Tableof Contents

 

 

 

**UNITED STATES********SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **(Mark one)**                                                                                                                                                                          |                                                                                                                                                      |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                   | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY  PERIOD ENDED JUNE 30, 2008** |
|                                                                                                                                                                                    | ** **                                                                                                                                                |
| **OR**                                                                                                                                                                                  |
| ** **                                                                                                                                                                              |
| **o**                                                                                                                                                                                   | **TRANSITION REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                              |
|                                                                                                                                                                                    | ** **                                                                                                                                                |
| **For the transition period from              to             ** |

 

**CommissionFile Number 001-33815**

 

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**Virtual Radiologic Corporation**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **27-0074530**                      |
|------------------------------------------------------------------|------------|-------------------------------------|
| (State  or other jurisdiction of  incorporation or organization) | ** ** | (IRS  Employer  Identification No.) |
| ** **                                                       | ** ** | ** **                          |
| **5995 Opus Parkway, Suite 200  Minnetonka, Minnesota**     | ** ** | **55343**                           |
| (Address  of principal executive offices)                        | ** ** | (Zip  code)                         |

 

**(952) 392-1100**

(Registrant’s telephone number, including area code)

 

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

 

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

 
| Large  accelerated filer o | Accelerated  filer o | Non-accelerated  filer x  (Do not check if a smaller reporting  company) | Smaller  reporting  company o |
|----------------------------|---------------------------|--------------------------------------------------------------------------|------------------------------------|

 

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

 

As of July 28, 2008,16,766,636 shares of the registrant’s common stock were outstanding.

 

 

 

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Tableof Contents

 

**TABLE OFCONTENTS**

 
| **Part I – Financial Information** | ** **                                                                                  |
|----------------------------------------------|---------------------------------------------------------------------------------------------|
| Item 1.                                 | Financial Statements                                                                        | 3 |
| Item 2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 18 |
| Item 3.                                 | Quantitative  and Qualitative Disclosures About Market Risk                                 | 37 |
| Item 4.                                 | Controls and  Procedures                                                                    | 37 |
| **Part II – Other Information**    | ** **                                                                                  |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 38 |
| Item 4.                                 | Submission  of Matters to a Vote of Security Holders                                        | 38 |
| Item 6.                                 | Exhibits                                                                                    | 38 |
| Signatures                                   | 40                                                                                          |

 

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Table of Contents

 

**PART I – Financial Information**

 

**ITEM 1.****                            ****Financial Statements**

 

**Virtual Radiologic Corporation**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Contents**

 
| ** **                                                                                                                                              | **Page** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| Consolidated Financial Statements (unaudited)                                                                                                           |     |
| Consolidated Balance Sheets as of  June 30, 2008 and December 31, 2007                                                                        | 4        |
| Consolidated  Statements of Operations for the three and six months ended June 30,  2008 and 2007                                                  | 5        |
| Consolidated  Statements of Changes in Stockholders’ Equity for the six months ended  June 30, 2008 and the year ended December 31, 2007 | 6        |
| Consolidated  Statements of Cash Flows for the six months ended June 30, 2008 and 2007                                                             | 7        |
| Notes to  Consolidated Financial Statements                                                                                                             | 8        |

 

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Table of Contents

 

**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

**(unaudited)**

**(in thousands, except per share data)**

 
| ** **                                                                                                                                                                                                                               | ** ** | **As of**    | ** ** | **As of**        | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                                                               | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| **Assets**                                                                                                                                                                                                                               | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                |       | $                 | 32,423     |                  | $          | 33,487 |   |
| Restricted cash                                                                                                                                                                                                                          |       | 700               |       | 700                   |       |
| Accounts receivable, net                                                                                                                                                                                                                 |       | 14,375            |       | 12,486                |       |
| Prepaid expenses                                                                                                                                                                                                                         |       | 1,049             |       | 2,073                 |       |
| Current taxes receivable                                                                                                                                                                                                                 |       | 1,135             |       | 1,995                 |       |
| Other current assets                                                                                                                                                                                                                     |       | 793               |       | 336                   |       |
| Total current assets                                                                                                                                                                                                                     |       | 50,475            |       | 51,077                |       |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Property, plant and equipment, net                                                                                                                                                                                                       |       | 10,956            |       | 8,013                 |       |
| Intangible assets, net                                                                                                                                                                                                                   |       | 5,355             |       | 252                   |       |
| Goodwill                                                                                                                                                                                                                                 |       | 673               |       | —                |       |
| Other assets                                                                                                                                                                                                                             |       | 501               |       | 94                    |       |
| Total assets                                                                                                                                                                                                                             |       | $                 | 67,960     |                  | $          | 59,436 |   |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                            |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                     |       |              |       |                  |       |
| Accounts payable                                                                                                                                                                                                                         |       | $                 | 754        |                  | $          | 801 |   |
| Accrued professional services compensation  expense                                                                                                                                                                                      |       | 5,413             |       | 4,681                 |       |
| Accrued sales, general and administrative  compensation expenses                                                                                                                                                                         |       | 1,588             |       | 1,717                 |       |
| Other accrued expenses                                                                                                                                                                                                                   |       | 1,182             |       | 1,273                 |       |
| Other current liabilities                                                                                                                                                                                                                |       | 674               |       | 398                   |       |
| Total current liabilities                                                                                                                                                                                                                |       | 9,611             |       | 8,870                 |       |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Deferred rent                                                                                                                                                                                                                            |       | 182               |       | 204                   |       |
| Non-current deferred tax liability                                                                                                                                                                                                       |       | 1,189             |       | —                |       |
| Other liabilities                                                                                                                                                                                                                        |       | 425               |       | 24                    |       |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Non-controlling interest                                                                                                                                                                                                                 |       | 16                |       | 8                     |       |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Commitments and contingencies (Note 8)                                                                                                                                                                                                   |       |              |       |                  |       |
|                                                                                                                                                                                                                                     |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                               |       |              |       |                  |       |
| Common stock, $.001 par value; 100,000,000  shares authorized at June 30, 2008 and December 31, 2007;  16,745,726 and 16,463,173 shares issued and outstanding at June 30, 2008  and December 31, 2007, respectively |       | 17                |       | 16                    |       |
| Additional paid-in capital                                                                                                                                                                                                               |       | 92,370            |       | 90,165                |       |
| Accumulated deficit                                                                                                                                                                                                                      |       | (35,851           | )          | (39,851               | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                     |       | 1                 |       | —                |       |
| Total stockholders’ equity                                                                                                                                                                                                          |       | 56,537            |       | 50,330                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                          |       | $                 | 67,960     |                  | $          | 59,436 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(unaudited)**

**(in thousands, except per share data)**

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Revenue                                                |       | $                                               | 25,921     |                                          | $          | 21,163 |   | $ | 49,241 |   | $ | 39,265 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Operating costs and expenses                           |       |                                            |       |                                          |       |   |   |   |   |
| Professional services                                  |       | 11,910                                          |       | 12,087                                        |       | 22,277 |   | 20,686 |   |
| Sales, general and administrative                      |       | 9,332                                           |       | 7,366                                         |       | 18,067 |   | 14,295 |   |
| Depreciation and amortization                          |       | 1,216                                           |       | 549                                           |       | 2,071 |   | 1,047 |   |
| Total operating costs and expenses                     |       | 22,458                                          |       | 20,002                                        |       | 42,415 |   | 36,028 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Operating income                                       |       | 3,463                                           |       | 1,161                                         |       | 6,826 |   | 3,237 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Other (expense) income                                 |       |                                            |       |                                          |       |   |   |   |   |
| Interest expense                                       |       | —                                          |       | (1                                            | )          | — |   | (7 | ) |
| Interest income                                        |       | 89                                              |       | 71                                            |       | 265 |   | 114 |   |
| Total other income                                     |       | 89                                              |       | 70                                            |       | 265 |   | 107 |   |
| Income before non-controlling interest and  income tax |       | 3,552                                           |       | 1,231                                         |       | 7,091 |   | 3,344 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Non-controlling interest expense (income)              |       | 4                                               |       | (341                                          | )          | 8 |   | 339 |   |
| Income before income tax expense                       |       | 3,548                                           |       | 1,572                                         |       | 7,083 |   | 3,005 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Income tax expense                                     |       | 1,548                                           |       | 995                                           |       | 3,083 |   | 1,387 |   |
| Net income                                             |       | 2,000                                           |       | 577                                           |       | 4,000 |   | 1,618 |   |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Series A Cumulative Redeemable  Convertible       |       |                                            |       |                                          |       |   |   |   |   |
| Preferred Stock accretion                              |       | —                                          |       | (24,892                                       | )          | — |   | (20,118 | ) |
| Net income (loss) available to common  stockholders    |       | $                                               | 2,000      |                                          | $          | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
|                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Earnings (loss) per common share                       |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                  |       | $                                               | 0.12       |                                          | $          | (3.27 | ) | $ | 0.24 |   | $ | (2.61 | ) |
| Diluted                                                |       | $                                               | 0.12       |                                          | $          | (3.27 | ) | $ | 0.23 |   | $ | (2.61 | ) |
| Weighted average common shares outstanding             |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                  |       | 16,719                                          |       | 7,446                                         |       | 16,667 |   | 7,088 |   |
| Diluted                                                |       | 17,198                                          |       | 7,446                                         |       | 17,233 |   | 7,088 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**

**(in thousands)**

 
| ** **                                                                    | ** ** | **Common Stock** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** **      | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | **Additional**  | ** ** | ** **      | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | **Paid-In**     | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                    | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Capital**     | ** ** | **Deficit**     | ** ** | **Loss** | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2006**                                         |       | 6,719                 |       | $          | 7          |            | $          | (31,049         | )          | $ | (3,393 | ) | $ | — |   | $ | (34,435 | ) |
| Accretion of Series A Cumulative Redeemable Convertible  Preferred Stock |       | —                |       | —     |       | (10,127         | )          | —          |       | — |   | (10,127 | ) |
| Equity based compensation for independent contractor physicians               |       | —                |       | —     |       | 3,687           |       | —          |       | — |   | 3,687 |   |
| Equity based compensation for employees                                       |       | —                |       | —     |       | 686             |       | —          |       | — |   | 686 |   |
| Independent contractor physician and employee stock option exercises          |       | 2,045                 |       | 2          |       | 1,512           |       | —          |       | — |   | 1,514 |   |
| Common stock re-purchased                                                     |       | (910                  | )          | (1         | )          | (10,009         | )          | —          |       | — |   | (10,010 | ) |
| Common stock re-issued                                                        |       | 910                   |       | 1          |       | 10,009          |       | —          |       | — |   | 10,010 |   |
| Warrant exercise                                                              |       | 72                    |       | —     |       | 1               |       | —          |       | — |   | 1 |   |
| Payment of dividend                                                           |       | —                |       | —     |       | —          |       | (39,909         | )          | — |   | (39,909 | ) |
| Common stock issued in initial public offering                                |       | 4,000                 |       | 4          |       | 63,236          |       | —          |       | — |   | 63,240 |   |
| Series A Preferred Stock conversion to common stock                      |       | 3,627                 |       | 3          |       | 61,650          |       | —          |       | — |   | 61,653 |   |
| Excess tax benefit from exercises of stock options                            |       | —                |       | —     |       | 4,780           |       | —          |       | — |   | 4,780 |   |
| Stock issuance costs                                                          |       | —                |       | —     |       | (4,211          | )          | —          |       | — |   | (4,211 | ) |
| Net income                                                                    |       | —                |       | —     |       | —          |       | 3,451           |       | — |   | 3,451 |   |
| **Balance at December 31, 2007**                                         |       | 16,463                |       | $          | 16         |            | $          | 90,165          |       | $ | (39,851 | ) | $ | — |   | $ | 50,330 |   |
| Equity based compensation for independent contractor physicians               |       | —                |       | —     |       | (559            | )          | —          |       | — |   | (559 | ) |
| Equity based compensation for employees                                       |       | —                |       | —     |       | 704             |       | —          |       | — |   | 704 |   |
| Independent contractor physician and employee stock option exercises          |       | 283                   |       | 1          |       | 201             |       | —          |       | — |   | 202 |   |
| Excess tax benefit from exercises of stock options                            |       | —                |       | —     |       | 1,917           |       | —          |       | — |   | 1,917 |   |
| Stock issuance costs                                                          |       | —                |       | —     |       | (58             | )          | —          |       | — |   | (58 | ) |
| Net income                                                                    |       | —                |       | —     |       | —          |       | 4,000           |       | — |   | 4,000 |   |
| Other comprehensive loss                                                      |       |                  |       |       |       |            |       |            |       |   |   |   |   |
| Foreign currency translation adjustments                                      |       | —                |       | —     |       | —          |       | —          |       | 1 |   | 1 |   |
| **Balance at June 30, 2008**                                             |       | 16,746                |       | $          | 17         |            | $          | 92,370          |       | $ | (35,851 | ) | $ | 1 |   | $ | 56,537 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(unaudited)**

