Certain statements contained herein may constitute forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act and 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, concentration of revenue from one source, competitors with broader product lines and greater resources, emergence into new markets, the termination of any of our significant contracts or partnerships, our inability to maintain working capital requirements to fund future operations or our inability to attract and retain highly qualified management, technical and sales personnel.

You should read the following discussion and analysis in conjunction with the audited Financial Statements and Notes attached thereto, and the other financial information appearing elsewhere in this Annual Report.

Overview

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

For ISV customers, we design, manufacture and integrate low-maintenance servers (called "appliances" in this market) so ISVs can make their software product easier to deploy and support, more competitive and open new markets by delivering their application software on fully-integrated, ready-to-use appliances.

In addition, we serve information technology end users directly, in both the public and private sectors, with products and services focused on IT centric solutions. Our IT centric solutions include our appliance servers, products from our strategic partners along with our consulting services.

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

Fiscal Year 2008

Significant Customer Contract

During fiscal year 2008, we were awarded a contract by a major Federal Integrator. The contract called for us to supply ruggedized systems. Over the seven month contract engagement, during fiscal year 2008, we produced approximately 2,650 units and recognized approximately $7.8 million of revenue associated with this contract.

Launching of SteelWorks Mobile

In 2008, we launched our SteelWorks Mobile and SteelWorks FedMobile appliance solutions. As an extension of our ISV business, we developed an appliance solution specifically for the Blackberry Enterprise Server ("BES"). Developed in conjunction with Research in Motion ("RIM"), we believe the BES appliance solution is the single best way to implement the Blackberry Enterprise Server software environment. SteelWorks Mobile is an integrated server appliance that enables virtually any size organization to implement the BES at a fraction of the cost, time and resource commitment. We have filed for three patents for the appliance related to the technology we created for the installation wizard, backup and restore features. These patents are currently pending approval from the U.S. Patent and Trademark office.

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

Joint Venture

In October 2008, we created a joint venture in the United Arab Emirates (UAE) region with XSAT. SteelCloud MEA, LLC (Middle East, Africa) the newly formed joint venture company, is jointly owned, 20% by XSAT and 80% by SteelCloud. Under the terms of the joint agreement, XSAT will provide a local presence for our products to its customers within the UAE region. XSAT will also provide warranty and support for the products sold within that region.

Services Business Growth and Focus

In fiscal 2008, we increased our focus on our professional services business. We currently serve customers primarily in the metropolitan Washington DC market but will look to expand that territory in fiscal 2009. We are increasing our expertise within the Microsoft Exchange and SharePoint markets. We believe that the number of professional services opportunities related to these two services will greatly expand in the near future (fiscal 2009 and beyond). As such, we have begun to develop and cultivate this expertise.

In addition, we have won contracts with National Zoo, Blue Cross Blue Shield Association, Graduate Management Admissions Council and WMATA. We anticipate further expansion of the professional services business in fiscal 2009.

Critical Accounting Policies

The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles requires management to make certain judgments, estimates and assumptions that could affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. We based our estimates and assumptions on historical experience and on various other assumptions believed to be applicable, and evaluated them on an on-going basis to ensure they remained reasonable under current conditions. Actual results could differ significantly from those estimates.

The significant accounting policies used in the preparation of our financial statements are described in Note 3 "Significant Accounting Policies" to our Financial Statements. Some of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that has both a material impact on our financial condition and results of operations and requires us to make difficult, complex and/or subjective judgments, often as a result of the need to make estimates about matters that are inherently uncertain.

We believe that the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

We recognize revenue in accordance with the SEC Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements, corrected copy" ("SAB 104"). Generally, SAB 104 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) collectability is reasonably assured.

Effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, we have adopted Emerging Issues Task Force Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables" ("EITF 00-21"). Issued in December 2002 by the Financial Accounting Standards Board ("FASB"), EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF 00-21 does not change otherwise applicable revenue recognition criteria. In the event we enter into a multiple element arrangement and there are undelivered elements as of the balance sheet date, we assess whether the elements are separable and have determinable fair value in determining the amount of revenue to record.

We recognize revenue associated with the resale of maintenance contracts on a net basis in accordance with Emerging Issues Task Force Issue No 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent" ("EITF 99-19"), and interpretations thereof.

We derive our revenue from the following sources: product sales, information technology support services, software license as a reseller and support sales and software training and implementation services.

