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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the transition period from        to        

Commission File Number 0-22229

VITAL IMAGES, INC.

(Exact name of registrant as specified in its charter)

(952) 487-9500

(Registrant’s telephone number, including area code)

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  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o   No  o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o   No  x

On May 4, 2009, there were 14,380,334 shares of the Registrant’s common stock, par value $.01 per share, outstanding.

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Vital Images, Inc.
Form 10-Q
March 31, 2009

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Part I. Financial Information

Item 1.    Financial Statements

Vital Images, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except per share amounts)
(Unaudited)

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

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Vital Images, Inc.

Condensed Consolidated Statements of Operations

(In thousands, except per share amounts)
(Unaudited)

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

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Vital Images, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)
(Unaudited)

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

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Vital Images, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.           Basis of presentation

The accompanying unaudited Condensed Consolidated Financial Statements of Vital Images, Inc. (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, for a fair statement have been included. Operating results for the three months ended March 31, 2009 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the year ending December 31, 2009. The December 31, 2008 condensed consolidated balance sheet information was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States of America. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

The Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. The Company views its operations and manages its business as one reportable segment - the development and marketing of software and related services for advanced visualization and analysis solutions for use by medical professionals in clinical analysis and therapy planning. Factors used to identify the Company’s single operating segment include the financial information available for evaluation by the chief operating decision maker in making decisions about how to allocate resources and assess performance. The Company markets its products and services through a direct sales force and independent distributors in the United States and international markets.

2.           Significant customers and geographic data

Significant customer (dollars in thousands):

As of March 31, 2009 and December 31, 2008, Toshiba Medical Systems Corporation (“Toshiba”) accounted for 55% and 42% of accounts receivable, respectively. As of March 31, 2009 and December 31, 2008, McKesson Information Systems LLC accounted for 13% and 7% of accounts receivable, respectively.

Revenue by geographic area is summarized as follows (dollars in thousands):

The Company’s export sales are primarily negotiated, invoiced and paid in U.S. dollars, with a portion of sales transactions denominated in foreign currencies.

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3.           Research and Development

In January 2009, the Company and Toshiba entered into a co-development and collaboration agreement in which the two companies will enter into a mutual license of intellectual property and will jointly invest to develop and deliver innovative technology advancements for Toshiba’s medical equipment and the Company’s advanced visualization software solutions. The Company accounts for the agreement under the provisions of Emerging Issues Task Force (“EITF”) Issue No. 07-1, “Accounting for Collaborative Arrangements” (“EITF 07-1”). The Company’s policy is to recognize payments received under the agreement as an offset to research and development expense in the period in which the related costs are incurred. During the first quarter of 2009, the Company received $569,000 and recognized a credit of $243,000 to its research and development expense for reimbursement from Toshiba for development costs the Company incurred under the agreement. The remaining unrecognized balance of $326,000 was included in other current liabilities as of March 31, 2009.

4.           Equity-based compensation

The following table illustrates how equity-based compensation was allocated to the statements of operations (in thousands):

As of March 31, 2009, approximately $7.3 million of unrecognized compensation expense related to stock options was expected to be recognized over a weighted-average period of 3.1 years. As of March 31, 2009, approximately $505,000 of unrecognized compensation expense related to restricted stock awards was expected to be recognized over a weighted-average period of 2.9 years.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model. The Black-Scholes option valuation model requires the development of assumptions that are input into the model. These assumptions include the expected stock volatility, the risk-free interest rate, the option’s expected life and the dividend yield on the underlying stock.

For purposes of calculating the fair value of options under Statement of Financial Accounting Standard (“SFAS”) No. 123(R), “Share-Based Payment,” the weighted-average fair value of options granted was $3.34 and $5.67 for the three months ended March 31, 2009 and 2008, respectively. The weighted-average fair values for the options were based on the fair values on the dates of grant. The fair values for the options were calculated using the Black-Scholes option-pricing model, with the following weighted-average assumptions and expense adjusted using the following expected forfeiture rate assumptions:

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The following table summarizes stock option activity for the three months ended March 31, 2009:

Options granted during the three months ended March 31, 2009 primarily consisted of the Company’s annual grant to employees in the first quarter of 2009.