**(in thousands)**

 
| ** **                                                                        | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                        | ** ** | **2008**                                      | ** ** | **2007** | ** ** |
| **Cash flows from operating activities**                                          |       |                                          |       |   |   |
| Net income                                                                        |       | $                                             | 4,000      |   | $ | 1,618 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities |       |                                          |       |   |   |
| Non-controlling interest                                                          |       | 8                                             |       | 339 |   |
| Provision for doubtful accounts and sales  allowance                              |       | 309                                           |       | 105 |   |
| Depreciation and amortization                                                     |       | 2,071                                         |       | 1,047 |   |
| Loss on disposal of property, plant and  equipment                                |       | 49                                            |       | 12 |   |
| Equity based compensation for independent  contractor physicians                  |       | (559                                          | )          | 2,053 |   |
| Equity based compensation for employees                                           |       | 704                                           |       | 116 |   |
| Deferred income taxes                                                             |       | 1,059                                         |       | — |   |
| Changes in operating assets and  liabilities, net of impact of acquisition:       |       |                                          |       |   |   |
| Accounts receivable                                                               |       | (1,634                                        | )          | (3,852 | ) |
| Prepaid expenses                                                                  |       | 1,024                                         |       | 836 |   |
| Current taxes receivable                                                          |       | 860                                           |       | (3,482 | ) |
| Other current assets                                                              |       | (164                                          | )          | (145 | ) |
| Other assets                                                                      |       | (3                                            | )          | 30 |   |
| Accounts payable                                                                  |       | 136                                           |       | 47 |   |
| Accrued expenses                                                                  |       | 848                                           |       | 2,165 |   |
| Current taxes payable                                                             |       | —                                        |       | (608 | ) |
| Other current liabilities                                                         |       | 142                                           |       | 2 |   |
| Deferred rent                                                                     |       | (21                                           | )          | (7 | ) |
| Net cash provided by operating activities                                         |       | 8,829                                         |       | 276 |   |
| **Cash flows from investing activities**                                          |       |                                          |       |   |   |
| Purchases of property, plant and equipment                                        |       | (5,072                                        | )          | (2,265 | ) |
| Proceeds from sale of property, plant and  equipment                              |       | 10                                            |       | — |   |
| Payments to acquire patents                                                       |       | (62                                           | )          | (13 | ) |
| Cash paid for acquisition, net of cash  acquired                                  |       | (6,521                                        | )          | — |   |
| Net cash used in investing activities                                             |       | (11,645                                       | )          | (2,278 | ) |
| **Cash flows from financing activities**                                          |       |                                          |       |   |   |
| Payments on capital leases                                                        |       | —                                        |       | (20 | ) |
| Payments of offering costs                                                        |       | (306                                          | )          | (441 | ) |
| Proceeds from warrant exercise                                                    |       | —                                        |       | 1 |   |
| Proceeds from stock option exercises                                              |       | 141                                           |       | 910 |   |
| Payments for the re-purchase of common  stock                                     |       | —                                        |       | (10,010 | ) |
| Proceeds from the re-issuance of common  stock                                    |       | —                                        |       | 10,010 |   |
| Excess tax benefit from exercises of stock  options                               |       | 1,917                                         |       | 3,944 |   |
| Net cash provided by financing activities                                         |       | 1,752                                         |       | 4,394 |   |
| Net (decrease) increase in cash and cash  equivalents                             |       | (1,064                                        | )          | 2,392 |   |
| **Cash and cash equivalents**                                                     |       |                                          |       |   |   |
| Beginning of period                                                               |       | 33,487                                        |       | 5,958 |   |
| End of period                                                                     |       | $                                             | 32,423     |   | $ | 8,350 |   |
|                                                                              |       |                                          |       |   |   |
| **Supplemental disclosure of cash flow information**                              |       |                                          |       |   |   |
| Cash (received) paid for income taxes                                             |       | $                                             | (776       | ) | $ | 1,336 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

**(unaudited)**

 

***1. Business Overview***

 

Virtual RadiologicCorporation, or VRC, a Delaware corporation, provides radiologicinterpretations, or reads, via teleradiology for emergency and routine carecoverage to radiology practices, hospitals, clinics and diagnostic imagingcenters primarily located within the United States. Virtual RadiologicProfessionals, LLC, or VRP, a Delaware limited liability company, is VRC’saffiliated physician-owned medical practice that contracts with the Company’saffiliated radiologists for the provision of their services to fulfill customercontracts held by VRC or the other Affiliated Medical Practices (as definedbelow).

 

VirtualRadiologic Professionals of California, P.A., Virtual Radiologic Professionalsof Illinois, S.C., Virtual Radiologic Professionals of Michigan, P.C., VirtualRadiologic Professionals of Minnesota, P.A., Virtual Radiologic Professionalsof New York, P.A. and Virtual Radiologic Professionals of Texas, P.A. arecollectively referred to as the “Professional Corporations.” Each of theseentities is a professional corporation with one stockholder, who is also anofficer and a director of VRC, and an owner of VRP. The ProfessionalCorporations were formed as the Company’s business expanded to facilitatecompliance with the corporate practice of medicine laws in the states in whichthey conduct business. VRP and the Professional Corporations are collectivelyreferred to as the “Affiliated Medical Practices.”

 

VRC also has awholly owned and consolidated subsidiary, Virtual Radiologic Limited, or VRL,formed under the laws of England and Wales and located in London, England. VRLwas formed to facilitate international expansion of the Company’s business toprovide teleradiology services and products to customers located outside of theUnited States.

 

The term “Company”as used in this report refers to VRC, its Affiliated Medical Practices and VRL.

 

The Company is involved inthe application of various convergent technologies that allow radiologists toremotely diagnose patients and enhance the overall productivity of theradiology profession through a distributed diagnostic network that has beendeveloped by the Company and is integrated into its nationwide virtual privatenetwork. The Company serves radiology practices, hospitals, clinics anddiagnostic imaging centers by providing diagnostic image interpretations, orreads, 24 hours a day, 365 days a year. The Company’s distributedoperating model provides its team of American Board of Radiology-certifiedradiologists with the flexibility to choose the location from which they work, primarilywithin the United States, and allows the Company to serve customers locatedthroughout the country. The Company’s services include both preliminary reads,which are performed for emergent care purposes, and final reads, which areperformed for both emergent and non-emergent care. The Company provides theseservices through a scalable communications network incorporating encryptedbroadband internet connections and proprietary workflow management software.

 

***2. Summary of Significant Accounting Policies***

 

***Interim Financial Statements***

 

The Company has prepared theunaudited interim consolidated financial statements and related unauditedfinancial information in the footnotes in accordance with accounting principlesgenerally accepted in the United States of America, or GAAP, and the rules andregulations of the Securities and Exchange Commission, or the SEC, for interimfinancial statements. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with GAAP have beencondensed or omitted pursuant to such rules and regulations. These interimfinancial statements reflect all adjustments consisting of normal recurringaccruals, which, in the opinion of management, are necessary to present fairlythe Company’s consolidated financial position, the results of its operationsand its cash flows for the interim periods. These interim consolidatedfinancial statements should be read in conjunction with the consolidated annualfinancial statements and the notes thereto included in our 2007 Annual Reporton Form 10-K filed with the SEC on March 17, 2008. The nature of theCompany’s business is such that the results of any interim period may not beindicative of the results to be expected for the entire year.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

The December 31, 2007balance sheet data has been derived from audited financial statements as ofthat date, but does not include all footnote disclosures required by GAAP.  However, the Company believes that thedisclosures presented are adequate to make the information presented notmisleading.

 

***Principles of Consolidation andBasis of Presentation***

 

The Company consolidates itsfinancial results in accordance with Financial Accounting Standards Board, orFASB, Interpretation No. 46R, *Consolidationof Variable Interest Entities,* or FIN 46R, which requires aprimary beneficiary to consolidate entities determined to be variable interestentities, or VIEs. The Company has determined that the Affiliated MedicalPractices are VIEs and that VRC is the primary beneficiary of such VIEs, asdefined by FIN 46R. The Affiliated Medical Practices were created as theCompany’s business expanded for the purpose of facilitating compliance withcorporate practice of medicine laws in the various states in which VRCoperates. The management of VRC was involved significantly in the design andcreation of the VIEs and, with the exception of rendering medical judgments,holds significant influence over their continuing operations. Although VRCholds no legal ownership in the VIEs, as a result of the pricing structureinherent in the management agreements that exist between the entities, VRC willabsorb a majority of the VIEs expected future losses and receive a majority ofthe VIEs expected residual returns. As such, the Company has concluded that VRCis required to consolidate the VIEs. As of June 30, 2008, VRC has fundedlosses of the VIEs totaling approximately $7.7 million and expects tocontinue to fund the majority of the losses for the foreseeable future. VRCwill only receive residual returns up to the amount of previously recognizedlosses.

 

As of June 30, 2008 andDecember 31, 2007 and for the three and six months ended June 30,2008 and 2007, the financial statements of VRC have been presented on aconsolidated basis to include its variable interests in the Affiliated MedicalPractices. In addition, as of June 30, 2008 and December 31, 2007,and for the three and six months ended June 30, 2008, VRC consolidatedVRL, its wholly owned subsidiary.

