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."

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 Enterprisehas 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 Enterpriseoffers 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.

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:

Option                                           Clinical Use
†Vscore                      -Quantifies calcium in the four major coronary
                             arteries
†CT Brain Perfusion          -Analyzes the blood flow of stroke victims
†Innerview GI (virtual       -Locates and analyzes polyps in the colon
colonoscopy)
†Automated Vessel            -Characterizes the course and dimensions of diseased
Measurements                 blood vessels
†CT Cardiac                  -Determines the extent of obstructive coronary artery
                             disease
†SUREPlaque™                 -Aids in evaluating, characterizing and quantifying
                             plaque inside the coronary arteries
†Vessel Probe                -Defines vascular anatomy and the extent of
                             obstruction in vessels other than the coronary
                             arteries
†CT Lung and Lung Tools      -Visualizes and measures nodules in the lungs
†ImageChecker® CT            -Detects pulmonary nodules in the chest
†Fusion7D™                   -Visualizes images and fuse studies from multiple
                             modalities, such as magnetic resonance, or MR, and
                             PET
†CADstream™                  -Analyzes MR breast exams
†QMass™ MR                   -Analyzes MR cardiac images
†EP Planning                 -3D advanced visualization and modeling tool for the
                             electrophysiology lab
†Collaboration               -Enables two users to collaborate while viewing the
                             same study at the same time
†PET/CT Overlay              -Provides the ability to overlay PET and CT images
                             with Standardized Uptake Value (SUV) calculations

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

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.



                              For the Three Months Ended
                                       March 31,
                                2009              2008

Revenue:
License fees                        40.5 %            54.0 %
Maintenance and services            57.9              43.5
Hardware                             1.6               2.5
Total revenue                      100.0             100.0

Cost of revenue:
License fees                         6.5               6.6
Maintenance and services            16.1              14.9
Hardware                             1.4               1.1
Total cost of revenue               24.0              22.6

Gross profit                        76.0              77.4

Operating expenses:
Sales and marketing                 40.3              46.5
Research and development            22.0              24.7
General and administrative          20.1              21.2
Total operating expenses            82.4              92.4

Operating loss                      (6.4 )           (15.0 )

Interest income                      2.9               9.8
Loss before income taxes            (3.5 )            (5.2 )

Income tax benefit                  (1.8 )            (1.8 )

Net loss                            (1.7 )%           (3.4 )%

Revenue



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



                                For the Three Months Ended
                                        March 31,
                             2009       2008         Change
Revenue:
License fees               $  5,994   $  9,358   $ (3,364 ) (36 )%
Maintenance and services      8,561      7,534      1,027    14 %
Hardware                        233        425       (192 ) (45 )%
Total revenue              $ 14,788   $ 17,317   $ (2,529 ) (15 )%

License fee revenue (dollars in thousands)

                                              For the Three Months Ended
                                                       March 31,
                                            2009      2008         Change
License fee revenue:
Vitrea licenses                           $  1,579   $ 3,020   $ (1,441 ) (48 )%
Vitrea options and third party software      3,395     5,895     (2,500 ) (42 )%
ViTAL Enterprise                               658         -        658   100 %
Other                                          362       443        (81 ) (18 )%
Total license fee revenue                 $  5,994   $ 9,358   $ (3,364 ) (36 )%

ViTAL Enterprise, introduced in May 2008, enables unlimited enterprise access to the complete ViTAL solution offering, including Vitrea, ViTALConnectand 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):

                                      For the Three Months Ended
                                               March 31,
                                    2009      2008         Change
License fee revenue:
Direct and other distributors     $  1,360   $ 3,197   $ (1,837 ) (57 )%
Toshiba                              4,634     6,161     (1,527 ) (25 )%
Total license fee revenue         $  5,994   $ 9,358   $ (3,364 ) (36 )%

Percent of license fee revenue:
Direct and other distributors           23 %      34 %
Toshiba                                 77        66
Total license fee revenue              100 %     100 %

Maintenance and services revenue (dollars in thousands)

                                        For the Three Months Ended
                                                 March 31,
                                      2009       2008        Change
Maintenance and services revenue:
Maintenance and support             $   7,371   $ 6,117   $ 1,254    21 %
Customer education                        955     1,054       (99 )  (9 )%
Professional services                     235       363      (128 ) (35 )%
Total maintenance and services      $   8,561   $ 7,534   $ 1,027    14 %

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):

                                For the Three Months Ended
                                        March 31,
                             2009       2008         Change
Gross profit:
License fees               $  5,024   $  8,205   $ (3,181 ) (39 )%
Maintenance and services      6,184      4,962      1,222    25 %
Hardware                         24        230       (206 ) (90 )%
Total gross profit         $ 11,232   $ 13,397   $ (2,165 ) (16 )%

Gross margin:
License fees                     84 %       88 %
Maintenance and services         72 %       66 %
Hardware                         10 %       54 %
Total gross margin               76 %       77 %

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 Enterprisesale 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

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:

                                                         Percent Change for
                              Percent of Revenue for      the Three Months
                                 the Three Months              Ended
                                  Ended March 31,            March 31,
                                2009           2008         2008 to 2009
Operating expenses:
Sales and marketing                40.3 %         46.5 %                (26 )%
Research and development           22.0           24.7                  (24 )%
General and administrative         20.1           21.2                  (19 )%
Total operating expenses           82.4 %         92.4 %                (24 )%

Sales and marketing

Sales and marketing expenses are as follows (dollars in thousands):

                                      For the Three Months Ended March 31,
                                     2009           2008            Change
Salaries, benefits and bonuses    $     2,596    $     3,439    $    (843 ) (25 )%
Overhead and other expenses               818            984         (166 ) (17 )%
Travel, meals and entertainment           642            826         (184 ) (22 )%
Trade shows and advertising               590            819         (229 ) (28 )%
Commissions                               496          1,196         (700 ) (59 )%
Depreciation                              471            419           52    12 %
Equity-based compensation                 342            368          (26 )  (7 )%
Total                             $     5,955    $     8,051    $  (2,096 ) (26 )%

The decrease in salaries and benefits costs for the three months ended March 31, 2009, compared to the 2008 first quarter, resulted from decreased headcount, primarily from our 11% reduction in workforce in November 2008. The decrease in commissions expense for the three months ended March 31, 2009, compared to the same period in 2008, was due to decreased direct sales. We had 79 and 101 sales and marketing personnel as of March 31, 2009 and 2008, respectively.

We will continue to manage sales and marketing expenses based on market conditions and business opportunities.

Research and development

Research and development expenses are as follows (dollars in thousands):

                                     For the Three Months Ended March 31,
                                    2009           2008            Change
Salaries, benefits and bonuses   $     2,442    $     2,839    $    (397 ) (14 )%
Overhead and other expenses              655            629           26     4 %
Depreciation                             203            230          (27 ) (12 )%
Equity-based compensation                195            265          (70 ) (26 )%
Consulting                                 9            322         (313 ) (97 )%
Development reimbursement               (243 )            -         (243 ) 100 %
Total                            $     3,261    $     4,285    $  (1,024 ) (24 )%

The decrease in research and development expenses for the three months ended March 31, 2009, compared to the same period in 2008, was primarily due to a decrease in compensation costs and consulting expense as a result of the workforce reduction in November 2008 and other cost-control measures. Additionally, during the 2009 first quarter, we entered into a co-development and collaboration agreement with Toshiba, 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 our advanced visualization software solutions. During the first quarter of 2009, we recognized a credit of $243,000 to our research and development expenses for reimbursement from Toshiba for development costs we incurred under the co-development agreement. We had 96 and 116 research and development personnel as of March 31, 2009 and 2008, respectively.

We will continue to devote resources to develop applications and solutions to improve the cost, quality and accessibility of health care.

General and administrative

General and administrative expenses are as follows (dollars in thousands):

                                           For the Three Months Ended March 31,
                                         2009           2008             Change
Salaries, benefits and bonuses        $     1,329    $     1,384    $      (55 )  (4 )%
Overhead and other expenses                   673            826          (153 ) (19 )%
Accounting, auditing and legal fees           466            535           (69 ) (13 )%
Equity-based compensation                     375            523          (148 ) (28 )%
Consulting                                    126            383          (257 ) (67 )%
Total                                 $     2,969    $     3,651    $     (682 ) (19 )%

The decrease in general and administrative expenses during the three months ended March 31, 2009, compared to the same period in 2008, was due in part to a lower utilization of consultants and reduced headcount resulting from the November 2008 workforce reduction. We had 47 and 54 general and administrative personnel as of March 31, 2009 and 2008, respectively.

We will continue to manage general and administrative expenses relative to changes in revenue.

Interest income

We generated $430,000 of interest income in the first quarter of 2009, compared to $1.7 million in the first quarter of 2008. The decrease for the three months ended March 31, 2009, compared to the same period in 2008, was primarily due to a decline in interest rates.

Income taxes

Our consolidated effective income tax rate was 52.0% and 34.3% for the three months ended March 31, 2009 and 2008, respectively. Our consolidated effective income tax rate was 46.0% for fiscal year 2008. The increase in our effective tax rates for the first quarter of 2009, compared to the first quarter of 2008, was due primarily to the relative impact of research and development credits on pretax results in first quarter of 2009.

We had $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 . . .