The following discussion and analysis should be read in conjunction with our financial statements and notes thereto included in this report on Form 10-Q, and the audited financial statements and notes as of and for the year ended December 31, 2011 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on February 17, 2012. Operating results are not necessarily indicative of results that may occur in future periods. This report contains various forward-looking statements regarding our business, financial condition, results of operations and future plans and projects. Forward-looking statements discuss matters that are not historical facts and can be identified by the use of words such as "believes," "expects," "anticipates," "estimates," "can," "could," "may," "will," "would," "might," or similar expressions. In this report, for example, we make forward-looking statements regarding, among other things, our expectations about the rate of revenue growth in specific business segments and the reasons for that growth and our profitability, our expectations regarding an increase in sales, strategic traction and marketing and sales spending, uncertainties relating to our ability to compete, uncertainties relating to our ability to increase our market share, changes in coverage and reimbursement policies of the Center for Medicare and Medicaid Services along with third-party payers and the effect on our ability to sell our products and services, our ability to timely develop new products or services that will be accepted by the market, competition from alternative imaging modalities, declining average selling prices for our Product offerings, supplies of radiopharmaceuticals, and the profitability of our business. Although these forward-looking statements reflect our good faith judgment, such statements can only be based upon facts and factors currently known to us. Forward-looking statements are inherently subject to risks and uncertainties, many of which are beyond our control. As a result, our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below under the caption "Risk Factors." For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You should not unduly rely on these forward-looking statements, which speak only as of the date on which they were made. They give our expectations regarding the future, but are not guarantees. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law.
Overview
We are a leading developer and manufacturer of medical diagnostic imaging systems including solid-state gamma cameras for nuclear cardiology and general nuclear medicine applications. We also are one of the largest national providers of in-office nuclear cardiology imaging and ultrasound services to physician practices, hospitals and imaging centers through our Digirad Imaging Solutions ("DIS") business segment. We designed and commercialized the first solid-state nuclear gamma camera for the detection of cardiovascular disease and other medical conditions. Our imaging systems are sold in both portable and fixed configurations, and provide enhanced operability, improved patient comfort and, in the case of our triple-headed Cardius® 3 XPO and Cardius® X-ACT system, shorter image acquisition time when compared to traditional vacuum tube cameras or our single or dual headed cameras. Our nuclear cameras fit easily into floor spaces as small as seven feet by eight feet and facilitate the delivery of nuclear medicine procedures in a physician's office, an outpatient hospital setting or within multiple departments of a hospital. Our Business Segments
We generate revenues within two primary operating segments: our DIS segment (our personnel and equipment service business) and our Product segment (the manufacture and sales of our medical diagnostic camera business and associated