 

The effect of the VIEs’consolidation on the Company’s consolidated balance sheet at June 30,2008, was an increase in the Company’s assets and liabilities of approximately$12.2 million and $5.7 million, respectively. At December 31,2007, as a result of consolidating the VIEs, the Company’s assets andliabilities increased by approximately $9.8 million and $4.9 million,respectively. The liabilities of the VIEs consolidated by the Company do notrepresent additional claims on the Company’s general assets; rather theyrepresent claims against the specific assets of the individual or respectiveVIEs. Likewise, the assets of the VIEs consolidated by the Company do notrepresent additional assets available to satisfy claims against the Company’sgeneral assets. For the three months ended June 30, 2008, the revenue ofthe VIEs represented approximately 46%, or $11.8 million of theconsolidated revenue of the Company. For the three months ended June 30,2007, the revenue of the VIEs represented approximately 48%, or$10.1 million, of the consolidated revenue of the Company. For the sixmonths ended June 30, 2008, the revenue of the VIEs representedapproximately 45%, or $22.0 million of the consolidated revenue of theCompany. For the six months ended June 30, 2007, the revenue of the VIEsrepresented approximately 47%, or $18.4 million, of the consolidatedrevenue of the Company. Through consolidation, the Company recognizes all netlosses of each VIE in excess of the equity of that VIE. The Company recognizesnet earnings of each VIE only to the extent it is recovering losses previouslyrecognized with respect to that VIE. Earnings of each VIE in excess of theCompany’s previously recognized losses with respect to that VIE are eliminatedfrom the Company’s earnings and are attributed to the respective equity ownersof that VIE by recording such earnings as non-controlling interest on theCompany’s consolidated financial statements. During the three months ended June 30,2007, certain of these VIEs experienced net losses which reduced their positiveequity position.  As a result, theCompany recognized non-controlling interest income of approximately$341,000.  During the six months ended June 30,2007, certain of these VIEs experienced net income. This created a positiveequity position for certain of the VIEs and, as a result, the Companyrecognized non-controlling interest expense of approximately $339,000. Duringthe three and six months ended June 30, 2008, one of the VIEs experiencednet income that increased its positive equity position. As a result, for thethree and six months ended June 30, 2008, the Company recognizednon-controlling interest expense of approximately $4,000 and $8,000,respectively.

 

The consolidated financialstatements and the related footnote information presented as of June 30,2008 and December 31, 2007 and for the three and six months ended June 30,2008 and 2007, represent the consolidated operations of the Company.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

***Recent Accounting Pronouncements***

 

In September 2006, theFinancial Accounting Standards Board, or FASB, issued Statement of FinancialAccounting Standard, or SFAS, No. 157, *FairValue Measurements,* or SFAS No. 157. This standard clarifiedthe principle that fair value should be based on the assumptions that marketparticipants would use when pricing an asset or liability. Additionally, itestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. On February 12, 2008 the FASB issued FASB StaffPosition, or FSP, FAS 157-2, *EffectiveDate of FASB Statement No. 157,* or FSP FAS 157-2. FSPFAS 157-2 defers the implementation of SFAS No. 157 for certainnonfinancial assets and nonfinancial liabilities. The portion of SFAS No. 157that has been deferred by FSP FAS 157-2 will be effective for the Companybeginning in the first quarter of fiscal year 2009. The Company is currentlyevaluating the impact of this portion of the statement. The portion notdeferred was adopted with no impact as the Company does not hold any financialassets or financial liabilities that are covered by this pronouncement.

 

In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities,* or SFASNo. 159. This standard provides companies with an option to reportselected financial assets and liabilities at fair value and establishespresentation and disclosure requirements designed to facilitate comparisonsbetween companies that choose different measurement attributes for similartypes of assets and liabilities. SFAS No. 159 was effective in the firstquarter of 2008. The Company has not elected the fair value option for eligibleitems that existed as of January 1, 2008.

 

In December 2007, theFASB issued SFAS No. 141 (revised 2007), *BusinessCombinations*, or SFAS No. 141R. SFAS No. 141R establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,any noncontrolling interests in the acquiree and the goodwill acquired. Some ofthe key changes under SFAS No. 141R will change the accounting treatmentfor certain specific acquisition related items including: (1) accountingfor acquired in-process research and development as an indefinite-livedintangible asset until approved or discontinued rather than as an immediateexpense; (2) expensing acquisition costs rather than adding them to thecost of an acquisition; (3) expensing restructuring costs in connectionwith an acquisition rather than adding them to the cost of an acquisition; (4) includingthe fair value of contingent consideration at the date of an acquisition in thecost of an acquisition; and (5) recording at the date of an acquisitionthe fair value of contingent liabilities that are more likely than not tooccur. SFAS No. 141R also includes a substantial number of new disclosurerequirements. SFAS No. 141R applies prospectively to business combinationsfor which the acquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008, and interimperiods within those fiscal years. Early application of this statement isprohibited. The Company is currently evaluating the impact of this statement.

 

In December 2007, theFASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements*, *an amendment of ARB 51*, or SFAS No. 160,which changes the accounting and reporting for minority interests. Minorityinterests will be recharacterized as noncontrolling interests and will bereported as a component of equity separate from the parent’s equity, andpurchases or sales of equity interests that do not result in a change incontrol will be accounted for as equity transactions. In addition, net incomeattributable to the noncontrolling interest will be included in consolidatednet income on the face of the income statement and, upon a loss of control, theinterest being sold, as well as any interest retained, will be recorded at fairvalue with any gain or loss recognized in earnings. SFAS No. 160 iseffective for fiscal years beginning on or after December 15, 2008. Thestatement shall be applied prospectively as of the beginning of the fiscal yearin which it is initially applied, except for the presentation and disclosurerequirement which shall be applied retrospectively for all periods presented.Early adoption of this statement is prohibited. The Company is currentlyevaluating the impact of this statement.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures AboutDerivative Instruments and Hedging Activities, an amendment of SFAS No. 133*,which changes the disclosure requirements for derivative instruments andhedging activities. Entities will be required to provide enhanced disclosuresabout (a) how and why an entity uses derivative instruments, (b) howderivative instruments and related hedged items are accounted for under SFAS No. 133and its related interpretations, and (c) how derivative instruments andrelated hedged items affect an entity’s financial position, financialperformance and cash flows. This statement is effective for financial 

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

statements issued for fiscal years beginningafter November 15, 2008.  TheCompany is currently evaluating the impact of this statement.

 

In May 2008, the FASBissued SFAS No. 162, *The Hierarchy of GenerallyAccepted Accounting Principles*, which changed the framework forselecting accounting principles in conformity with GAAP.  The GAAP hierarchy will now be included in theaccounting literature established by the FASB. This statement is not expected to impact current practice.

 

***3. Selected Consolidated Financial Statement Information***

 

***Property, Plant and Equipment, Net***

 
| ** **                                       | ** ** | **As of**          | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Equipment                                        |       | $                       | 9,827      |                  | $          | 6,390 |   |
| Software                                         |       | 4,685                   |       | 3,575                 |       |
| Furniture and fixtures                           |       | 1,658                   |       | 1,648                 |       |
| Leasehold improvements                           |       | 343                     |       | 345                   |       |
| Other                                            |       | 99                      |       | 141                   |       |
| Total property, plant and equipment              |       | 16,612                  |       | 12,099                |       |
| Less: Accumulated depreciation and  amortization |       | 5,656                   |       | 4,086                 |       |
| Property, plant and equipment, net               |       | $                       | 10,956     |                  | $          | 8,013 |   |

 

Depreciation andamortization related to the property, plant and equipment of the Company wasapproximately $1.1 million and $545,000 for the three months ended June 30,2008 and 2007, respectively and approximately $1.9 million and $1.0 million forthe six months ended June 30, 2008 and 2007, respectively.

 

***4. Acquisition***

 

On April 14, 2008, the Company entered into aMembership Interest Purchase Agreement with Diagna Radiology, LLC, or Diagna,and Diagna’s owners, pursuant to which the Company purchased all of themembership interests of Diagna.  Diagnais a teleradiology provider who offers 24-hour a day emergent and non-emergentservices including subspecialty expertise in neuroradiology, musculoskeletaland nuclear medicine.  Totalconsideration for the transaction was approximately $6.6 million, whichincludes $6.0 million of initial purchase price, $504,000 based on preliminaryworking capital and $93,000 of initial direct acquisition costs. Diagna’sowners may also receive additional cash consideration of up to an aggregate of$2.2 million to be paid as an earnout within 45 days of the end of each of thefirst two yearly anniversaries of the closing. The earnout payments are to becalculated based upon revenues generated by Diagna customers during those twoperiods, and are subject to certain minimum gross profit requirements.

 

The acquisition of Diagna has been accounted forunder the purchase method of accounting in accordance with SFAS No. 141, *Business Combinations*.  Under the purchase method of accounting, thepurchase price is allocated to the assets acquired and liabilities assumedbased on their estimated fair values.

 

The allocation of the purchase price has beenprepared based on preliminary estimates of fair values, including acquiredcustomer relationships and non-compete agreements. Management determined thefair values using assistance of an independent valuation firm.  These allocations are preliminary and aresubject to possible adjustments.  Weexpect the final valuation to be complete on or before December 31, 2008and therefore the actual amounts recorded upon the finalization may differmaterially from the amounts presented below.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

The following table presents the preliminaryallocation of the purchase price to the acquired assets and liabilities:

 
| ** **                                | ** ** | **(in thousands)** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| Current assets, including cash of $57,000 |       | $                       | 650        |   |
| Property, plant and equipment             |       | 184                     |       |
| Intangible assets                         |       | 5,198                   |       |
| Goodwill                                  |       | 673                     |       |
| Total assets acquired                     |       | 6,705                   |       |
|                                      |       |                    |       |
| Current liabilities                       |       | 107                     |       |
| Total liabilities assumed                 |       | 107                     |       |
|                                      |       |                    |       |
| Net assets acquired                       |       | $                       | 6,598      |   |

 

The acquisition of Diagna results in the assetsacquired and liabilities assumed being recorded based on their estimated fairvalues on the acquisition date. Of the approximately $5.2 million of acquiredintangible assets, approximately $300,000 was assigned to non-competeagreements with an estimated economic life of two years and $4.9 million wasassigned to customer relationships with a preliminary estimated economic lifeof ten years.  The economic lifeattributed to our acquired customer relationships is based on the Company’shistorically low attrition rates as well as historically low attrition rateswithin the industry. Goodwill of $673,000 represents the excess of the purchaseprice over the fair value of tangible and identifiable intangible assetsacquired and liabilities assumed. Goodwill will not be amortized but instead will be tested at leastannually for impairment consistent with the guidance in SFAS No. 142, *Goodwill and Other Intangible Assets*, orSFAS No. 142.

 

Beginning on April 15th,2008 the financial position and results of operations of Diagna have beenconsolidated with the Company’s consolidated balance sheet, statements ofoperations and cash flows as of and for the three and six months ended June 30,2008. Assuming the acquisition of Diagna had been completed at the beginning ofthe respective reporting periods, pro-forma revenue would have been $22.5million and $41.9 million for the three and six months ended June 30,2007, respectively, and $26.1 million and $50.7 million for the three and sixmonths ended June 30, 2008, respectively. The resulting pro-forma net income would have been $0.5 million and $1.6million for the three and six months ended June 30, 2007, respectively,and $1.9 million and $3.8 million for the three and six months ended June 30,2008, respectively.  Pro-forma diluted(loss) earnings per common share would have been $(3.28) and $(2.61) for thethree and six months ended June 30, 2007, respectively, and $0.11 and$0.22 for the three and six months ended June 30, 2008, respectively.  The pro-forma information gives effect toactual operating results prior to the acquisition, and makes adjustment for,among other things, additional intangible asset amortization. The actualoperating results prior to the acquisition, including the additional intangibleasset amortization are tax-effected at the Company’s effective tax rate duringthe applicable period. These adjustments are subject to change as these initialestimates are refined over time. No effect has been given to cost reductions oroperating synergies in this presentation. These pro-forma amounts are notnecessarily indicative of the results that would have been obtained if theacquisition had occurred as of the beginning of the periods presented or thatmay occur in the future, and does not reflect future synergies, integrationcosts, or other such costs or savings. The unaudited pro-forma financialinformation is presented for informational purposes only.