In the first quarter of 2007, the Company granted shares of restricted stock with performance-based vesting to certain employees. No equity-based compensation expense for the awards was recognized for the three months ended March 31, 2009, as the Company did not consider achievement of the performance metrics to be probable. The cumulative amount of the expense related to these awards not recognized as of March 31, 2009 but that may be recognized in future periods if performance metrics are met was $158,000.

5.           Per share data

Basic net loss per share is computed using net loss and the weighted-average number of common shares outstanding. Diluted net loss per share reflects the weighted-average number of common shares outstanding plus any potentially dilutive shares outstanding during the period. Potentially dilutive shares consist of shares issuable upon the exercise of stock options, as well as unvested restricted stock.

For the three months ended March 31, 2009 and 2008, common share equivalents are not included in the diluted net loss per share calculations because they were antidilutive. Antidilutive stock options and restricted stock awards excluded from net loss per share totaled 2.7 million for each of the three months ended March 31, 2009 and 2008.

6.           Comprehensive (loss) income

Comprehensive (loss) income, as defined by SFAS No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”), includes net (loss) income and items defined as other comprehensive income. SFAS No. 130 requires that items defined as other comprehensive (loss) income, such as unrealized gains and losses on certain marketable securities, be separately classified in the financial statements. Such items are reported in the consolidated statements of stockholders’ equity as comprehensive (loss) income.

The components of comprehensive loss were as follows (in thousands):

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7.           Fair Value Measurements

The following table provides the assets and liabilities carried at fair value measured on a recurring basis in accordance with SFAS No. 157, “Fair Value Measurements,” as of March 31, 2009 (in thousands):

Cash equivalents and marketable securities measured at fair value using quoted market prices are classified within Level 1 of the valuation hierarchy. Marketable securities classified within Level 2 of the valuation hierarchy consist of asset-backed securities for which significant observable market data exists but the Company’s nonstandard lot sizes prevent measurement using quoted market prices. The valuation of asset-backed securities is determined by reviewing quoted market prices for traded lots of the same or similar securities. All asset-backed securities held by the Company are rated AAA and are current on scheduled pay-downs, with expected full maturity within the next 12 months.

The Company analyzes its investments for impairment on an ongoing basis. Factors considered in determining whether an unrealized loss is a temporary loss or an other-than-temporary loss include the length of time and extent to which the securities have been in an unrealized loss position and the Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated market recovery. The Company has the ability and intent to hold these investments until the anticipated recovery of their fair value, which may be maturity, and therefore the Company did not consider these investments to be other than temporarily impaired as of March 31, 2009.

8.           Other intangible assets

Acquired intangible assets subject to amortization were as follows (in thousands):

Intangible assets subject to amortization are amortized on a straight-line basis over the estimated period of benefit. Amortization expense related to other intangible assets was $156,000 and $261,000 for the three months ended March 31, 2009 and 2008, respectively. As of March 31, 2009, fully amortized existing software technology was still in use.

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The estimated future amortization expense for identified intangible assets as of March 31, 2009 is as follows (in thousands):

The preceding expected amortization expense is an estimate. Actual amortization expense may differ from estimates due to any additional intangible asset acquisitions, impairment of intangible assets, accelerated amortization of intangible assets and other events. A patent acquired in the HInnovation, Inc. acquisition having a net book value of $522,000 as of March 31, 2009 is currently under review by the United States Patent and Trademark Office.

9.           Restructuring charge

The Company reduced its workforce by approximately 11% under a plan announced in November 2008 in order to align the Company’s operations with the current market conditions and improve profitability in 2009 and beyond. During the three months ended March 31, 2009 the Company paid the remaining balance of $141,000 that was accrued as of December 31, 2008 related to severance and other termination costs.

10.    Deferred revenue

The components of deferred revenue were as follows:

11.    Income taxes

Under the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), the Company did not have any material unrecognized tax benefits as of March 31, 2009 and December 31, 2008. The Company recorded no interest and penalties during the three months ended March 31, 2009 and 2008 and had no accrued interest and penalties as of March 31, 2009 and December 31, 2008. The Company is no longer subject to U.S. federal tax examinations by tax authorities for tax years before 2004. The Company is open to state tax audits until the applicable statute of limitations expires. The Company does not expect that the total amount of unrecognized tax benefits as of March 31, 2009 will change materially in the next 12 months.

