Executive summary

Since the second quarter of 2007, financial results for Vital Images, Inc. (also referred to as "we", "us" and "our") have been significantly affected by weakness in the computed tomography, or CT, and picture archiving and communication systems, or PACS, markets and by the broad impact of the Deficit Reduction Act.

Vital Images, Inc. summary 2008 results were as follows:

†          Total revenue of $68.1 million, compared to $70.2 million for 2007.

†          Gross margin of 77%, compared to 78% for 2007.

†          Operating expenses of $62.1 million, compared to $61.8 million for
2007.

†          Net loss of $(2.8) million, or $(0.17) loss per diluted share,

Total cash, cash equivalents and marketable securities were $147.0 million as of December 31, 2008, compared to $178.4 million as of December 31, 2007. Working capital (defined as current assets less current liabilities) was $135.4 million as of December 31, 2008, compared to $173.9 million as of December 31, 2007. The decrease in cash and working capital during 2008 was primarily the result of repurchases of our common stock totaling $38.2 million under a share repurchase program authorized by our Board of Directors in 2008.

During 2008, we continued to experience the effects of the industry-wide slowdown in the high-end CT market and the Deficit Reduction Act that significantly impacted our 2007 results. Additionally, in 2008 we were impacted by the general decline in the U.S. economy, which resulted in contracted capital spending by U.S. hospitals and lower interest rates on our cash and investments. We generated $4.6 million of interest income in 2008, compared to $8.9 million in 2007. A decline in interest rates resulted in a 2.9% return on investments in 2008 compared to a 5.1% return on investments in 2007.

We partially mitigated these negative factors by making progress on our transition to an enterprise company, as demonstrated by our introduction of ViTAL Enterprise in the 2008 second quarter, and by implementing significant cost-control measures, including an 11% workforce reduction in the 2008 fourth quarter. We also responded by implementing a $40.0 million share repurchase program, resulting in the repurchase of 2.8 million shares of our common stock for $38.2 million during 2008.

We further strengthened our strategic relationship with Toshiba in 2008, renewing our global distribution agreement through December 31, 2013 and, in January 2009, entering into an agreement under which we will jointly develop applications. Our revenue from international sales grew 45% in 2008, and Toshiba has been the primary source of our international growth.

Although we expect the negative market factors that affected our 2007 and 2008 results to continue into 2009 and beyond, we remain committed to developing the best software solutions for the enterprise and taking exceptional care of our customers.

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 physician workflow and productivity, enhance the ability to make clinical decisions, facilitate less invasive patient care, and complement 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."

Critical accounting policies and estimates

Our discussion and analysis of financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The notes to the Consolidated Financial Statements contained in this Annual Report describe our significant accounting policies used in the preparation of the Consolidated Financial Statements. 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 estimates. We continually evaluate our critical accounting policies and estimates.

We believe the critical accounting policies listed below reflect significant judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements.

Allowance for doubtful accounts

We maintain an allowance for doubtful accounts in an amount estimated to be sufficient to provide adequate protection against losses resulting from extending credit to our customers. In judging the adequacy of the allowance for doubtful accounts, we consider multiple factors, including historical bad debt experience, the general economic environment, the need for specific client reserves and the aging of our outstanding receivables. A portion of this provision is included in operating expenses as a general and administrative expense and a portion of this provision is included as a reduction of license revenue. A considerable amount of judgment is required in assessing these factors. If the factors utilized in determining the allowance do not reflect future performance, then a change in the allowance for doubtful accounts would be necessary in the period such determination has been made, which would impact future results of operations. As of December 31, 2008, the allowance for doubtful accounts was $638,000 for gross accounts receivable of $13.7 million.

Deferred taxes

Significant judgment is required in determining the realizability of our deferred tax assets. We must assess the likelihood that our net deferred tax assets will be recovered from future taxable income, and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent that we establish a valuation allowance, we must include an expense within the tax provision in the statement of operations. As of December 31, 2008, the consolidated balance sheet included net deferred tax assets of $14.6 million.

Considerations for determining the realizability of our deferred tax assets primarily involve cumulative pre-tax income for financial reporting purposes, cumulative taxable income for the past three years, estimated future pre-tax income for financial reporting purposes and estimated future taxable income from our core business. We also consider the expiration dates and amounts of net operating loss carryforwards and other tax credits, and estimate the impact of future tax deductions from the exercise of stock options. These estimates are projected through the life of the related deferred tax assets based on assumptions which we believe to be reasonable and consistent with current operating results.