 

***5. Goodwill and Other Intangible Assets***

 

The Company recognized $673,000 of goodwill as aresult of the acquisition of Diagna.  Inaccordance with SFAS No. 142, goodwill will not be amortized, but insteadwill be tested for impairment at least annually and more frequently ifindicators of impairment are present.

 

A summary of intangible assets is as follows:

 
| ** **                        | ** ** | ** **                      | ** ** | **As of June 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                        | ** ** | ** **                      | ** ** | **(in thousands)**                     | ** ** |
| ** **                        | ** ** | **Estimated  Useful Life** | ** ** | **Original  Cost**                          | ** ** | **Accumulated  Amortization**                   | ** ** | **Carrying  Value** | ** ** | **Original  Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Carrying  Value** | ** ** |
| Amortized intangible assets:      |       |                            |       |                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| Patents                           |       | 15 years                        |       | $                                           | 337        |                                            | $          | (43 | ) | $ | 294 |   | $ | 284 |   | $ | (32 | ) | $ | 252 |   |
| Non-compete agreements            |       | 2 years                         |       | 298                                         |       | (31                                             | )          | 267 |   | — |   | — |   | — |   |
| Customer relationships            |       | 10 years                        |       | 4,900                                       |       | (106                                            | )          | 4,794 |   | — |   | — |   | — |   |
| Total amortized intangbile assets |       |                            |       | $                                           | 5,535      |                                            | $          | (180 | ) | $ | 5,355 |   | $ | 284 |   | $ | (32 | ) | $ | 252 |   |

 

The Company records amortization related to patentsand non-compete agreements on a straight line basis over their estimated usefullives of 15 years and 2 years, respectively. The Company also recordsamortization related to customer relationships over their estimated useful lifeof 10 years based on the expected future economic benefits of those customerrelationships on an accelerated basis. Amortization expense related tointangible assets was approximately $143,000 and $4,000 for the three monthsended June 30, 2008 and 2007, respectively, and $149,000 and $8,000 forthe six months ended June 30, 2008 and 2007, respectively.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

A summary of estimated future amortization expense isas follows:

 
| ** **                               | ** ** | **Amount**              | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **(in thousands)** | ** ** |
|                                     |       |                    |       |
| Six months ending December 31, 2008 |       | $                       | 342        |   |
| Year ending December 31, 2009       |       | 1,103                   |       |
| Year ending December 31, 2010       |       | 866                     |       |
| Year ending December 31, 2011       |       | 681                     |       |
| Year ending December 31, 2012       |       | 565                     |       |
| Thereafter                               |       | 1,798                   |       |
| Total                                    |       | $                       | 5,355      |   |

 

***6. Preferred Stock***

 

On May 2, 2005, theCompany closed on a sale of shares of its Series A Cumulative RedeemableConvertible Preferred Stock, or Series A Preferred Stock. In connectionwith the preparation of the Company’s financial statements for the three andsix months ended June 30, 2007 the Company’s Board of Directorsestablished what it believed to be a fair market value of the Company’s Series APreferred Stock. This determination was based on a variety of factors,including consideration of the Company’s most recent financial performance andfuture financial projections, consideration of the Company’s position in theindustry relative to its competitors, consideration of external factorsimpacting the value of the Company in its marketplace, consideration of thestock volatility of comparable companies in its industry, general economictrends and the application of various valuation methodologies. The increase inthe market value of the Series A Preferred Stock at June 30, 2007 wasrecorded in the consolidated statements of changes in stockholders’ equity asaccretion of Series A Cumulative Redeemable Convertible Preferred Stock inadditional paid-in capital and as a decrease in net income available to commonstockholders in the consolidated statements of operations as Series ACumulative Redeemable Convertible Preferred Stock accretion. Each share of Series APreferred Stock was automatically converted into shares of the Company’s commonstock on November 20, 2007, upon the closing of the initial publicoffering of the Company’s common stock, pursuant to a registration statement onForm S-1 at a public offering price of $17.00 per share. As a result,dividends no longer accumulate, and previously accumulated, undeclared andunpaid dividends are no longer payable by the Company.

 

***7. Stock Options and Accounting for Stock-Based Compensation***

 

On September 7, 2007,the Company’s Board of Directors adopted the Amended and Restated EquityIncentive Plan, or the Plan, to consolidate and replace, upon effectiveness ofthe Company’s initial public offering, equity-based plans previously maintainedby the Company.  The primary purpose ofcombining these plans was to ease the administrative burden associated withadministering the Company’s equity-based compensation program. The Plan becameeffective on November 14, 2007 and increased the total shares authorizedand reserved for future issuance to 5,475,000 shares. The Plan provides for thegrant of incentive stock options, nonqualified stock options, stockappreciation rights and restricted stock to the Company’s officers, employeesand independent contractors. As of June 30, 2008, there were 2,198,941options outstanding, which includes 120,000 options granted in May 2007 tomembers of the Company’s Board of Directors that were not issued pursuant tothe Plan.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

Stock option activity foremployees, directors and independent contractor physicians during the sixmonths ended June 30, 2008 was as follows:

 
| ** **                            | ** ** | ** **         | ** ** | ** **      | ** ** | **Weighted**             | ** ** | ** **               | ** ** |
|---------------------------------------|------------|--------------------|------------|-----------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                            | ** ** | **Options**        | ** ** | **Average**     | ** ** | **Exercise Prices** | ** ** |
| ** **                            | ** ** | **Available**      | ** ** | ** **      | ** ** | **Exercise Price**  | ** ** | **Per Share**       | ** ** |
| ** **                            | ** ** | **for Grant** | ** ** | **Outstanding** | ** ** | **Per Share**       | ** ** | **Ranging From(2)** | ** ** |
| Balance at December 31, 2007 (1) |       | 616,591            |       | 2,284,906       |       | $                        | 8.96       |                     |       |   |
| Granted                               |       | (282,000           | )          | 282,000         |       | 15.97                    |       | $10.20 - $17.75          |       |
| Exercised                             |       | —             |       | (282,553        | )          | 1.53                     |       | 1.00 - 17.00             |       |
| Forfeited                             |       | 85,412             |       | (85,412         | )          | 10.91                    |       | 1.00 - 17.55             |       |
| **Balance at June 30, 2008**     | ** ** | **420,003**        | ** ** | **2,198,941**   | ** ** | **10.74**                |       |                     |       |
| **Exercisable at June 30, 2008** | ** ** | ** **         | ** ** | **537,800**     | ** ** | **6.51**                 | ** ** | **2.00 - 19.23**         | ** ** |
|                                       |            |                    |            |                 |            |                          |            |                          |            |  |

 

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(1)                                      The number of options outstanding includes120,000 options granted in May 2007 to members of the Company’s Board ofDirectors that were not issued pursuant to the Plan.

 

(2)                                      Prior to the Company’s shares trading on theNASDAQ Global Market, which trading commenced on November 15, 2007, theexercise prices of all options were determined by the Company’s Board ofDirectors, based on the estimated fair value of the common stock on the date ofgrant. For all stock options granted subsequent to November 14, 2007, theCompany uses the closing price of its common stock on the NASDAQ Global Marketon the date of grant to determine the exercise price of such options.

 

***Stock-Based Compensation—Employees***

 

For the three and six monthsended June 30, 2008, the Company issued 210,000 and 251,000 options tocertain employees and directors, respectively. The Company recordedapproximately $422,000 and $704,000 in stock-based compensation expense relatedto employee and director options for the three and six months ended June 30,2008, respectively.

 

SFAS No. 123R requiresthat the cash retained as a result of the tax deductibility of employee anddirector share-based awards be presented as a component of cash flows fromfinancing activities in the consolidated statements of cash flows. During thesix months ended June 30, 2008, the Company realized approximately $1.9million as a result of the tax deductibility of employee and directorshare-based awards exercised during the period.

 

***Stock-Based Compensation—Physicians***

 

For the three and six monthsended June 30, 2008, the Company issued 5,000 and 31,000 options,respectively, to its affiliated radiologists, who are independent contractorphysicians. The Company recorded stock-based compensation income related to theseindependent contractor physicians’ options of approximately $64,000 and$559,000 for the three and six months ended June 30, 2008, respectively.

 

***8. Commitments and Contingencies***

 

On January 22, 2008,the Company entered into two new license agreements for the provision ofnetwork related services that also allow the Company to utilize space to house oneof the Company’s data centers. The license agreements commenced on February 15,2008 and June 1, 2008 and have 36 month terms, expiring in February 2011and May 2011, respectively. Both license agreements have monthly minimumusage requirements of $10,000 for which the Company is obligated to pay ifactual services used do not exceed these minimums. These service minimums havebeen recorded as a liability as of June 30, 2008, in accordance with FASBInterpretation No. 45, *Guarantor’s Accounting andDisclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others*, and FSP FIN 45-3, *Applicationof FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to aBusiness or Its Owners*. The maximum potential amount of futurepayments is $665,000 and the current portion of this obligation is $240,000,which is recorded in other current liabilities on the consolidated balancesheet as of June 30, 2008. The non-current portion is recorded in otherliabilities on the consolidated balance

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

sheet as of June 30, 2008. Thisobligation will become due immediately if the Company prematurely terminateseither of these license agreements.

 

***Litigation***

 

On July 31, 2007, MergeeMed, Inc., or Merge, filed a complaint against the Company in the UnitedStates District Court for the Northern District of Georgia, Atlanta Division,alleging that the Company has willfully infringed on certain of Merge’s patentsrelating to teleradiology. Merge is seeking treble damages as well as its costsand legal fees in pursuing the action. Merge has asked the court for aninjunction, ordering the Company to cease the alleged infringement of theirpatents, and also that the case be tried before a jury. While the Company iscontinuing to evaluate Merge’s allegations, it intends to defend against thisclaim and may incur substantial costs in doing so. On September 14, 2007,the Company filed a Request for Reexamination with the United States Patent andTrademark Office, or PTO, for the patents that Merge has asserted against theCompany, asking the PTO to reexamine the validity of the Merge patents basedupon certain prior art. The PTO granted the Company’s reexamination request in November 2007.Also in September 2007, the Company filed a motion with the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, askingthe court to stay the proceeding that Merge has commenced in that court pendingthe outcome of the PTO reexamination. On December 11, 2007, the courtgranted the Company’s motion to stay the patent suit pending the outcome of thereexamination. In February 2008, subsequent to the grant of the stay bythe court, the Company filed an additional Request for Reexamination with thePTO for these same patents based on additional prior art. There is no assurancethat the PTO will grant this additional request. The Company has not recognizedany expense related to the settlement of this matter as an adverse outcome ofthis claim is not probable and cannot be reasonably estimated.