The Company’s consolidated effective income tax rate was 52.0% and 34.3% for the three months ended March 31, 2009 and 2008, respectively. The Company’s consolidated effective income tax rate was 46.0% for fiscal year 2008. The provision for income taxes consists of provisions for federal, state and foreign income taxes. The consolidated income tax rate is a composite rate of the applicable rates in the various jurisdictions. The increase in the estimated annual effective tax rate for 2009 over the 2008 annual effective tax rate is primarily due to the relative impact of research and development credits on the Company’s income or loss before income taxes.

The Company has $14.9 million of deferred tax assets as of March 31, 2009. The ability to realize these deferred tax assets involves estimates of future taxable income, the estimated impact of future tax deductions from the exercise of stock options outstanding as of each balance sheet date, and the expiration dates and amounts of net operating loss carryforwards and other tax credits. If the Company decreases its estimates of future taxable income or tax deductions from the exercise of stock options, or its stock price increases significantly without an increase in taxable income, causing management to believe that the Company’s deferred tax assets may not be utilizable, the Company may need to establish additional valuation allowances on its deferred tax assets, which would reduce or eliminate the Company’s ability to use its deferred tax assets to offset taxes due and could materially impact the Company’s financial position and results of operations.

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After giving consideration to the above factors, the Company concluded that the net deferred tax assets of $14.9 million as of March 31, 2009 do not require any additional valuation allowance. The Company had a valuation allowance of $221,000 as of March 31, 2009 and December 31, 2008 relating to net operating losses and tax credits that expire prior to 2013.  However, if the Company does not achieve a substantial improvement in pretax results in 2009 over 2008, it is reasonably possible that the Company may need to establish additional valuation allowances for some or all of the Company’s deferred tax assets, which could materially impact the Company’s income tax provision, financial position and results of operations.

12.    Commitments and contingencies

Under general contract terms, the Company often includes provisions in its software license agreements under which the Company agrees to indemnify its customers against liability and damages arising from claims of patent, copyright, trademark or trade secret infringement by the Company’s software. The Company has not incurred any material costs as a result of this type of indemnification clause, and the Company does not maintain a product warranty liability related to such indemnification clauses.

The Company has entered into various employment agreements with certain executives of the Company, which include provisions for severance payments subject to certain conditions and events.

The Company is involved in various claims and legal actions in the normal course of business. Management is of the opinion that the outcome of such legal actions will not have a significant adverse effect on the Company’s financial position, results of operations or cash flows. Notwithstanding management’s belief, an unfavorable resolution of some or all of these matters could materially affect the Company’s future results of operations or cash flows.

13.    Share Repurchase Programs

During 2008, the Company’s Board of Directors approved a share repurchase program, which authorized open market transactions of up to $40.0 million, including fees and expenses, of the Company’s common stock. The program authorized management to repurchase shares from time to time, depending on market conditions. During the first quarter of 2009, the Company purchased 149,000 shares for $1.8 million under the program. The Company completed the $40.0 million share repurchase program on February 6, 2009, having repurchased an aggregate 2.9 million shares under the program.

On March 3, 2009, the Company announced an additional share repurchase program, authorizing up to an additional 1.0 million shares to be repurchased on the open market. During the first quarter of 2009, the Company completed stock repurchases under this program of 145,000 shares for $1.5 million, inclusive of fees and expenses. Subsequent to March 31, 2009 and through May 7, 2009, the Company purchased 82,000 shares under the program, bringing the total aggregate shares repurchased under this additional share repurchase program to 227,000 shares.

At time of repurchase, shares are returned to the status of authorized and unissued shares. The Company has accounted for the repurchases as constructively retired and recorded such repurchases as a reduction of common stock and additional paid-in capital.