As of December 31, 2008, the significant components of our deferred tax assets were as follows:

† Deferred tax assets for net operating loss carryforwards and other tax credits of $8.7 million, which is net of a valuation allowance of $221,000 relating to tax credits and certain state net operating loss carryforwards that expire prior to 2013. We will require approximately $18.0 million in cumulative future taxable income to be generated at various times over the next 18 years to realize the related deferred tax assets prior to expiration.

† Deferred tax asset related to equity based compensation of $3.7 million. Many of the stock options related to this deferred tax asset are currently significantly out-of-the money and may expire unutilized during the next six years. Our projections of future taxable income have taken into consideration our expectations that a portion of these out-of-the money options will not result in future tax deductions and will not reduce future taxable income.

After giving consideration to the above factors, we concluded that the net deferred tax assets of $14.6 million as of December 31, 2008 do not require any additional valuation allowance. However, if we do not achieve a substantial improvement in pretax results in 2009 over 2008, it is reasonably possible that we may need to establish additional valuation allowances for some or all of our deferred tax assets, which could materially impact our income tax provision, financial position and results of operations.

Long-lived assets

We review long-lived assets for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable, in accordance with Statement of Financial Accounting Standard ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." Events or changes in circumstances that indicate the carrying amount may not be recoverable include, but are not limited to, a significant decrease in the market value of the business or asset acquired, a significant adverse change in the extent or manner in which the business or asset acquired is used, or a significant adverse change in the business climate. If such events or changes in circumstances are present, the undiscounted cash flows method is used to determine whether the asset is impaired. Cash flows would include the estimated terminal value of the asset and exclude any interest charges. To the extent the carrying value of the asset exceeds the undiscounted cash flows over the estimated remaining life of the asset or asset groups, the impairment is measured as the difference between the carrying value of the asset and its fair value, determined using the discounted cash flows. The discount rate utilized would be based on our best estimate of the related risks and return at the time the impairment assessment is made.

Our long-lived assets consist of property and equipment of $11.5 million and other intangible assets subject to amortization of $808,000 as of December 31, 2008. A patent acquired in the HInnovation, Inc. acquisition having a $594,000 net book value as of December 31, 2008 is currently under review by the United States Patent and Trademark Office ("USPTO").

Goodwill

We account for goodwill in accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." Under SFAS No. 142, goodwill and intangible assets with indefinite lives are reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. We operate as one reporting unit and therefore compare the book value to the market value (consisting of market capitalization plus a control premium of 25%). As of December 31, 2008, we had 14.7 million shares outstanding, a closing stock price of $13.91 per share, a market value of $255.1 million, and a book value of $168.7 million, which would indicate that our goodwill was not impaired. Furthermore, based on December 31, 2008 data including 14.7 million shares outstanding, our book value of $168.7 million, and a control premium of 25%, our stock price would need to trade below $9.20 per share for a sustained period of time to indicate that our goodwill may be impaired. If the market value exceeds the book value, goodwill is considered not impaired, and thus the second step of the impairment test is not necessary. If our book value exceeds the market value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the goodwill with the book value of the goodwill. If the carrying value of the goodwill exceeds the implied fair value of the goodwill, an impairment loss would be recognized in an amount equal to the excess. We completed the annual goodwill impairment assessment as of December 31, 2008, in which no impairment was identified. Goodwill was $9.1 million as of December 31, 2008. If market conditions continue to fluctuate, we may incur goodwill impairment charges that adversely affect our financial position and operating results.

Revenue Recognition

We follow specific and detailed guidelines in determining the proper amount of revenue to be recorded; however, certain judgments affect the application of our revenue recognition policy.

We recognize revenue in accordance with American Institute of Certified Public Accountants ("AICPA") Statement of Position ("SOP") 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, as well as Technical Practice Aids issued from time to time by the AICPA, and SEC Staff Accounting Bulletin
("SAB")

No. 104. We recognize revenue when it is realized or realizable and earned. We consider revenue realized or realizable and earned when we have persuasive evidence of an arrangement, the product has been shipped or the services have been provided to the customer, the sales price is fixed or determinable, and collectability is probable.

Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from period to period. The significant judgments for revenue recognition typically involve whether collectability can be considered probable and whether fees are fixed or determinable. Significant judgment is also required when evaluating and assessing revenue recognition relating to our distribution agreements with original equipment manufacturers, value-added resellers and independent distributors (collectively, "Resellers"). In addition, our transactions often consist of multiple element arrangements, which must be analyzed to determine the fair value of each element, the amount of revenue to be recognized upon shipment, if any, and the period and conditions under which deferred revenue should be recognized. As a result, if facts and circumstances change that affect our current judgments, our revenue could be materially different in the future.

Equity-based compensation

We recognize equity-based compensation expense under the fair value recognition provisions of SFAS No. 123(R), "Share-Based Payment." We recognize equity-based compensation net of an estimated forfeiture rate and recognize compensation cost only for those shares expected to vest over the requisite service period of the award.

The fair value of each option award is estimated as of 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 are the expected stock volatility, the risk-free interest rate, the option's expected life and the dividend yield on the underlying stock. Expected volatility is calculated based on the historical volatility of our common stock over the expected option life and other appropriate factors. Risk-free interest rates are calculated based on continuously compounded U.S. Treasury risk-free rates for the appropriate term. Prior to March 9, 2006, the expected life of stock options was calculated by performing a detailed analysis of all historical stock option information available. On March 9, 2006, we began to grant options with a five-year legal life instead of the eight-year legal life that had historically been used. As a result, we elected to use the "simplified" method, as described in SAB No. 107, to estimate the expected life of options granted on and after March 9, 2006. We will utilize the simplified method until sufficient historical information becomes available on the five-year legal life options. The dividend yield is assumed to be zero, as we have never paid or declared any cash dividends on our common stock and do not intend to pay dividends on our common stock in the foreseeable future. The expected forfeiture rate is estimated based on historical experience.

Determining the appropriate fair value model and calculating the fair value of equity-based payment awards require the input of the subjective assumptions described above. The assumptions used in calculating the fair value of equity-based payment awards represent management's best estimates, which involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our equity-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the equity-based compensation expense could be significantly different from what we have recorded in the current period. See Note 2 to the Consolidated Financial Statements for a further discussion of equity-based compensation.

Results of Operations

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

                                          For the Year Ended December 31,
                                         2008           2007         2006

Revenue:
License fees                                50.3 %         56.5 %       65.7 %
Maintenance and services                    47.6           42.0         32.1
Hardware                                     2.1            1.5          2.2
Total revenue                              100.0          100.0        100.0

Cost of revenue:
License fees                                 7.2            6.7          7.1
Maintenance and services                    14.8           14.2         11.4
Hardware                                     1.3            1.0          1.7
Impairment of patent                           -            0.3            -
Total cost of revenue                       23.3           22.2         20.2

Gross profit                                76.7           77.8         79.8

Operating expenses:
Sales and marketing                         44.4           45.6         36.0
Research and development                    25.1           21.7         18.6
General and administrative                  20.6           20.7         15.4
Restructuring charge                         1.0              -            -
Total operating expenses                    91.1           88.0         70.0

Operating (loss) income                    (14.4 )        (10.2 )        9.8

Interest income                              6.8           12.6          4.7
(Loss) income before income taxes           (7.6 )          2.4         14.5

(Benefit) provision for income taxes        (3.5 )          0.5          5.2

Net (loss) income                           (4.1 )%         1.9 %        9.3 %

Revenue (dollars in thousands)



                               For the Year Ended December 31,               Increase (Decrease)            Percent Increase (Decrease)
                               2008            2007          2006       2007 to 2008      2006 to 2007     2007 to 2008     2006 to 2007
Revenues:
License fees               $     34,290    $     39,673    $ 46,332    $       (5,383 )  $       (6,659 )            (14 )%          (14 )%
Maintenance and services         32,436          29,487      22,615             2,949             6,872               10 %            30 %
Hardware                          1,415           1,016       1,565               399              (549 )             39 %           (35 )%
Total revenue              $     68,141    $     70,176    $ 70,512    $       (2,035 )  $         (336 )             (3 )%           (0 )%

For 2009, we expect revenue of $61.0 million to $66.0 million, or a 3% to 10% decrease from 2008 revenue.