 

During the quarter ended June 30,2008 the Company received notice of a settlement in a medical malpracticelawsuit to which the Company and one of its’ affiliated radiologists wereparties.  The Company’s obligation withregard to this settlement totaled $350,000 which is the full amount of theCompany’s deductible under its professional malpractice liability insurance policy.  This amount is recorded in accounts payableon the consolidated balance sheet and in sales, general and administrativeexpense on the consolidated statements of operations as of and for the threeand six months ended June 30, 2008. This case is now closed and theCompany will not have further obligations with regard to this matter.

 

The Company is involved invarious other litigation in the normal course of business. Although the resultsof litigation and claims cannot be predicted with certainty, as of June 30,2008 and December 31, 2007 the Company’s management believed that thefinal outcome of these matters would not have a material adverse effect on theCompany’s business, consolidated financial position, results of operations orcash flows.

 

***9. Related Party Transactions***

 

The Company has entered intoa non-exclusive, non-transferable license agreement for the use of certainimage management software from a minority stockholder of the Company. For thethree months ended June 30, 2008 and 2007, the Company incurred licensingfees under this contract of approximately $250,000 and $209,000,respectively.  For the six months ended June 30,2008 and 2007, the Company incurred licensing fees under this contract ofapproximately $493,000 and $397,000, respectively.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30,2008 AND 2007**

 

The following tableillustrates the revenues, expenses and cash flows that result from themanagement and professional service agreements between the related partiesdescribed in Note 1.

 
| ** **                                                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                   | ** ** | **(in thousands)**                         | ** ** |
| ** **                                                                   | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| VRP professional services revenue from VRC                                   |       | $                                               | 5,646      |                                          | $          | 5,542 |   | $ | 10,912 |   | $ | 10,899 |   |
| VRC professional services expense to VRP                                     |       | 5,646                                           |       | 5,542                                         |       | 10,912 |   | 10,899 |   |
| VRP professional services revenue from the  Professional Corporations        |       | 5,900                                           |       | 6,162                                         |       | 10,974 |   | 11,669 |   |
| Professional Corporations professional  services expense to VRP              |       | 5,900                                           |       | 6,162                                         |       | 10,974 |   | 11,669 |   |
| VRC management fee revenue from the Professional  Corporations               |       | 5,841                                           |       | 4,859                                         |       | 10,864 |   | 8,868 |   |
| Professional Corporations management fee  expense to VRC                     |       | 5,841                                           |       | 4,859                                         |       | 10,864 |   | 8,868 |   |
| Cash paid for professional services by VRC  to VRP                           |       | 5,646                                           |       | 5,542                                         |       | 10,912 |   | 10,899 |   |
| Cash paid for professional services by the  Professional Corporations to VRP |       | 5,900                                           |       | 6,162                                         |       | 10,974 |   | 11,669 |   |
| Cash paid for management fees by the  Professional Corporations to VRC       |       | 5,841                                           |       | 4,859                                         |       | 10,864 |   | 8,868 |   |
|                                                                              |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

 

***10. Earnings Per Share***

 

The Company calculatesearnings per share in accordance with Emerging Issues Task Force Issue No. 03-6,*Participating Securities and the two-classmethod under FASB Statement No. 128,* or EITF Issue No. 03-6.In calculating basic earnings per share, this method requires net income to bereduced by the amount of dividends declared in the current period for eachclass of stock and by the contractual amount of dividends or otherparticipation payments that are paid or accumulated for the current period.Undistributed earnings for the period are allocated to participating securitiesbased on the contractual participation rights of the security to share in thosecurrent earnings assuming all earnings for the period are distributed. Prior tothe conversion of the Company’s Series A Preferred Stock, preferredstockholders had contractual participation rights on a converted basis thatwere equivalent to those of common stockholders. Therefore, the Companyallocated undistributed earnings to preferred and common stockholders based ontheir respective ownership percentage, on a converted basis, as of the end ofthe period.

 

EITF Issue No. 03-6also requires companies with participating securities to calculate dilutedearnings per share using the if-converted method. This method requires netincome to be adjusted by the amount of dividends declared or accumulated and bythe accretion or decretion associated with convertible securities, subject tothe antidilution provisions of SFAS No. 128 *Earnings per Share,* or SFAS No. 128. The if-convertedmethod also requires the denominator to include the additional shares issuedupon the assumed conversion of the convertible securities along with theadditional share equivalents from the assumed conversion of stock options andwarrants calculated using the treasury stock method, again subject to theantidilution provisions of SFAS No. 128. Prior period earnings per shareamounts have been presented to comply with the provisions of EITF Issue No. 03-6.

 

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS –(CONTINUED)**

**FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2008 AND 2007**

 

Thefollowing table presents the computation of earnings per share:

 
| ** **                                                                       | ** ** | **Three Months Ended  June 30,**                    | ** ** | **Six Months Ended  June 30,** | ** **   |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------|--------------|
| ** **                                                                       | ** ** | **2008**                                                           | ** ** | **2007**                                      | ** **   | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                                       | ** ** | ** **                                                         | ** ** | ** **                                    | ** **   | ** ** | ** ** | ** ** | ** ** |
| **Basic and Diluted Earnings per Share  (Two-class Method)**                     | ** ** | ** **                                                         | ** ** | ** **                                    | ** **   | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                       |       | $                                                                  | 2,000      |                                          | $            | 577 |   | $ | 4,000 |   | $ | 1,618 |   |
| Less:                                                                            |       |                                                               |       |                                          |         |   |   |   |   |
| Series A Cumulative Redeemable  Convertible Preferred Stock accretion       |       | —                                                             |       | (24,892                                       | )            | — |   | (20,118 | ) |
| Undistributed income (loss)                                                      |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
|                                                                             |       |                                                               |       |                                          |         |   |   |   |   |
| **Distributed Earnings per Share  Basic and Diluted**                            |       | $                                                                  | —     |                                          | $            | — |   | $ | — |   | $ | — |   |
| ** **                                                                       |       |                                                               |       |                                          |         |   |   |   |   |
| **Undistributed Earnings per Share  Basic**                                      |       |                                                               |       |                                          |         |   |   |   |   |
| Undistributed income (loss)                                                      |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
| Series A Preferred ownership on a  converted basis                          |       | 0                                                                  | %          | 32                                            | %            | 0 | % | 34 | % |
| Series A Preferred stockholders  interest in undistributed income           |       | $                                                                  | —     |                                          | $            | — | (a) | $ | — |   | $ | — | (a) |
| Weighted average Series A Preferred  shares                                 |       | —                                                             |       | 3,627                                         |         | — |   | 3,627 |   |
| Undistributed earnings per share -  Series A Preferred Stock                |       | $                                                                  | —     |                                          | $            | — |   | $ | — |   | $ | — |   |
| Undistributed income (loss)                                                      |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
| Common ownership                                                                 |       | 100                                                                | %          | 68                                            | % (a)        | 100 | % | 66 | % (a) |
| Common stockholders interest in  undistributed income (loss)                     |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
| Weighted average common shares outstanding  - Basic                              |       | 16,719                                                             |       | 7,446                                         |         | 16,667 |   | 7,088 |   |
| Total basic earnings (loss) per share -  Common                                  |       | $                                                                  | 0.12       |                                          | $            | (3.27 | ) | $ | 0.24 |   | $ | (2.61 | ) |
|                                                                             |       |                                                               |       |                                          |         |   |   |   |   |
| **Diluted Earnings per Share  (If-converted Method)**                            |       |                                                               |       |                                          |         |   |   |   |   |
| Net income (loss) available to common  stockholders                              |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
| Less: Series A Cumulative Redeemable  Convertible Preferred Stock accretion |       | —                                                             |       | —                                        | (b)          | — |   | — | (b) |
| Net income (loss) used in diluted earnings  per share                            |       | $                                                                  | 2,000      |                                          | $            | (24,315 | ) | $ | 4,000 |   | $ | (18,500 | ) |
| Weighted average common shares outstanding  - Basic                              |       | 16,719                                                             |       | 7,446                                         |         | 16,667 |   | 7,088 |   |
| Convertible preferred stock                                                      |       | —                                                             |       | —                                        | (b)          | — |   | — | (b) |
| Common share equivalents                                                         |       | 479                                                                | (d)        | —                                        | (c) (d) | 566 | (d) | — | (c) (d) |
| Shares used to compute earnings per common  share - Diluted                      |       | 17,198                                                             |       | 7,446                                         |         | 17,233 |   | 7,088 |   |
| Total diluted earnings (loss) per share                                          |       | $                                                                  | 0.12       |                                          | $            | (3.27 | ) | $ | 0.23 |   | $ | (2.61 | ) |

 

----

(a)                                      Preferred stockholders do not participate in anyundistributed losses with common stockholders.

(b)                                      The impact of the assumed conversion of the Series APreferred Stock has been excluded from the calculation of diluted earnings pershare because the effect is anti-dilutive.

(c)                                      Common share equivalents are not included in thediluted earnings per common share calculation for these periods as they areanti-dilutive. Potential common shares totaled approximately 2.0 millionand 2.3 million for the three and six months ended June 30, 2007,respectively.

(d)                                      The calculation of common stock equivalents excludesoptions to purchase approximately 1.4 million and 959,000 shares of commonstock for the three and six months ended June 30, 2008, respectively, andapproximately 119,000 and 126,000 shares of common stock for the three and sixmonths ended June 30, 2007, respectively, as a result of theiranti-dilutive effect on diluted earnings per share.

 

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**ITEM 2.****                            ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**Special Note Regarding ForwardLooking Statements**

 

Certainstatements in this quarterly report are “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended, including, in particular,statements about our plans, objectives, strategies and prospects regarding,among other things, our business and results of operations. These statementsinvolve a number of risks, uncertainties and other factors that could cause ouractual results, performance or achievements to be materially different from anyfuture results, performance or achievements expressed or implied by theseforward-looking statements. Statements that are not historical facts in thisreport are forward-looking statements that involve certain risks, uncertaintiesand assumptions. Should one or more of these risks or uncertaintiesmaterialize, or should underlying assumptions prove incorrect, actual resultsmay vary materially from those indicated. Except as required by applicable law,we undertake no duty to update these forward-looking statements due to newinformation or as a result of future events.

 

Factors thatcould cause our actual results to differ materially from those expressed orimplied in such forward-looking statements include, but are not limited to thefollowing:

 

·                  the competition in the teleradiologymarket, including the possibility of pricing pressure resulting from thatcompetition;

 

·                  our ability to effectively manage ourgrowth and development;

 

·                  the outcome of the intellectualproperty claim against us by Merge eMed, Inc., and any other futureintellectual property claims;

 

·                  our ability to recruit and retainqualified radiologists;

 

·                  our customers ability to attract andretain additional radiologists, which may result in a reduction in the volumeof reads they send to us;

 

·                  the loss of key members of managementand personnel;

 

·                  our ability to obtain properphysician licenses and hospital credentials on behalf of our affiliatedradiologists;

 

·                  the regulation of the corporatepractice of medicine;

 

·                  our dependence on our AffiliatedMedical Practices, which we do not own;

 

·                  our ability to enforce thenon-competition agreements with our affiliated radiologists;

 

·                  new technologies;

 

·                  the breach of our security measuresthat safeguard patient and customer data;

 

·                  the performance of our informationsystems, which are dependent on systems provided by third parties;

 

·                  our ability to comply with governmentregulations;

 

·                  the general economic conditions ofthe markets that we operate in; and

 

·                  other risk factors listed from timeto time in our reports filed with the SEC, including without limitation, thesection entitled “Risk Factors” in our Annual Report on Form 10-K for theyear ended December 31, 2007.

