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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2009

OR

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 August 3, 2009, there were 14,238,409 shares of the Registrant’s common stock, par value $.01 per share, outstanding.

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Vital Images, Inc.
Form 10-Q
June 30, 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 and six months ended June 30, 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, resellers and independent distributors in the United States and international markets.

The Company has evaluated subsequent events through the date the financial statements were issued, August 10, 2009.

2.           Significant customers and geographic data

Significant customer revenue (dollars in thousands):

As of June 30, 2009 and December 31, 2008, Toshiba Medical Systems Corporation (“Toshiba”) accounted for 52% and 42% of accounts receivable, respectively. As of June 30, 2009 and December 31, 2008, McKesson Information Systems LLC accounted for 10% and 7% of accounts receivable, respectively.

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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.

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 three and six months ended June 30, 2009, the Company received payments of $455,000 and $1,024,000, respectively, and recognized credits of $262,000 and $505,000, respectively, to its research and development expense for reimbursement from Toshiba to offset the development costs the Company incurred during the respective periods under the agreement. The remaining unrecognized balance of $519,000 was included in other current liabilities as of June 30, 2009 and will be recognized as a credit to research and development expense in future periods as the development costs are incurred.

4.           Asset impairment

In 2007, the Company began the implementation of an enterprise resource planning (“ERP”) system. The ERP system was intended to replace numerous disconnected business management software applications and link the data contained within these disconnected systems to enable better management of the Company’s business and derive more useful data for various business functions, such as sales, marketing, finance and customer support.

Phase 1 of the implementation, which related to the replacement of the Company’s general ledger, was completed in 2007. The related capitalized costs are being depreciated over seven years and, as of June 30, 2009, the net book value of Phase 1 was $693,000. Phase 2 of the implementation, which consisted of replacing the Company’s various customer relationship management and order processing systems, has not been implemented to date and was put on hold in 2008 in conjunction with the Company’s cost-control efforts, and the Company has not capitalized any costs relating to Phase 2 since that time. In conjunction with continuing cost-control measures, the Company determined that it would not implement Phase 2 at this time. As a result, the Company recognized an asset impairment charge of $3.1 million related to the Phase 2 implementation.

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5.           Equity-based compensation

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

As of June 30, 2009, approximately $6.6 million of unrecognized compensation expense related to stock options was expected to be recognized over a weighted-average period of 2.9 years. As of June 30, 2009, approximately $428,000 of unrecognized compensation expense related to restricted stock awards was expected to be recognized over a weighted-average period of 2.7 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 $3.94 and $3.44 for the three and six months ended June 30, 2009 and $5.81 and $5.68 for the three and six months ended June 30, 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:

The following table summarizes stock option activity for the six months ended June 30, 2009:

Options granted during the three and six months ended June 30, 2009 primarily consisted of the Company’s annual grant to employees in the first quarter of 2009.

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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 and six months ended June 30, 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 June 30, 2009 but that may be recognized in future periods if performance metrics are met was $177,000.

6.           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 and six months ended June 30, 2009 and 2008, common share equivalents are not included in the diluted net loss per share calculations because they were antidilutive. Shares subject to antidilutive stock options and restricted stock awards excluded from net loss per share totaled 2.7 million for the three and six months ended June 30, 2009 and 2.6 million for the three and six months ended June 30, 2008.

7.           Comprehensive income (loss)

Comprehensive income (loss), as defined by SFAS No. 130, “Reporting Comprehensive Income” (“SFAS No. 130”), includes net income (loss) and items defined as other comprehensive income. SFAS No. 130 requires that items defined as other comprehensive income (loss), 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 income (loss).

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

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8.           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 June 30, 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 an asset-backed security. The valuation of this asset-backed security is determined by reviewing quoted market prices for traded lots of the same or similar securities. This security is rated AAA and is current on scheduled pay-downs, with expected full maturity within the next 12 months. The Company did not consider this investment to be other than temporarily impaired as of June 30, 2009.

9.           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 $90,000 and $261,000 for the three months ended June 30, 2009 and 2008, respectively, and $246,000 and $522,000 for the six months ended June 30, 2009 and 2008, respectively. As of June 30, 2009, fully amortized existing software technology was still in use.

The estimated future amortization expense for identified intangible assets as of June 30, 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

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intangible assets and other events. A patent acquired in the HInnovation, Inc. acquisition having a net book value of $450,000 as of June 30, 2009 is currently under review by the United States Patent and Trademark Office.

10.    Deferred revenue

The components of deferred revenue were as follows:

11.    Income taxes

Companies are required to assess whether a valuation allowance should be recorded against their deferred tax assets based on the consideration of all available evidence, using a “more likely than not” realization standard. The four sources of taxable income that must be considered in determining whether deferred tax assets will be realized are: 1) future reversals of existing taxable temporary differences; 2) future taxable income exclusive of reversing temporary differences and carryforwards; 3) taxable income in prior carryback years if carryback is permitted under the tax law; and 4) tax planning strategies.