14.    New Accounting Pronouncements

Recent Accounting Standards Adopted in 2009

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which provides enhanced guidance for using fair value to measure assets and liabilities. In February 2008, the FASB issued Staff Position (FSP) No. 157-2, which deferred the effective date of SFAS No. 157 for one year relative to certain nonfinancial assets and nonfinancial liabilities. On January 1, 2009, the Company adopted the requirements of SFAS No. 157 that had been deferred under FSP 157-2. The adoption did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In December 2007, the FASB ratified the EITF consensus on EITF 07-1, “Accounting for Collaborative Arrangements,” which defines collaborative arrangements and establishes reporting and disclosure requirements for

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transactions between participants in a collaborative arrangement and between participants in the arrangements and third parties. EITF 07-1 is effective for periods beginning after December 15, 2008 and applies to arrangements in existence as of the effective date. The Company adopted the requirements of EITF 07-1 on January 1, 2009 and applied its provisions to the accounting for its collaborative arrangement with Toshiba, as discussed in Note 3. The adoption did not have a material impact on the Company’s consolidated results of operations or financial condition.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”), which changes accounting for business acquisitions. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction and establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed in a business combination.  The Company adopted the requirements of SFAS No. 141(R) on January 1, 2009. The application of SFAS No. 141(R) is likely to have a significant impact on how the Company allocates the purchase price of prospective business combinations, including the recognition and measurement of assets acquired and liabilities assumed and the expensing of direct transaction costs and costs to integrate the acquired business. The adoption did not have an impact on the Company’s results of operations or financial condition for the three months ended March 31, 2009, as the Company did not enter into any business combinations during the period.

In June 2008, the FASB staff issued FSP EITF 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP EITF 03-6-1”). The Company adopted the requirements of FSP EITF 03-6-1 on January 1, 2009. The adoption did not have a material impact on the Company’s consolidated results of operations or financial condition.

Recent Accounting Standards Not Yet Adopted

In April 2009, the FASB staff issued FSP FAS 115-2 and FAS 124-2, “Recognition and Presentation of Other-Than-Temporary Impairments” (“FSP 115-2”), which is effective for the Company for the quarterly period beginning April 1, 2009. FSP 115-2 amends existing guidance for determining whether an other than temporary impairment of debt securities has occurred. Among other changes, the FASB replaced the existing requirement that an entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert (a) it does not have the intent to sell the security, and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis. The Company does not expect that the adoption of FSP 115-2 will have a material impact on the Company’s consolidated results of operations or financial condition.

In April 2009, the FASB staff issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (“FSP 107-1”), which is effective for the Company for the quarterly period beginning April 1, 2009. FSP 107-1 requires an entity to provide the annual disclosures required by FASB SFAS No. 107, “Disclosures about Fair Value of Financial Instruments,” in its interim financial statements. The Company does not expect that the adoption of FSP 107-1 will have a material impact on the Company’s consolidated results of operations or financial condition.

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

Executive summary

The financial results for Vital Images, Inc. (also referred to as “we”, “us” and “our”) have continued to be affected by the general decline in the U.S. economy, which has resulted in contracted capital spending by U.S. hospitals and lower interest rates on our cash and investments.  Additionally, we have been impacted by weakness in the high-end computed tomography, or CT, and picture archiving and communication systems, or PACS, markets and the impact of the Deficit Reduction Act of 2005.

Revenue decreased for the first quarter of 2009, compared to the same period in 2008, reflecting the markets’ continued weakness. Expenses decreased during the 2009 first quarter, as we experienced lower compensation costs, compared to the same period in 2008, resulting primarily from our 11 % workforce reduction in November 2008. Other cost-control measures also contributed a decrease in all operating expense categories during the 2009 first quarter, compared to the same period in 2008.

·                  Revenue in the 2009 first quarter decreased 15% to $14.8 million, compared to $17.3 million for the first quarter of 2008.

·                  Gross margin was 76%, compared to 77% for the first quarter of 2008.

·                  Loss before income taxes was $(523,000), compared to $(905,000) for the first quarter of 2008.

·                  Net loss was $(251,000), or $(0.02) per diluted share, compared to $(594,000), or $(0.03) per diluted share, for the first quarter of 2008.

Total cash, cash equivalents and marketable securities were $144.9 million as of March 31, 2009, compared to $147.0 million as of December 31, 2008. Working capital (defined as current assets less current liabilities) was $121.3 million as of March 31, 2009, a decrease from $135.4 million as of December 31, 2008. The decrease in cash and working capital during the first three months of 2008 was primarily the result of purchases of noncurrent marketable securities totaling $11.9 million at March 31, 2009 and repurchases of our common stock totaling $3.2 million under our share repurchase programs.