 

Given theseuncertainties, you should not place undue reliance on these forward-lookingstatements.

 

In thisreport, Virtual Radiologic Corporation is sometimes referred to as “VRC.”Virtual Radiologic Professionals of California, P.A., Virtual RadiologicProfessionals of Illinois, S.C., Virtual Radiologic Professionals of Michigan,P.C., Virtual Radiologic Professionals of Minnesota, P.A., Virtual RadiologicProfessionals of New York, P.A. and Virtual Radiologic Professionals of Texas,P.A. are collectively referred to as the “Professional Corporations.” VirtualRadiologic Professionals, LLC, or VRP, and the Professional Corporations arecollectively referred to as the “Affiliated Medical Practices.” VRC has awholly owned and consolidated subsidiary, Virtual 

 

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Radiologic Limited, or VRL,formed under the laws of the England and Wales and located in London, England.The terms “Company,” “we,” “us,” and “our” as used in this report refer to VRC,its Affiliated Medical Practices and VRL.

 

**Overview**

 

Weprovide radiologic interpretations, or reads, via teleradiology for emergencyand routine care coverage.  We believe weare the second largest provider of teleradiology services in the United States.We serve our customers—radiology practices, hospitals, clinics and diagnosticimaging centers—by providing reads 24 hours a day, 365 days a year.Our unique distributed operating model provides our qualified team of AmericanBoard of Radiology-certified radiologists with the flexibility to choose thelocation from which they work, primarily within the United States, and allowsus to serve customers located throughout the country. Our services include bothpreliminary reads, which are performed for emergent care purposes, and finalreads, which are performed for both emergent and non-emergent care. We providethese services through a robust, highly scalable communications networkincorporating encrypted broadband internet connections and proprietary workflowmanagement software.

 

Wecontinued to focus our growth initiatives on supplementing our coreteleradiology business through the expansion of our unique distributedoperating model and enhancements to our proprietary workflow managementsoftware through the second quarter of 2008. We have also continued to focus onacquiring new customers, attracting and retaining additional radiologists,generating additional sales from existing customers and further penetrationinto the final read market.

 

Wecontracted with 84 net new customers during the three months ended June 30,2008, which resulted in an additional 101 hospitals and other medicalfacilities to whom we provide service. For the six months ended June 30, 2008, we contracted with 106 netnew customers, which resulted in an additional 135 hospitals and other medicalfacilities. Included in the new customer and facility numbers as of June 30,2008 are the 43 customers and 56 hospitals and other medical facilities thatwere added from the acquisition of Diagna Radiology, LLC, or Diagna, on April 14,2008.  This 32% year-over-year growth incustomers brought the total number of customers that we serve to 575 as of June 30,2008. In addition, we ended the quarter providing service to 939 medicalfacilities including 878 hospitals, which represents approximately 15% of allhospitals in the United States and a 25% year-over-year growth in the number offacilities that we serve.

 

Duringthe three months ended June 30, 2008, we added 7 radiologists undercontract and 8 radiologists providing service. During the six months ended June 30, 2008, we added 13 radiologistsunder contract and 12 radiologists providing service, resulting in 145radiologists under contract and 124 radiologists providing service as of June 30,2008.  Included in the new radiologistnumbers as of June 30, 2008 are 7 radiologists providing service that camefrom the Diagna acquisition. We believe that the benefits of our distributedoperating model, such as flexible choice of location, predictable schedules andcompetitive compensation, have allowed us to successfully recruit and retainradiologists. 

 

Inaddition to our customer and radiologist growth, our read volume grew by 30% to538,194 total reads during the three months ended June 30, 2008, comparedto 413,167 total reads during the three months ended June 30, 2007.  Our read volume grew by 32% to 1,008,888total reads during the six months ended June 30, 2008, compared to 765,317total reads during the six months ended June 30, 2007. The increase inread volume was primarily due to the growth in our customer base along withincreased volumes from existing customers and customers acquired in the Diagnaacquisition. Approximately 22% of our revenue from reads for the three and sixmonths ended June 30, 2008 was derived from final reads and the remaining78% was derived from preliminary reads.

 

OnJuly 8, 2008, we entered into a multi-year teleradiology servicesagreement with Lion City Radiology of Singapore to provide preliminaryinterpretations of CT and MRI images for imaging centers affiliated with LionCity Radiology of Singapore and the United Arab Emirates.  The agreement also contemplates the provisionof final interpretations upon approval by the Singapore Ministry of Health.

 

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Thefollowing discussion pertains to our financial position as of June 30,2008 and December 31, 2007, and our results of operations for the threeand six months ended June 30, 2008 and 2007. Results of the periods arenot necessarily indicative of the results to be expected for the complete year.

 

**Basis of Presentation**

 

Weconsolidate our financial results under the principles of Financial AccountingStandards Board, or FASB, Interpretation No. 46R, *Consolidation of Variable Interest Entities,*or FIN 46R, which requires a primary beneficiary to consolidate entitiesdetermined to be variable interest entities, or VIEs. VIEs are those entitieswhich an enterprise funds, and as a result recognizes, a majority of the entity’sexpected losses, receives a majority of the entity’s expected residual returns,or both, as a result of ownership, contractual or other financial interest inthe entity. Our Affiliated Medical Practices were formed as our businessexpanded, to facilitate compliance with the corporate practice of medicine lawsin the various states in which VRC operates. Although VRC holds no legalownership in the Affiliated Medical Practices, as a result of the pricingstructure in the management agreements that exist between the entities, betweenJanuary 1, 2005 and June 30, 2008, VRC funded losses of certainAffiliated Medical Practices totaling $7.7 million. Prior to January 1,2005, VRC funded no losses of the Affiliated Medical Practices. Further, VRCwill only receive residual returns up to the amount of previously recognizedlosses. In addition, the management of VRC was involved significantly in thedesign and creation of the Affiliated Medical Practices and, with the exceptionof rendering medical judgments, holds significant influence over theircontinuing operations. We have therefore determined that the Affiliated MedicalPractices are VIEs and that VRC is their primary beneficiary as defined byFIN 46R. As a result, we have concluded that VRC is required toconsolidate the Affiliated Medical Practices. Through consolidation, werecognize all net losses of each Affiliated Medical Practice in excess of theequity of that Affiliated Medical Practice. We recognize net earnings of eachAffiliated Medical Practice only to the extent we are recovering lossespreviously recognized by us with respect to that Affiliated Medical Practice.Earnings of each Affiliated Medical Practice in excess of losses previouslyrecognized by us with respect to that Affiliated Medical Practice are excludedfrom our earnings and are attributed to the respective equity owners of thatAffiliated Medical Practice by recording such earnings as non-controllinginterest in our consolidated financial statements. For the three and six monthsended June 30, 2008 certain of our Affiliated Medical Practicesexperienced net income that resulted in a non-controlling interest expense ofapproximately $4,000 and $8,000, respectively.

 

VRLwas formed on November 23, 2007 and is located in London, England. VRL isa wholly owned and consolidated subsidiary of VRC and was established tofacilitate international expansion of our business to provide teleradiologyservices and products to customers located outside of the United States.Currently, VRL has one employee and an immaterial amount of operating assetsand liabilities. VRL’s functional currency is the British Pound.

 

**Critical Accounting Policies**

 

Thediscussion and analysis of our financial condition and results of operationsare based on our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States ofAmerica, or GAAP. The preparation of these financial statements in accordancewith GAAP requires us to utilize accounting policies and make certain estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingencies as of the date of the financial statements and thereported amounts of revenue and expenses during a fiscal period. The SECconsiders an accounting policy to be critical if it is important to a company’sfinancial condition and results of operations, and if it requires the exerciseof significant judgment and the use of estimates on the part of management inits application. We believe the following to be our critical accountingpolicies because they are important to the presentation of our financialcondition and results of operations, and require critical management judgmentand estimates about matters that are uncertain:

 

·                  principles of consolidation;

 

·                  revenue recognition and allowance fordoubtful accounts;

 

·                  accounting for stock-based compensation; and

 

·                  income taxes.

 

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Ifactual results or events differ materially from those contemplated by us inmaking these estimates, our reported financial condition and results ofoperations for future periods could be materially affected.

 

***Principles of Consolidation***

 

VRL was formed on November 23,2007 and is located in London, England. VRL is a wholly owned and consolidatedsubsidiary of VRC and is included with VRC in the following condensedconsolidating balance sheets as of June 30, 2008 and December 31,2007, and statements of operations for the three and six months ended June 30,2008.

 

As described above, we consolidate our financial results in accordancewith FIN 46R, which requires a primary beneficiary to consolidate entitiesdetermined to be VIEs.  We havedetermined that VRC is the primary beneficiary of the Affiliated MedicalPractices, as defined by FIN 46R, and as a result is required to consolidatethe Affiliated Medical Practices.

 

The following tables show the unaudited condensed consolidating balancesheets as of June 30, 2008 and December 31, 2007, and the unauditedcondensed consolidating statements of operations for the three and six monthsended June 30, 2008 and 2007.  Theamounts reflected in the eliminations columns of the condensed consolidatingfinancial statements represent affiliated party management and professionalfees and non-controlling interest.  Thefollowing tables should be read together with our consolidated financialstatements and related footnotes included elsewhere in this report.

 

**Condensed Consolidating Balance Sheets**

**(unaudited)**

 
| ** **                                      | ** ** | **As of June 30, 2008** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | ** **                                  | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                  | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **VRC**                                     | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                     | ** ** |
| Cash and cash equivalents                       |       | $                                           | 27,998     |   | $ | 4,425 |   | $ | — |   | $ | 32,423 |   |
| Other current assets                            |       | 24,482                                      |       | 19,699 |   | (26,129 | ) | 18,052 |   |
| Non-current assets                              |       | 17,485                                      |       | 19 |   | (19 | ) | 17,485 |   |
| Total assets                                    |       | $                                           | 69,965     |   | $ | 24,143 |   | $ | (26,148 | ) | $ | 67,960 |   |
|                                            |       |                                        |       |   |   |   |   |   |   |
| Current liabilities                             |       | $                                           | 3,932      |   | $ | 31,808 |   | $ | (26,129 | ) | $ | 9,611 |   |
| Other non-current liabilities                   |       | 1,815                                       |       | — |   | (19 | ) | 1,796 |   |
| Total liabilities                               |       | 5,747                                       |       | 31,808 |   | (26,148 | ) | 11,407 |   |
| Non-controlling interest                        |       | —                                      |       | — |   | 16 |   | 16 |   |
| Total stockholders’ equity (deficiency)    |       | 64,218                                      |       | (7,665 | ) | (16 | ) | 56,537 |   |
| Total liabilities and stockholders’ equity |       | $                                           | 69,965     |   | $ | 24,143 |   | $ | (26,148 | ) | $ | 67,960 |   |

 
| ** **                                      | ** ** | **As of December 31, 2007** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                      | ** ** | ** **                                      | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                      | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **VRC**                                         | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                         | ** ** |
| Cash and cash equivalents                       |       | $                                               | 31,497     |   | $ | 1,990 |   | $ | — |   | $ | 33,487 |   |
| Other current assets                            |       | 37,178                                          |       | 51,302 |   | (70,890 | ) | 17,590 |   |
| Non-current assets                              |       | 8,359                                           |       | 19 |   | (19 | ) | 8,359 |   |
| Total assets                                    |       | $                                               | 77,034     |   | $ | 53,311 |   | $ | (70,909 | ) | $ | 59,436 |   |
|                                            |       |                                            |       |   |   |   |   |   |   |
| Current liabilities                             |       | $                                               | 19,350     |   | $ | 60,410 |   | $ | (70,890 | ) | $ | 8,870 |   |
| Other non-current liabilities                   |       | 247                                             |       | — |   | (19 | ) | 228 |   |
| Total liabilities                               |       | 19,597                                          |       | 60,410 |   | (70,909 | ) | 9,098 |   |
| Non-controlling interest                        |       | —                                          |       | — |   | 8 |   | 8 |   |
| Total stockholders’ equity (deficiency)    |       | 57,437                                          |       | (7,099 | ) | (8 | ) | 50,330 |   |
| Total liabilities and stockholders’ equity |       | $                                               | 77,034     |   | $ | 53,311 |   | $ | (70,909 | ) | $ | 59,436 |   |

 

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**CondensedConsolidating Statements of Operations**

**(Unaudited)**

 
| ** **                                                    | ** ** | **Three months ended June 30, 2008** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                    | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                    | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                       | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                       | ** ** |
| Revenue                                                       |       | $                                                             | 19,955     |   | $ | 23,352 |   | $ | (17,386 | ) | $ | 25,921 |   |
| Operating costs and expenses                                  |       | 16,206                                                        |       | 23,638 |   | (17,386 | ) | 22,458 |   |
| Operating income (loss)                                       |       | 3,749                                                         |       | (286 | ) | — |   | 3,463 |   |
| Other income                                                  |       | 89                                                            |       | — |   | — |   | 89 |   |
| Income (loss) before non-controlling  interest and income tax |       | 3,838                                                         |       | (286 | ) | — |   | 3,552 |   |
| Non-controlling interest expense                              |       | —                                                        |       | — |   | 4 |   | 4 |   |
| Income tax expense                                            |       | 1,545                                                         |       | 3 |   | — |   | 1,548 |   |
| Net income (loss)                                             |       | $                                                             | 2,293      |   | $ | (289 | ) | $ | (4 | ) | $ | 2,000 |   |

 
| ** **                                                    | ** ** | **Three months ended June 30, 2007** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                    | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                    | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                       | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                       | ** ** |
| Revenue                                                       |       | $                                                             | 15,968     |   | $ | 21,758 |   | $ | (16,563 | ) | $ | 21,163 |   |
| Operating costs and expenses                                  |       | 13,477                                                        |       | 23,088 |   | (16,563 | ) | 20,002 |   |
| Operating income (loss)                                       |       | 2,491                                                         |       | (1,330 | ) | — |   | 1,161 |   |
| Other income                                                  |       | 70                                                            |       | — |   | — |   | 70 |   |
| Income (loss) before non-controlling  interest and income tax |       | 2,561                                                         |       | (1,330 | ) | — |   | 1,231 |   |
| Non-controlling interest income                               |       | —                                                        |       | — |   | (341 | ) | (341 | ) |
| Income tax expense                                            |       | 995                                                           |       | — |   | — |   | 995 |   |
| Net income (loss)                                             |       | $                                                             | 1,566      |   | $ | (1,330 | ) | $ | 341 |   | $ | 577 |   |

 
| ** **                                                    | ** ** | **Six months ended June 30, 2008** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                  | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                  | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                     | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                     | ** ** |
| Revenue                                                       |       | $                                                           | 38,144     |   | $ | 43,847 |   | $ | (32,750 | ) | $ | 49,241 |   |
| Operating costs and expenses                                  |       | 30,757                                                      |       | 44,408 |   | (32,750 | ) | 42,415 |   |
| Operating income (loss)                                       |       | 7,387                                                       |       | (561 | ) | — |   | 6,826 |   |
| Other income                                                  |       | 265                                                         |       | — |   | — |   | 265 |   |
| Income (loss) before non-controlling  interest and income tax |       | 7,652                                                       |       | (561 | ) | — |   | 7,091 |   |
| Non-controlling interest expense                              |       | —                                                      |       | — |   | 8 |   | 8 |   |
| Income tax expense                                            |       | 3,078                                                       |       | 5 |   | — |   | 3,083 |   |
| Net income (loss)                                             |       | $                                                           | 4,574      |   | $ | (566 | ) | $ | (8 | ) | $ | 4,000 |   |

 

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| ** **                                                    | ** ** | **Six months ended June 30, 2007** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                  | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                  | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                     | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                     | ** ** |
| Revenue                                                       |       | $                                                           | 29,750     |   | $ | 40,950 |   | $ | (31,435 | ) | $ | 39,265 |   |
| Operating costs and expenses                                  |       | 26,325                                                      |       | 41,138 |   | (31,435 | ) | 36,028 |   |
| Operating income (loss)                                       |       | 3,425                                                       |       | (188 | ) | — |   | 3,237 |   |
| Other income                                                  |       | 107                                                         |       | — |   | — |   | 107 |   |
| Income (loss) before non-controlling  interest and income tax |       | 3,532                                                       |       | (188 | ) | — |   | 3,344 |   |
| Non-controlling interest expense                              |       | —                                                      |       | — |   | 339 |   | 339 |   |
| Income tax expense                                            |       | 1,387                                                       |       | — |   | — |   | 1,387 |   |
| Net income (loss)                                             |       | $                                                           | 2,145      |   | $ | (188 | ) | $ | (339 | ) | $ | 1,618 |   |

 

***Revenue Recognition and Allowance forDoubtful Accounts***

 

Wesell our services to radiology practices, hospitals, clinics and diagnosticimaging centers, and recognize revenue when a read or service has beencompleted and we determine that payment for the read or service is reasonablyassured. Accounts receivable are recorded at the invoiced amount and generallydo not bear interest.

 

Wemaintain an allowance for doubtful accounts at a level that our managementestimates to be sufficient to absorb future losses due to accounts that arepotentially uncollectible. The allowance is based on the current aging of pastdue accounts, our historical experience, the financial condition of thecustomer and the general economic conditions of each customer’s market place.Management uses all information available to them in establishing what webelieve is an adequate allowance to absorb future losses. While our historicalcredit losses have not differed materially from our estimates, and we do notcurrently believe any material changes in estimates are likely in the nearfuture, actual future results could differ materially from current estimatesresulting in an increase or decrease in cash flows from receivable collectionsand/or in the allowance for doubtful accounts and the corresponding provisionfor bad debt expense. Any such changes in estimates could have a materialimpact on our consolidated balance sheets, statements of operations and/or cashflows in subsequent periods. We maintained an allowance for doubtful accountsof approximately $354,000 and $208,000 as of June 30, 2008 and 2007,respectively.

 

Werecord an allowance for sales credits that our management estimates to beadequate to cover future sales credits granted which relate primarily tomaintaining customer satisfaction with our services. The allowance is based onour historical experience related to sales credits granted. Although we havenot historically made any material adjustments to prior period estimates, andwe do not anticipate any material impact on future results of operations orcash flows, actual results could differ materially from these estimatesresulting in an increase in the allowance for sales credits and thecorresponding provision for sales credits. We maintained an allowance for salescredits of approximately $19,000 and $15,000 as of June 30, 2008 and 2007,respectively.

 

***Accounting for Stock-Based Compensation***

 

***Physician Stock-Based Compensation.***  Werecord stock-based compensation expense in connection with any equityinstrument awarded to our affiliated radiologists in accordance with EmergingIssues Task Force Issue No. 96-18, *Accountingfor Equity Instruments that are Issued to Other than Employees for Acquiring,or in Conjunction with Selling, Goods or Services,* or EITF Issue No. 96-18.We calculate the stock-based compensation expense related to such issuance bydetermining the then current fair value of the award using a Black-Scholesmodel at the date of grant and at the end of each subsequent financialreporting period thereafter. Physician stock-based compensation expense isincluded in professional services expense.

 

***Employee Stock-Based Compensation.***  Wealso record stock-based compensation expense in connection with any award ofstock options to employees and directors. We calculate the stock-basedcompensation expense associated with such awards to our employees and directorsgranted prior to January 1, 2006, in accordance with Accounting PrinciplesBoard No. 25, *Accounting for StockIssued to Employees*, or APB

 

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No. 25, using theintrinsic value method and in accordance with Statement of Financial AccountingStandards No. 123R, *Accounting forStock Based Compensation*, or SFAS No. 123R, for awards grantedon or after January 1, 2006, by determining the fair value using aBlack-Scholes model. We calculate the stock-based compensation expense relatedto awards to our employees and directors based on the fair value of awards onthe date granted. Employee stock-based compensation expense is included in sales,general and administrative expense.

 

***Determination of Fair Value of Our StockOptions.***  As discussed above, we record stock-basedcompensation expense associated with our awards of stock options in accordancewith SFAS No. 123R and EITF Issue No. 96-18, as applicable, whichrequire us to calculate the expense associated with such awards by determiningtheir fair value. To determine the fair value, we use a Black-Scholes modelthat takes into account the exercise price of the award, the fair value and volatilityof the common stock underlying the award, the risk-free interest rate and thecontractual life of the award as determined at the date of grant.

 

Priorto our shares trading on the NASDAQ Global Market, which commenced on November 15,2007, our Board of Directors considered a number of relevant factors, includingarm’s length equity transactions, current developments in the business, ourfinancial prospects, the market performance of our primary competitor and ourBoard’s independent judgment to establish the exercise price of our stockoptions at various grant dates. As of November 15, 2007, we use theclosing price of our common stock on the NASDAQ Global Market on the date ofgrant to determine the exercise price of such options.

 

Thefollowing table shows the fair value of one share of our common stock and theexercise price of one option granted on all of the stock option grant datesduring the six months ended June 30, 2008 and 2007.

 
| **Grant Date**    | ** ** | ** ** | **Fair Value of One  Share of  Common Stock** | ** ** | **Exercise Price  of One Option  Granted** | ** ** |
|------------------------|------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| April 1, 2007     |       | $          | 12.00                                                                  |       | $                                                         | 12.00      |   |
| April 2, 2007     |       | 12.00      |                                                                   | 12.00      |                                                      |
| May 9, 2007       |       | 12.00      |                                                                   | 12.00      |                                                      |
| May 29, 2007      |       | 12.00      |                                                                   | 12.00      |                                                      |
| June 20, 2007     |       | 19.23      |                                                                   | 19.23      |                                                      |
| January 28, 2008  |       | 17.55      |                                                                   | 17.55      |                                                      |
| February 4, 2008  |       | 16.46      |                                                                   | 16.46      |                                                      |
| February 27, 2008 |       | 17.75      |                                                                   | 17.75      |                                                      |
| February 29, 2008 |       | 17.38      |                                                                   | 17.38      |                                                      |
| April 14, 2008    |       | 16.54      |                                                                   | 16.54      |                                                      |
| May 7, 2008       |       | 14.52      |                                                                   | 14.52      |                                                      |
| May 12, 2008      |       | 13.40      |                                                                   | 13.40      |                                                      |
| May 19, 2008      |       | 11.75      |                                                                   | 11.75      |                                                      |
| May 30, 2008      |       | 10.20      |                                                                   | 10.20      |                                                      |
| June 5, 2008      |       | 12.49      |                                                                   | 12.49      |                                                      |
| June 30, 2008     |       | 13.25      |                                                                   | 13.25      |                                                      |
|                        |            |            |                                                                        |            |                                                           |            |  |  |

 

***Income Taxes***

 

VRCrecognizes income taxes under the asset and liability method. As such, deferredtaxes are based on the temporary differences, if any, between the financialstatement and tax bases of assets and liabilities that will result in futuretaxable or deductible amounts. The deferred taxes are determined using theenacted tax rates that are expected to apply when the temporary differencesreverse. Income tax expense is the tax payable for the period plus the changeduring the period in deferred income taxes. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized.