For product sales where title transfers upon shipment and risk of loss transfers to our customer, we generally recognize revenue at the time of shipment. For product sales where title and risk of loss transfers upon destination, we generally recognize revenue when products reach their destination. 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 ranging from one to three years. We accrue an estimated warranty reserve in the period of sale to provide for estimated costs associated with providing warranty services.

In October 2008 we began delivering our appliance solution specifically developed for Blackberry Enterprise Servers ("BES"). This solution is bundled hardware-software system and subject to American Institute of Certified Public Accountants' Statement of Position ("SOP") 97-2, "Software Revenue Recognition," as modified by SOP 98-9, "Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions." Our software does not require significant modification and customization services. We do not have vendor-specific objective evidence ("VSOE") of fair value for our software. Accordingly, when the software is sold in conjunction with the Company's hardware, software revenue is recognized upon delivery of the hardware.

For services revenue under time and material contracts, we recognize revenue as services are provided based on the hours of service at stated contractual rates.

We incur shipping and handling costs, which are recorded in cost of revenues.

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

Equity-Based Compensation

We adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), "Share-Based Payment" ("SFAS No. 123R") on November 1, 2005. Issued in December 2004 by the FASB, SFAS No. 123R requires that the fair value compensation cost relating to share-based payment transactions be recognized in financial statements. Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized over the employee's requisite service period. The fair value of the stock options and employee stock purchase plan ("ESPP") awards was estimated using a Black-Scholes option valuation model. This model requires the input of highly subjective assumptions and elections in adopting and implementing SFAS No. 123R, including expected stock price volatility and the estimated life of each award. The fair value of equity-based awards is amortized over the vesting period of the award and we have elected to use the straight-line method for amortizing our stock option and ESPP awards. We adopted the modified prospective transition method as provided by SFAS No. 123R and compensation costs for all awards granted after the date of adoption and the unvested portion of previously granted awards outstanding are measured at their estimated fair value.

Income Taxes

We recognize deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of certain assets and liabilities. A valuation allowance is established, as necessary, to reduce deferred income tax assets to an amount expected to be realized in future periods. We determine our valuation allowance pursuant to the provisions of FASB Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," which requires us to weigh all positive and negative evidence including past operating results and forecasts of future taxable income. In assessing the amount of the valuation allowance as of October 31, 2007 and 2008, we considered, in particular, our forecasted taxable income for the upcoming fiscal year, current backlog of orders, including those recently received, and other significant opportunities currently in our sales and marketing pipeline with a high probability of generating revenues. Based upon this review, we have continued to fully reserve for all deferred tax assets as of October 31, 2008.

We adopted the provisions of FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109" ("FIN 48"), on November 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109, "Accounting for Income Taxes". It prescribes that a company should use a more-likely-than-not recognition threshold based on the technical merits of the tax position taken. Tax positions that meet the more-likely-than-not recognition threshold should be measured as the largest amount of the tax benefits, determined on a cumulative probability basis, which is more likely than not to be realized upon effective settlement in the financial statements. Our unrecognized tax benefits at October 31, 2008 are approximately $61,000, which includes approximately $49,000 of unrecognized tax benefits for windfall tax benefits from stock options exercised that are not recognized under SFAS 123R. During the year ended October 31, 2008, we increased our unrecognized tax benefits by approximately $100,000 due to windfall benefits from stock options exercised and additional exposures identified during the year. We reduced our unrecognized tax benefits by approximately $654,000 by adjusting our NOL carryforwards and making an automatic change in accounting method. Both of these adjustments were made with the filing of our income tax return for the tax year ended October 31, 2007. We have a valuation allowance against the full amount of our net deferred tax assets and therefore the adoption of FIN 48 had no impact on our retained earnings. The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate is $0.

We conduct business in the U.S. and are subject to U.S. taxes. As a result of our business activities, we file tax returns that are subject to examination by the respective federal and state tax authorities. For income tax returns filed by us, we are no longer subject to U.S. federal, or state tax examination by tax authorities for years before the tax year ended October 31, 2005, although significant net operating loss carryforward tax attributes that were generated prior to the tax year ended October 31, 2005 may still be adjusted upon examination by tax authorities if they either have been or will be utilized. Our accounting policy is to recognize interest and penalties related to income tax matters in general and administrative expense. We have $0 accrued for interest and penalties as of October 31, 2008.