Overview

We are a leading provider of advanced visualization and analysis solutions for use by medical professionals in clinical analysis and therapy planning. We provide software, customer education, software maintenance and support, professional services and, on occasion, third-party hardware to our customers. Our technology rapidly transforms complex data generated by diagnostic imaging equipment into functional digital images that can be manipulated and analyzed using our specialized applications to better understand internal anatomy and pathology. Our solutions are designed to improve the cost, quality and accessibility of health care by improving physician workflow and productivity, enhancing the ability to make clinical decisions, facilitating less invasive patient care, and complementing often significant capital investments in diagnostic imaging equipment made by our customers. Our software is compatible with equipment from all major manufacturers of diagnostic imaging equipment, such as CT scanners, and can be integrated into PACS. Many hospitals use PACS to acquire, distribute and archive medical images and diagnostic reports, reducing the need for film and increasing reliance on advanced visualization solutions such as ours. We also offer a Web-based solution that provides physicians with anywhere, anytime access to medical images and visualization tools through any Internet-enabled computer.

We operate and manage our business as a single business segment — the development and marketing of software and related services for advanced visualization and analysis solutions for use by medical professionals in clinical analysis and therapy planning. We market our products and services through a direct sales force, resellers and independent distributors in the United States and in international markets. Our common stock is currently traded on The NASDAQ Global Select Market under the symbol “VTAL.”

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ViTAL Enterprise, introduced in May 2008, enables unlimited enterprise access to the complete ViTAL solution offering, including Vitrea, Vitrea Web, ViTALConnect and our specialized clinical options. ViTAL Enterprise provides customers with full access to our best-in-class clinical solutions and comprehensive services, including education, consulting and maintenance. ViTAL Enterprise has the flexibility to scale to the size of the customer’s enterprise by providing access to the complete ViTAL solution based on unlimited users or concurrent users. Additionally, ViTAL Enterprise offers customers the ability to license the solution through capital or subscription pricing, and it is available to our worldwide installed base of existing customers. We anticipate an increasing percentage of license fee revenue will be from sales of ViTAL Enterprise.

Vitrea® software, our flagship software product, is an easy-to-use, intuitive, high-speed volume rendering technology that creates interactive two-dimensional, or 2D, three-dimensional, or 3D, and four-dimensional, or 4D, images from information generated by standard CT scanners. Vitrea is commonly deployed on standalone workstations, as well as on PACS, using standard computer hardware, and provides advanced visualization for radiological, cardiac, oncological and surgical applications. Vitrea renders vibrant, clear color images at high speeds and enables users to interactively navigate within these images to visualize, measure and understand internal structures and disease conditions. We believe our user interfaces are intuitive, and they are specifically configured to assist physicians in optimizing their clinical workflow.

Vitrea Web provides users with everywhere access to Vital Images’ powerful advanced clinical applications via the Web. With Vitrea Web, customers have the same capabilities of a standalone workstation to review, analyze and communicate findings, all from any PC. Vitrea Web enables advanced best of breed clinical applications access throughout the healthcare enterprise.

ViTALConnect® software allows multiple physicians to collaboratively use advanced visualization in their medical practices. It provides radiologists and referring physicians anywhere, anytime access to interactive 2D, 3D and 4D medical images and the ability to measure, rotate, analyze and segment those images. Our latest release includes features previously available only on multimodality workstations, such as a variety of multi-planar reformat, or MPR, modes, thick slab rendering in MPR, 3D volumetric visualization with simple point of interest navigation, 4D dataset visualization, CT/positron emission tomography, or PET, fusion and advanced analysis tools.

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Advanced visualization options expand the relevance of our products beyond the radiology department to referring physicians and surgical specialists, particularly in the areas of cardiology, cardiovascular, oncology, neurology and gastroenterology. Our advanced visualization options allow physicians to customize their Vitrea software according to their unique requirements. Most options are proprietary; however, Vitrea also serves as an integration platform for applications offered by our visualization technology partners. Our options include:

Our software solutions are used with medical diagnostic equipment, primarily in clinical analysis and therapy planning. Our software applies proprietary technologies to a variety of data supplied by CT scanners to allow medical clinicians to create 2D, 3D and 4D views of human anatomy and to non-invasively navigate within these images to better visualize and understand internal structures and pathologies. Our main customers are hospitals and clinics, university medical schools and diagnostic imaging companies. We market our products and services to these customers both directly through our own sales force and indirectly through digital imaging equipment manufacturers and PACS companies, who sell our products with other products they either manufacture or acquire from third parties.