License fee revenue (dollars in thousands)

                         For the Year Ended December 31,               Increase (Decrease)            Percent Increase (Decrease)
                         2008            2007          2006       2007 to 2008      2006 to 2007     2007 to 2008     2006 to 2007
License fee
revenue:
Vitrea licenses      $      9,242    $     12,853    $ 18,585    $       (3,611 )  $       (5,732 )            (28 )%          (31 )%
Vitrea options
and third party
software                   20,559          24,967      26,486            (4,408 )          (1,519 )            (18 )%           (6 )%
ViTAL Enterprise            3,303               -           -             3,303                 -              100 %             - %
Other                       1,186           1,853       1,261              (667 )             592              (36 )%           47 %
Total license fee
revenue              $     34,290    $     39,673    $ 46,332    $       (5,383 )  $       (6,659 )            (14 )%          (14 )%

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 features. We expect that revenue from Vitrealicenses, Vitrea options and third party software will continue to decrease in significance as compared to overall license fee revenue as sales of ViTAL Enterpriseincrease. The decrease in license fee revenue during 2008, as compared to 2007, was driven primarily by a decrease in the number of Vitrealicenses sold by our direct sales force, offset in part by new sales of ViTAL Enterprise, and by a greater percentage of license fee revenue from Toshiba, which has lower revenue per license. Sales of ViTAL Enterprise also impact overall revenue mix, as a larger percentage of each ViTAL Enterprise sale is allocated to maintenance and services revenue than has historically been allocated for sales of Vitrea. The decrease in 2007 license fee revenue resulted from a 16% decrease in the number of Vitrea licenses sold in 2007 compared to 2006.

The following table sets forth information on license fee revenue by source:

                                      For the Year Ended December 31,
                                      2008            2007         2006
License fee revenue:
Direct                            $      9,750    $     14,202   $ 20,273
Toshiba                                 23,276          22,141     20,414
McKesson                                 1,264           3,330      5,645
Total license fees                $     34,290    $     39,673   $ 46,332

Percent of license fee revenue:
Direct                                      28 %            36 %       44 %
Toshiba                                     68              56         44
McKesson                                     4               8         12
Total license fee revenue                  100 %           100 %      100 %

Maintenance and services revenue (dollars in thousands)

                                                                                                    Percent Increase
                                For the Year Ended December 31,           Increase (Decrease)          (Decrease)
                                                                          2007 to      2006 to     2007 to    2006 to
                                2008            2007          2006         2008          2007       2008       2007
Maintenance and services
revenue:
Maintenance and support     $     26,656    $     22,811    $ 16,379    $     3,845    $  6,432         17 %       39 %
Customer education                 4,478           5,590       5,178         (1,112 )       412        (20 )%       8 %
Professional services              1,302           1,086       1,058            216          28         20 %        3 %
Total maintenance and
services                    $     32,436    $     29,487    $ 22,615    $     2,949    $  6,872         10 %       30 %

In 2008, maintenance and services revenue was positively impacted by sales of ViTAL Enterprise, as a larger percentage of each ViTAL Enterprise sale is allocated to maintenance and services revenue than has historically been allocated for sales of Vitrea. As in 2008, we expect that in future periods, although sales of ViTAL Enterprisewill result in proportionately lower license revenue upon sale, we will benefit from a recurring revenue stream from maintenance and services contracts.

The increase in maintenance and support revenue in 2008 was primarily driven by an increase in the number of customers on maintenance contracts, resulting from both new license sales and improvement in the percentage of our existing customers who went on maintenance contracts. The increase in maintenance and support revenue in 2007 was primarily driven by an increase in the number of customers on maintenance contracts, as well as by increased pricing on maintenance and support.

Decreased license sales in 2008, compared to 2007, and a general deferral of education sessions contributed to lower customer education revenue in 2008. Professional services revenue, which includes installation and other implementation-related services, increased due to an increase in services related to sales of ViTAL Enterprise. The increase in customer education revenue and professional services revenue in 2007 was due in part to customer education revenue recognized in 2007 related to strong Vitrea license sales near the end of 2006.

Hardware revenue

Hardware revenue increased 39% to $1.4 million, compared to $1.0 million in . . .