The Company has evaluated its deferred tax assets each reporting period, including making an assessment of cumulative pretax results in recent years and projections of cumulative pretax results in future periods. As a general guideline, the Company considered the cumulative pretax results from the most recent three years. A significant negative factor in the Company’s assessment at June 30, 2009 was that the Company will transition to a three-year historical cumulative pretax loss during 2009, as highly profitable quarters in 2006 are removed from the cumulative three-year pretax results. In addition, uncertain near-term market and economic conditions reduced the Company’s ability to rely on projections of future taxable income in assessing the realization of the Company’s deferred tax assets. As a result, during the three months ended June 30, 2009, the Company recorded a non-cash charge of $15.0 million to the provision for income taxes to establish a full valuation allowance against its deferred tax assets. If pretax results improve in future periods, the Company may be able to utilize the deferred tax assets to reduce tax payments.

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.

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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 of 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. The Company completed stock repurchases under this program of 236,000 shares for $2.5 million during the three months ended June 30, 2009 and 382,000 shares for $4.0 million during the six months ended June 30, 2009, inclusive of fees and expenses. Subsequent to June 30, 2009 and through August 7, 2009, the Company had purchased 30,000 shares under the program, bringing the total aggregate shares repurchased under this additional share repurchase program to 412,000 shares.

At the 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

In June 2009, the FASB issued SFAS No. 168, “The FASB Accounting Standards CodificationTM and the Hierarchy of Generally Accepted Accounting Principles—a replacement of FASB Statement No. 162” (“SFAS No. 160”). Under SFAS No. 160, The FASB Accounting Standards Codification (“Codification”) will become the source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of SFAS No. 160, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-grandfathered non-SEC accounting literature not included in the Codification will become non-authoritative. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. In the FASB’s view, the issuance of this Statement and the Codification will not change GAAP, except for those nonpublic nongovernmental entities that must now apply the American Institute of Certified Public Accountants Technical Inquiry Service Section 5100, “Revenue Recognition,” paragraphs 38—76. The Company does not expect that the adoption of SFAS No. 160 will have a material impact on the Company’s consolidated financial statements.

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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 second quarter of 2009, compared to the same period in 2008, reflecting the markets’ continued weakness. Sales and marketing, research and development, and general and administrative expenses for the 2009 second quarter decreased 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 to decreases in operating expense categories during the 2009 second quarter, compared to the same period in 2008.

·                  Revenue for the 2009 second quarter decreased 15% to $13.4 million, compared to $15.7 million for the second quarter of 2008.

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

·                  Loss before income taxes was $(4.6) million, compared to $(2.6) million for the second quarter of 2008.

·                  Net loss was $(19.6) million, or $(1.37) per diluted share, compared to $(1.6) million, or $(0.09) per diluted share, for the second quarter of 2008.

·                  Second quarter non-cash charges of $18.1 million for the second quarter of 2009 consisted of a $15.0 million valuation allowance against our deferred tax assets, and a $3.1 million write-off relating to the unimplemented portion of our enterprise resource planning system as a result of our cost-control efforts.

Revenue decreased for the six months ended June 30, 2009, compared to the same period in 2008, reflecting the markets’ continued weakness. Sales and marketing, research and development, and general and administrative expenses for the six months ended June 30, 2009 decreased 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 to decreases in operating expense categories during the six months ended June 30, 2009, compared to the same period in 2008.

·                  Revenue decreased 15% to $28.2 million, compared to $33.0 million for the first six months of 2008.

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

·                  Loss before income taxes was $(5.2) million, compared to $(3.5) million for the first six months of 2008.

·                  Net loss was $(19.9) million, or $(1.38) per diluted share, compared to $(2.2) million, or $(0.13) per diluted share, for the first six months of 2008.

·                  Non-cash charges totaling $18.1 million for the first six months of 2009 consisted of a $15.0 million valuation allowance against our deferred tax assets and a $3.1 million write-off relating to the unimplemented portion of our enterprise resource planning system as a result of our cost-control efforts.

Total cash, cash equivalents and marketable securities were $141.1 million as of June 30, 2009, compared to $144.9 million as of March 31, 2009 and $147.0 million as of December 31, 2008. Working capital (defined as current assets less current liabilities) was $113.9 million as of June 30, 2009, a decrease from $121.3 million as of March 31, 2009 and $135.4 million as of December 31, 2008. The decrease in cash , cash equivalents and marketable

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securities during the three and six months ended June 30, 2009 was primarily the result of repurchases of our common stock totaling $2.5 million and $5.8 million, respectively, under our share repurchase programs. The decrease in working capital was also due to purchases of noncurrent marketable securities totaling $4.9 million and $16.8 million, respectively.

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.”

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 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 that has Web access. 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 via the Web 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

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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.

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, which 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 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

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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 estimates. We continually evaluate our critical accounting policies and estimates. We discuss our critical accounting estimates in “Item 7. 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 six months ended June 30, 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)