Our products work with equipment from all major manufacturers of diagnostic imaging systems, including Toshiba Medical Systems Corporation (“Toshiba”), GE Medical Systems, Siemens Medical Systems, Inc. and Philips Medical Systems. Our products may also be integrated into PACS, such as those marketed by McKesson Corporation (“McKesson”) and Sectra AB, and run on off-the-shelf third-party computer hardware.

Critical accounting policies and estimates

Our discussion and analysis of financial condition and results of operations are based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. We have adopted various accounting policies to prepare the Condensed Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America. The most significant accounting policies are disclosed in Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2008. The preparation of these financial statements requires us 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 financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those

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estimates. We continually evaluate our critical accounting policies and estimates. We discuss our critical accounting estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008. The adoption of Emerging Issues Task Force (“EITF”) Issue No. 07-1, “Accounting for Collaborative Arrangements” and its application to our collaborative arrangement with Toshiba was the only significant new accounting policy during the first quarter of 2009.

Results of Operations

The following table sets forth information from our Condensed Consolidated Statements of Operations, expressed as a percentage of total revenue.

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Revenue

A comparison of revenue by category is as follows (dollars in thousands):

License fee revenue (dollars in thousands)

ViTAL Enterprise, introduced in May 2008, enables unlimited enterprise access to the complete ViTAL solution offering, including Vitrea, ViTALConnect and our specialized clinical options. We expect that revenue from sales of ViTAL Enterprise to become a larger portion of our total license revenue, which will cause revenue from sales of individual Vitrea licenses, Vitrea options and third party software to continue to decrease in significance. The decrease in license fee revenue during the three months ended March 31, 2009, compared to the same period in 2008, was driven primarily by continued pressure on hospital capital spending in the U.S., which was partially offset by international growth.

The following table sets forth information on license fee revenue by source (dollars in thousands):

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Maintenance and services revenue (dollars in thousands)

The increase in maintenance and support revenue for the three months ended March 31, 2009, compared to the same period in 2008, was due to an increase in the number of customers on maintenance contracts both from new license sales and increased maintenance contract capture rates. The decrease in customer education revenue for the three months ended March 31, 2009, compared to the same period in 2008, was due to the general timing of training sessions and the effect of decreased license sales. Professional services revenue decreased due to the amount and timing of installations and the effect of decreased license sales for the three months ended March 31, 2009, compared to the same period in 2008.

Hardware revenue

Hardware revenue decreased 45% to $233,000 in the first quarter of 2009, compared to $425,000 in the first quarter of 2008. We offer to sell hardware to our customers in conjunction with license sales, and fluctuations are driven by individual customer purchasing preferences. Sales of hardware systems are not core to our strategy and will fluctuate from period to period depending upon the needs and preferences of our customers.

Cost of revenue and gross profit

A comparison of gross profit and gross margin by revenue category is as follows (dollars in thousands):

License fee gross margin is affected by changes in average sales prices, product mix, and the mix between direct sales and sales to distribution partners, which tend to carry lower margins. The decrease in license fees gross margin for the three months ended March 31, 2009, compared to the same period in 2008, is due in part to a smaller percentage of each ViTAL Enterprise sale being allocated to license fee revenue than has historically been allocated for sales of Vitrea, without a corresponding decrease in costs. Additionally, license fee margins have been negatively affected by pricing pressuring in a difficult market.

Maintenance and services gross margin increased during the 2009 first quarter, compared to the 2008 first quarter, due in part to a larger percentage of each ViTAL Enterprise sale being allocated to maintenance and services revenue and a lower percentage allocated to license fee revenue, as noted above. In addition, in the first quarter of 2009, we

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recognized a $552,000 benefit to maintenance and support revenue arising from Toshiba billing adjustments relating to historic periods.

Hardware gross margins decreased for the three months ended March 31, 2009, compared to the same period in 2008, due to variability in pricing during the periods.

Operating expenses

The following is a comparison of operating expenses as a percent of revenue, as well as the percent change in total expense: