/01		43
		1/31/01		44					10-Q
		1/10/01		7		43
		11/1/00		44
		10/31/00		7		46			10-K405
		10/19/00		3		43
		9/25/00		3		26
		6/30/00		37					S-1/A
		3/13/00		36
		3/3/00		36
		2/11/00		18
		12/31/99		16		33
		12/29/99		18
		11/8/99		33
		10/31/99		11		46			10-K,  10-K/A,  NT 10-K
		8/31/99		7		43
		5/27/99		18
		5/1/99		7		13
		10/31/98		11		24			10-K,  10-K/A,  NT 10-K
		7/31/98		7		43			10-Q
		5/1/98		10		26
		4/23/98		17		18
		3/5/98		17
		2/26/98		3		26
		2/25/98		17
		1/30/98		18
		10/31/97		11		13
		9/12/97		11
		7/23/97		18
		5/5/97		18
		4/22/97		3		9
		4/4/97		18
		2/7/97		18
		1/6/97		36
		1/3/97		26
		7/15/94		18
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