maintenance services).
Our DIS Segment. Through DIS, we offer a convenient and economically efficient imaging services program as an alternative to purchasing a gamma camera or ultrasound equipment or outsourcing the procedures to another physician or imaging center. For physicians who wish to perform nuclear imaging, echocardiography, vascular or general ultrasound tests, or any combination of these procedures in their offices, we provide the ability for them to engage our services, which includes the use of our imaging system, qualified personnel, and related items required to perform imaging in their own offices and bill Medicare, Medicaid or one of the third-party healthcare insurers directly for those services. These services are also used by large and small hospitals, multi-practice physician groups, and imaging centers. The flexibility of our products and our DIS service allows physicians to ensure continuity of care and convenience for their patients and allows them to retain revenue from procedures they would otherwise refer to imaging centers and hospitals. DIS services are primarily provided to cardiologists, internal medicine physicians, and family practice doctors who enter into annual contracts for a set number of days ranging from once per month to five times per week. We experience some seasonality in our DIS business related to vacations, holidays, and inclement weather. Most of the DIS business focuses on cardiac care with an increase in a combination of cardiac and general ultrasound imaging in recent months. Many of the physicians who use DIS services are reliant on reimbursements from Medicare and third-party insurers where there has been downward pressure and uncertainty due to factors outside the physicians' control. The uncertainty created by the 2010 healthcare reform laws, Congress' continued deferred action on the Sustainable Growth Rate reimbursement factor (which is part of the Relative Value Unit calculation of reimbursements for all medical codes) and other legislation has also impacted our business. These changes may require further modifications to our business model in order for our physician customers and us to maintain a viable economic model.
Our Product Segment. Our Product revenue results primarily from selling solid-state gamma cameras and camera maintenance contracts. We sell our imaging systems to physician offices, hospitals and imaging centers primarily in the United States, although we have sold a small number of imaging systems internationally. The central component of our nuclear camera is the detector and it ultimately determines the overall clinical quality of the image our camera produces. Our nuclear cameras feature detectors based on advanced proprietary solid-state technology developed by us. Solid-state systems have a number of benefits over conventional photomultiplier tube-based camera designs typically offered by our competitors. Our solid-state technology systems are typically lighter and considerably more compact than most traditional nuclear systems, making them far easier and less costly to build, as well as very reliable. Our solid-state technology provides us with the capability to market and manufacture a diverse family of high-performance dedicated cardiac and general-purpose cameras that offer a number of economic, service and performance benefits over traditional PMT-based camera systems. We recently introduced our first general imaging camera called the ergo TM, which is targeted to hospital customers. Prior to that, we introduced a new product called the Cardius ® X-ACT camera, which is a rapid cardiac SPECT/VCT imager. The Cardius ® X-ACT camera is also positioned more toward the hospital and larger cardiology practices. Our Market
The target market for our products and services includes cardiologists, internal medicine physicians, family practice physicians, imaging centers and hospitals in the United States that perform or could perform nuclear cardiac, general nuclear and ultrasound procedures. We provide imaging services through DIS to more than 1,100 physicians and physician groups, and have sold over 700 cameras through our Product segment. More than half of our DIS nuclear and ultrasound imaging customers are internal medicine physicians or other primary care practitioners, and the remainder are primarily cardiologists. Our market has been negatively affected by lower physician reimbursements from the Center for Medicare and Medicaid Services (CMS) and third party providers for the codes under which our physician customers bill for our services, pricing pressures, decreases in radiopharmaceutical isotope supplies and continuing efforts by some third party payers to reduce health care expenditures by requiring physicians to obtain specific accreditations or certifications. We have been addressing and will continue to address these market pressures by introducing new products, modifying our DIS business model, and assisting our physician customers in complying with new regulations and requirements. Trends and Drivers
The medical device industry, including the market for nuclear and ultrasound imaging systems and services, is highly competitive. Our business continues to be affected by many factors, including healthcare reimbursement rates for cardiac imaging procedures, competition from alternative imaging modalities such as positron emission tomography (PET) and computed tomography (CT) angiography, competition from other small owner-operated mobile nuclear imaging providers, declining average selling prices for our product offerings and general uncertainty in the healthcare marketplace. We continue to experience significant market changes due to the fluctuations in reimbursement rates and the uncertainty of healthcare legislation. We also continue to experience a low demand for our cameras, partially due to very limited hospital and physician group capital budgets and the general low economic recovery rate. We expect most of these trends to continue in the foreseeable future.