Inventory

Inventory consists of materials and components used in the assembly of our products or maintained to support maintenance and warranty obligations and are stated at the lower of cost or market using actual costs on a first-in, first-out basis. We maintain a perpetual inventory system and continuously record the quantity on-hand and actual cost for each product, including purchased components, subassemblies and finished goods. We maintain the integrity of perpetual inventory records through periodic physical counts of quantities on hand. Finished goods are reported as inventory until the point of title transfer to the customer. Generally, title transfer is documented in the terms of sale. When the terms of sale do not specify, we assume title transfers when it completes physical transfer of the products to the freight carrier unless other customer practices prevail.

We periodically evaluate our inventory obsolescence to ensure inventory is recorded at its net realizable value. Our policy is to assess the valuation of all inventories, including manufacturing raw materials, work-in-process, finished goods and spare parts in each reporting period. Inherent in managements estimates of excess and obsolete inventory are management's forecasts related to our future manufacturing schedules, customer demand, technological and/or market obsolescence and possible alternative uses. If future customer demand or market conditions are less favorable than our projections, additional inventory write-downs may be required, and would be reflected in cost of sales in the period the revision is made.

Warranty

Typically, the sale of our specialized servers includes providing parts and service warranties to customers as part of the overall price of the systems. We offer warranties for our systems that typically cover a period of one to three years that commences upon shipment of the system to the customer. When appropriate, we record a reserve for estimated warranty expenses to cost of sales for each system upon revenue recognition. The amount recorded is based on an analysis of historical activity. All actual parts and labor costs incurred in subsequent periods are charged to the established reserves.

Actual warranty expenses are incurred on a system-by-system basis, and may differ from our original estimates. While we periodically monitor the performance and cost of warranty activities, if actual costs incurred are different than our estimates, we may recognize adjustments to the reserve in the period in which those differences arise or are identified.

In addition to standard warranties, we offer customer-paid extended warranty services. Revenues for extended maintenance and warranty services with a fixed payment amount are recognized on a straight-line basis over the term of the contract.

Segment Reporting

FASB Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"), establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. SFAS No. 131 also establishes a quantitative threshold, whereby an enterprise should report separately information about an operating segment if its reported revenue is 10 percent or more of the combined revenue of all reported operating segments. We are organized on the basis of products and services. Our chief operating decision maker is our Chief Executive Officer. While the Chief Executive Officer is apprised of a variety of financial metrics and information, the Chief Executive Officer makes decisions regarding how to allocate resources and assess performance based on a single operating unit.

Recently Issued Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS No. 157 provides a common definition of fair value and establishes a framework to make the measurement of fair value in U.S. Generally Accepted Accounting Principles more consistent and comparable. SFAS No. 157 also requires expanded disclosures to provide information about the extent to which fair value is used to measure assets and liabilities, the methods and assumptions used to measure fair value, and the effect of fair value measures on earnings. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Therefore, we are required to adopt SFAS No. 157 in the first quarter of 2009. We do not believe the provisions of SFAS 157 will have a material impact on our financial statements.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115" ("SFAS No. 159"). SFAS No. 159 provides a choice to measure many financial instruments and certain other items at fair value and requires disclosures about the election of the fair value option. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. Therefore, we are required to adopt SFAS No. 159 in the first quarter of 2009. We do not believe the provisions of SFAS 159 will have a material impact on our financial statements.

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

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

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

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

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

Fiscal Year Ended October 31, 2008 Compared to Fiscal Year Ended October 31, 2007

Net Revenue Discussion:

The following table summarizes our net revenue for the fiscal years ended
October 31, 2007 and 2008 in dollars and as a percentage of net revenues.

                                                      Fiscal Year Ended October 31,
                                  2007                           2008                     Increase (decrease)
                                        % of Net                       % of Net
                         Dollars        Revenues        Dollars        Revenues        Dollars         Percentage

Products               $ 21,421,129         91.87 %   $ 16,333,600         85.88 %   $ (5,087,529 )         (23.75 )%
Services                  1,894,551          8.13 %      2,685,296         14.12 %        790,745            41.74 %
Total net revenues     $ 23,315,680        100.00 %   $ 19,018,896        100.00 %   $ (4,296,784 )         (18.43 )%

The decrease in product revenue is primarily attributable to a decrease in our . . .