In our DIS segment, our physician customers continue to experience significant uncertainty in reimbursements from CMS and third party providers for the codes under which our physician customers bill for our services. This uncertainty has caused some of our physician customers to sell their practices to a hospital and others to reduce the volume of our service. As a result, we are continuing to modify our offering and pricing for our services upon contract renewal. The uncertainty over the enactment of future legislation that may impact reimbursement rates continues to linger and cause concern with our physician customers. We continue to consider modification to our business model in order to adapt to environmental and regulatory changes in our dynamic healthcare marketplace.
In our Product segment, we continue to build on past Product segment achievements by introducing new single photon emission computed tomography, or SPECT, products targeted specifically at the larger physician practices and hospital marketplace. The most widely used imaging acquisition technology utilizing gamma cameras is single SPECT, and all of our current cardiac gamma cameras employ SPECT methodology. Although the National Electrical Manufactures Association has reported that the dedicated cardiac nuclear market has declined by approximately 70 percent since 2005, according to industry sources (despite the improving image quality and increasing utilization rates of competing modalities such as CT, PET, and MRI, and diagnostic procedures such as CT angiography), SPECT procedures performed with gamma cameras will continue to be used for a substantial number of cardiac-specific imaging procedures. We believe continued utilization will be driven by patients having easier access to nuclear medicine services at physicians' offices, lower purchase and maintenance costs, a smaller physical footprint, and easier service logistics of gamma cameras. In an emerging trend in cardiology, SPECT technologies are being integrated with other imaging modalities to form hybrid imaging modalities, such as SPECT/CT, resulting in improved clinical quality and diagnostic certainty. We are also seeking other market opportunities to expand the use of our technology. We believe that our product mix will begin to reflect more ergo general purpose portable imaging system sales as we penetrate the hospital marketplace. Although the hospital sales cycles tend to be longer than the in-office market sales cycles, we have already sold and installed several ergo imaging systems into leading U.S. hospitals and expect that trend to continue. Nine Months of 2012 Financial Highlights Our consolidated revenues were $37.5 million for the nine months ended September 30, 2012, which represented a decrease of $4.4 million, or 10.4%, compared to the prior year period. DIS revenue decreased $1.3 million, or 4.6%, primarily due to a reduction in the number of days we scanned for our physician customers. The number of scan days was reduced due to a consolidation in the number of scan days by our physician customers in response to reimbursement uncertainty, in addition to other business factors such as physician pre-certification requirements, making it more difficult for our physician customers to utilize our services. Product revenues for the nine months ended September 30, 2012 decreased by $3.0 million, or 23.4%, compared to the prior year period, primarily due to a fewer number of new cameras sold to hospitals and cardiology practices. The increase in gross profit of our DIS segment was primarily attributable to lower radiopharmaceutical costs and improvement in operational performance, primarily associated with the management of labor and equipment resources. The decrease in gross profit of our Product segment was primarily attributable to lower camera sales and product mix.
We realized a net loss of $3.1 million for the nine months ended September 30, 2012, compared to a net loss of $0.5 million for the same nine month period in 2011. This was primarily the result of our decreased revenues coupled with our increased investment in market research and development with a focus on new innovative products.
Our DIS business currently operates in 19 states. For the nine months ended September 30, 2012, DIS operated 62 nuclear gamma cameras and 66 ultrasound imaging systems, compared to 64 nuclear gamma cameras and 67 ultrasound imaging systems during the same period in the prior year. We seek to improve our overall profitability through more efficient utilization of our fleet of gamma cameras and ultrasound equipment. We measure efficiency by tracking system utilization, which is measured based on the percentage of days that our nuclear gamma cameras and ultrasound equipment are used to deliver services to customers out of the total number of days that they are available to deliver such services. System utilization decreased to 55.2% for the nine months ended September 30, 2012, compared to 57.2% during the same period in the prior year, primarily due to fewer scan days as discussed above.

Results of Operations
The following table sets forth our results from operations expressed as
percentages of revenues for the three and nine months ended September 30, 2012
and 2011 (dollars in thousands):

                                                    Three Months Ended September 30,
                                                                                                Change from
                                     Percent of 2012                  Percent of 2011           Prior Year
                          2012           Revenues          2011           Revenues         Dollars       Percent
Revenues:
DIS                    $   8,856           74.9  %      $   9,293           69.1  %      $    (437 )       (4.7 )%
Product                    2,961           25.1  %          4,146           30.9  %         (1,185 )      (28.6 )%
Total revenues            11,817            100  %         13,439            100  %         (1,622 )      (12.1 )%
Total cost of revenues     8,688           73.5  %          9,289           69.1  %           (601 )       (6.5 )%
Gross profit               3,129           26.5  %          4,150           30.9  %         (1,021 )      (24.6 )%
Operating expenses:
Research and
development                1,055            8.9  %            702            5.2  %            353         50.3  %
Marketing and sales        1,348           11.4  %          1,575           11.7  %           (227 )      (14.4 )%
General and
administrative             1,744           14.8  %          1,848           13.8  %           (104 )       (5.6 )%
Amortization of
intangible assets             49            0.4  %             77            0.6  %            (28 )      (36.4 )%
Total operating
expenses                   4,196           35.5  %          4,202           31.3  %             (6 )       (0.1 )%

                                                     Nine Months Ended September 30,
                                                                                                Change from
                                     Percent of 2012                  Percent of 2011           Prior Year
                          2012           Revenues          2011           Revenues         Dollars       Percent
Revenues:
DIS                    $  27,522           73.4  %      $  28,839           68.9  %      $  (1,317 )       (4.6 )%
Product                    9,975           26.6  %         13,024           31.1  %         (3,049 )      (23.4 )%
Total revenues            37,497            100  %         41,863            100  %         (4,366 )      (10.4 )%
Total cost of revenues    27,015           72.0  %         30,199           72.1  %         (3,184 )      (10.5 )%
Gross profit              10,482           28.0  %         11,664           27.9  %         (1,182 )      (10.1 )%
Operating expenses:
Research and
development                2,998            8.0  %          2,124            5.1  %            874         41.1  %
Marketing and sales        4,735           12.6  %          4,616           11.0  %            119          2.6  %
General and
administrative             5,820           15.5  %          5,818           13.9  %              2            -  %
Amortization of
intangible assets            184            0.5  %            253            0.6  %            (69 )      (27.3 )%
Restructuring gain             -              -  %           (164 )         (0.4 )%            164       (100.0 )%
Total operating
expenses                  13,737           36.6  %         12,647           30.2  %          1,090          8.6  %
Loss from operations      (3,255 )         (8.7 )%           (983 )         (2.3 )%         (2,272 )      231.1  %
Total other income           190            0.5  %            468            1.1  %           (278 )      (59.4 )%
Net loss               $  (3,065 )         (8.2 )%      $    (515 )         (1.2 )%      $  (2,550 )      495.1  %

Comparison of Three Months Ended September 30, 2012 and 2011 Revenues
Consolidated. Consolidated revenue was $11.8 million for the three months ended September 30, 2012, a decrease of $1.6 million, or 12.1%, compared to the prior year quarter, primarily as a result of a decrease in the number of camera sales in our Product business segment along with a lower number of imaging days in our DIS business. DIS revenue accounted for 74.9% of total revenues for 2012, compared to 69.1% for the prior year quarter. We expect our DIS revenue to continue to represent the larger percentage of our consolidated revenue. DIS. Our DIS revenue was $8.9 million for the three months ended September 30, 2012, a decrease of $0.4 million, or 4.7%, compared to the prior year quarter. The decrease resulted from a reduction in the number of days our physician customers utilized our imaging services.
Product. Our Product revenue was $3.0 million for the three months ended September 30, 2012, a decrease of $1.2 million, or 28.6%, compared to the prior year quarter. The decrease in revenue resulted mainly from selling a fewer number of new gamma cameras as compared to the prior year quarter. Cost of Revenue and Gross Profit
Consolidated. Consolidated gross profit was $3.1 million for the three months ended September 30, 2012, a decrease of $1.0 million, or 24.6%, compared to the prior year quarter. The decrease in consolidated gross profit is primarily the result of lower camera sales, fewer imaging days, increase in labor costs and partially offset by lower radiopharmaceutical costs. Consolidated gross profit as a percentage of revenue decreased to 26.5% for the three months ended September 30, 2012 from 30.9% for the prior year quarter.
DIS. Cost of DIS revenue primarily consists of labor, radiopharmaceuticals, equipment depreciation, and other costs associated with the providing our services. Cost of DIS revenue was $6.9 million for the three months ended September 30, 2012, a decrease of $0.2 million, or 2.4%, compared to the prior year quarter. The decrease in cost of DIS revenue is primarily a result of decreased revenues and lower radiopharmaceutical costs. DIS gross profit was $2.0 million for the three months ended September 30, 2012, a decrease of $0.3 million, or 12.0%, from a gross profit of $2.2 million for the prior year quarter. DIS gross profit as a percentage of DIS revenue decreased to 22.3% for the three months ended September 30, 2012 from 24.2% for the prior year quarter. The reduction in gross profit was primarily attributable to an increase in labor cost offset by lower radiopharmaceutical costs.
Product. Cost of Product revenue primarily consists of materials, labor and overhead costs associated with the manufacturing, warranty and service contracts associated with our products. Cost of Product revenue was $1.8 million for the three months ended September 30, 2012, a decrease of $0.4 million , or 19.3%, compared to the prior year quarter. Product gross profit was $1.2 million for the three months ended September 30, 2012, a decrease of $0.8 million, or 39.5%, compared to the prior year period. Product gross profit as a percentage of Product revenue was 38.9% for the three months ended September 30, 2012, compared to 45.9% for the prior year quarter due to changes in product mix and lower camera sales.
Operating Expenses
Research and Development. Research and development expenses are the costs associated with the design, development and expansion of our existing technology and consist of salaries, development material costs, facility and overhead costs, consulting fees, and non-recurring engineering costs. We continue to invest in research and development with a focus on innovation as we seek to improve our existing technology. Research and development expenses were $1.1 million for the three months ended September 30, 2012, an increase of $0.4 million from the prior year quarter mainly due to initiatives to explore and develop new products and technologies. Research and development expenses were 35.6% of Product revenue for the three months ended September 30, 2012, compared to 16.9% in the prior year quarter, mainly due to a decrease in Product revenue of $1.2 million and the aforementioned exploration of new initiatives. We plan to continue investing in our technology platform to penetrate new and existing market segments and attract new customers.
Marketing and Sales. Marketing and sales expenses consist primarily of salaries, commissions, bonuses, recruiting costs, travel, marketing and collateral materials and trade show costs. Marketing and sales expenses were $1.3 million for the three months ended September 30, 2012, a decrease of $0.2 million, or 14.4%, compared to the prior year quarter, primarily as a result of lower personnel related costs and marketing support costs. Marketing and sales expenses as a percentage of total revenues were 11.4% and 11.7% for the three months ended September 30, 2012 and 2011, respectively.

General and Administrative. General and administrative expenses consist primarily of salaries and other related costs for accounting, human resources, information technology and executive personnel, legal related costs, professional fees, outside services, insurance, and costs related to our board of directors. General and administrative expenses were $1.7 million for the three months ended September 30, 2012, a decrease of $0.1 million, or 5.6%, compared to the prior year quarter. This decrease is primarily the result of lower payroll related costs. General and administrative expenses were 14.8% of total revenue for the three months ended September 30, 2012 compared to 13.8% for the prior year quarter.

Comparison of Nine Months Ended September 30, 2012 and 2011

Revenues
Consolidated. Consolidated revenue was $37.5 million for nine months ended September 30, 2012, a decrease of $4.4 million, or 10.4%, compared to the prior year, primarily as a result of a decrease in revenue from our Product segment from lower camera sales, coupled with a decline in DIS segment revenue due to fewer days of service. DIS revenue accounted for 73.4% of total revenues for 2012, compared to 68.9% for the prior year. We expect DIS revenue to continue to represent the larger percentage of our consolidated revenue.

DIS. Our DIS revenue was $27.5 million for the nine months ended September 30, 2012, a decrease of $1.3 million, or 4.6%, compared to the prior year. The decrease resulted from a reduction in the number of days our physician customers utilized our imaging services.

Product. Our Product revenue was $10.0 million for the nine months ended September 30, 2012, a decrease of $3.0 million, or 23.4%, compared to the prior year. The decrease in revenue was primarily due to lower camera sales and product mix.

Cost of Revenue and Gross Profit
Consolidated. Consolidated gross profit was $10.5 million for the nine months ended September 30, 2012, a decrease of $1.2 million, or 10.1%, compared to the prior year. The decrease in consolidated gross profit is primarily the result of fewer camera sales and a change in product mix, partially offset by improving gross margins in DIS due to lower radiophamaceutical costs during the nine months ended September 30, 2012. Consolidated gross profit as a percentage of revenue increased to 28.0% for the nine months ended September 30, 2012 from 27.9% for the prior year.

DIS. Cost of DIS revenue was $20.8 million for the nine months ended September 30, 2012, a decrease of $1.8 million, or 8.0%, compared to the prior year. The decrease in cost of DIS revenue was primarily a result of decreased expenses from fewer nuclear days and lower radiophamaceutical. DIS gross profit was $6.8 million for the nine months ended September 30, 2012, which represents an increase of $0.5 million, or 8.0%, from a gross profit of $6.3 million for the prior year. DIS gross profit as a percentage of DIS revenue increased to 24.6% for the nine months ended September 30, 2012 from 21.7% for the prior year due to improvement in operational performance primarily associated with the management of labor and equipment resources.

Product. Cost of revenues for the Product segment was $6.3 million for the nine months ended September 30, 2012, a decrease of $1.4 million, or 17.9%, compared to the prior year. The decrease in cost of Product revenue is primarily a result . . .