 

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Developinga provision for income taxes, including the effective tax rate and the analysisof potential tax exposure items, if any, requires significant judgment andexpertise in federal, state and foreign income tax laws, regulations andstrategies, including the determination of deferred tax assets. Our judgmentand tax strategies are subject to audit by various taxing authorities. While webelieve we have provided adequately for our income tax liabilities in theconsolidated financial statements, adverse determinations by these taxingauthorities could have a material adverse effect on our consolidated financialcondition, results of operations, and/or cash flows.

 

Aspreviously noted, we consolidate our financial results under the provisions ofFIN 46R. For income tax purposes, however, we are not considered aconsolidated entity. As a result, income generated by the Affiliated MedicalPractices, as well as any losses they are able to fund, are excluded from VRC’scalculation of income tax liability. In addition, losses generated by theAffiliated Medical Practices that are funded by VRC result in temporarydifferences between VRC’s book and tax bases of accounting. These temporarydifferences will reverse in future periods to the extent those losses are ableto be recovered by VRC.

 

**Factors Affecting Our Results of Operations**

 

***Revenue***

 

Wegenerate substantially all of our revenue from the radiology services that weprovide to our customers. We provide these services pursuant to contracts thattypically have a one-year term and automatically renew for successive one-yearterms unless terminated by the customer or by us. The amount that we charge forour radiology services varies by customer and is based upon a number offactors, including the hours of coverage, the number of reads, whether thereads are preliminary reads or final reads, and the technical andadministrative services provided. We recognize revenue when a read has beencompleted and we determine that payment for the read is reasonably assured. Wetypically bill our customers at the beginning of the month following the monthin which the services were provided. Because we contract directly with ourcustomers and are paid directly by our customers, we do not currently dependupon payment by third party payers such as Medicare, Medicaid, privateinsurance or patients.

 

Wehave experienced significant revenue growth from $27.0 million in 2005, to$54.1 million in 2006 and $86.2 million for the year ended December 31,2007. In addition, our revenue grew from $39.3 million for the six months endedJune 30, 2007 to $49.2 million for the six months ended June 30,2008. This growth in revenue resulted from:

 

·                  an increase in our customer base;

 

·                  an increase in utilization of our services byour customers;

 

·                  an expansion of our service hours;

 

·                  an increase in provision of higher-pricedfinal reads;

 

·                  high customer retention rates; and

 

·                  our acquisition of Diagna.

 

Asof June 30, 2008, our affiliated radiologists provided services to 575customers serving 939 medical facilities, which included 878 hospitalsrepresenting approximately 15% of hospitals in the United States.

 

***Operating Expenses***

 

Ouroperating expenses consist of professional services expense, sales, general andadministrative expense and depreciation and amortization.

 

***Professional Services Expense.*** Professional services expense is our most significant expense as apercentage of revenue. Our professional services expense consists of the feeswe pay to our affiliated radiologists for their services, physician stock-basedcompensation and medical liability expense, which consists of medical liabilityinsurance premiums expense.

 

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·                  ***PhysicianCash Compensation Expense.***  Physician cash compensation expense is theresult of engaging independent radiologists to provide reads for our customers.Each of our affiliated radiologists provides and is compensated for reads inaccordance with his or her independent physician agreement. We structure ourrelationships with our affiliated radiologists such that they generally havecontrol over their schedule and the location from which they work. Wecompensate our affiliated radiologists using a formula that includes a baselevel of compensation and additional amounts with regard to the number of hoursworked and the number and type of reads performed. We recognize physician cashcompensation expense in the month in which our affiliated radiologists performthe reads for our customers. Physician cash compensation also includes amountspaid for quality assurance services.

 

·                  ***PhysicianStock-Based Compensation Expense.***  We record stock-basedcompensation expense in connection with any award of stock options or othercompensatory issuance of shares of our common stock to our affiliatedradiologists and include that expense in our consolidated statement of incomeas part of our professional services expense. We calculate the stock-basedcompensation expense associated with these awards in accordance with EITF IssueNo. 96-18, by determining the fair value using a Black-Scholes model. EITFIssue No. 96-18 requires that the cost of equity instruments issued tothese affiliated radiologists be initially measured at their fair value at thedate the equity instruments were issued and adjusted over the service period,until vested or forfeited, to their then-current fair value in every subsequentreporting period. Accordingly, if the value of our common stock increases overa given period, this accounting treatment will generally result in physicianstock-based compensation expense that exceeds the expense we would have recordedif these individuals were employees.

 

·                  ***MedicalLiability Expense.***  Medical liability expense relates to theprocurement of medical malpractice insurance coverage. We recognize medicalliability insurance premiums over the term of the policy to which they relate.

 

***Sales, General and Administrative Expense.*** Sales, general and administrative expense is our second most significantexpense as a percentage of revenue. Sales, general and administrative expenseconsists primarily of employee compensation expense, sales and marketingexpense, information technology expense, the costs associated with thelicensing and credentialing of our affiliated radiologists and the costsassociated with maintaining our facilities.

 

***Other (Expense) Income***

 

Other (expense) incomeconsists primarily of non-operating interest income earned on cash balances andinvestments held in demand deposit accounts.

 

***Redeemable Preferred Stock Accretion***

 

On May 2, 2005, weissued shares of our Series A Preferred Stock, which were redeemable on orafter March 31, 2010, at the greater of the Redemption Price, as definedin our certificate of incorporation that was in effect prior to the closing ofour initial public offering, or the fair value of the Series A PreferredStock. As a result, we adjusted the value of the Series A Preferred Stockto its fair value at each reporting date. Upon the closing of our initialpublic offering in November 2007, all outstanding shares of our Series APreferred Stock were automatically converted into shares of our common stockand the rights of the holders of Series A Preferred Stock to exerciseredemption rights terminated. As a result, there will be no further recognitionof accretion or decretion related to our Series A Preferred Stock.

 

**Trends inOur Business and Results of Operations**

 

***Revenue***

 

Our business has grownrapidly since inception. This growth has been driven by an increase in thedemand for our services and a corresponding increase in our customer base. Wehave also experienced an increase in the utilization of our services by ourexisting customers, through expansion of our service hours, the provision offinal reads, a high customer retention rate and the growth in the use ofdiagnostic imaging technologies and procedures in the healthcare market. Ourrevenue growth has resulted primarily from increased 

 

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volumes across a growing customer base. Weexpect that our customers will continue to contract with us for additionalservices, including the performance of final reads.

 

The total number of reads weperformed has primarily increased on a quarter-by-quarter basis for the pasteight quarters as follows:

 
| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **June 30,**                | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
| ** **                                 | ** ** | **2008**                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2006** | ** ** | **2006** | ** ** |
| Total reads                                |       | 538,194                          |       | 470,694 |   | 453,280 |   | 473,263 |   | 413,167 |   | 352,149 |   | 309,151 |   | 302,497 |   |
| Percentage growth  over prior year quarter |       | 30.3                             | %          | 33.7 | % | 46.6 | % | 56.5 | % | 74.1 | % | 90.8 | % | 99.8 | % | 105.9 | % |

 

Our revenues are affected byseasonality. While our revenues have continued to grow each year, we typicallyexperience increased demand for our services and higher revenue growth duringthe later half of the year. We believe that during that time there are anincreased amount of outdoor and transportation activities, which leads to morehospital visits, as well as there being more frequent vacation time taken byour customers’ radiologists. During the first quarter of each year, whenweather conditions are colder for a large portion of the United States, we havehistorically experienced lower revenue growth than that experienced during thelater half of the year. We expect this seasonality with respect to our revenuesto continue. Our operating results may be subject to seasonal fluctuations,which makes our results difficult to predict and could cause our performance tofall short of quarterly expectations. We also expect to derive revenue in thefuture from contracts we have recently entered into for the licensing of ourtechnology infrastructure and the provision of management and support services,and from the deployment of our services in overseas markets.

 

In addition, our revenuesare affected by fluctuations in the price per study charged to the customers towhom we provide service. We have historically seen the greatest amount of pricevolatility in plain film reads.  In thesix months ended June 30, 2008 we began to see additional price declineson our preliminary reads and most notably in the CT modality. We expect recentpricing trends to continue, however we anticipate there will be continuedquarterly variations and that any negative price trends will be largely offsetby continuing improvements in operating efficiencies. The table belowillustrates the quarter-by-quarter percentage change in the average revenue perread for lower price plain film reads and all other modalities for the pasteight quarters:

 
| ** **                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **June 30,  2008**          | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** | **September 30,  2007** | ** ** | **June 30,  2007** | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** |
| Plain film (1)                  |       | (3.3)%                           |       | (3.1)% |   | (1.9)% |   | (2.0)% |   | 1.5% |   | (3.0)% |   | (3.6)% |   | (3.3)% |   |
| All other  modalities (2)  |       | (2.1)%                           |       | (0.9)% |   | (1.1)% |   | (0.7)% |   | 0.1% |   | (0.2)% |   | (0.3)% |   | 1.0% |   |

 

----

(1)  Plain film modality includes all x-ray technology images.

(2)  All other modalities are primarily comprised of CT, MRI andultrasound images.

 

***Physician Cash Compensation Expense***

 

Since our inception, ourphysician cash compensation expense has increased each year as we have addedmore affiliated radiologists to fulfill the increased demand for our servicesas our business and customer base have grown. However, physician cashcompensation expense as a percentage of revenue has decreased due to theincreased productivity of our affiliated radiologists. The increases inproductivity by the existing affiliated radiologists have been, and may continueto be, offset, in part, by significant increases in newly engaged affiliatedradiologists and the costs associated with the typical 90- to 180-day periodduring which newly engaged affiliated radiologists obtain necessary statelicenses and hospital credentials, and thereafter become accustomed to ourworkflow technology. We expect that our physician cash compensation expensewill continue to increase, but will decrease as a percentage of revenues as ourexpanding base of independent radiologists continues to grow.

 

***Physician Stock-Based CompensationExpense***

 

Physician stock-basedcompensation expense is a non-cash expense that fluctuates based upon the fairvalue of our common stock underlying the awards at the close of each reportingperiod as required by EITF Issue

 

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No. 96-18. As the value of an award isbased on the underlying value of our common stock, we may record additionalexpense or income based on fluctuations in that value. Our physicianstock-based compensation expense may increase in future periods if we issueadditional options and other stock-based awards to our affiliated radiologistsand/or if the value of our common stock increases. However, the amount ofexpense or income for any period attributable to physician stock-basedcompensation fluctuates and is difficult to predict.

 

***Medical Liability Expense***

 

Our medical liabilityexpense has increased each year since inception due to the increases in ourmedical liability insurance premiums primarily associated with the increasedvolume of reads our affiliated radiologists have performed, but has decreasedas a percentage of revenues. We expect this trend will continue.

 

***Sales, General and AdministrativeExpense***

 

Our sales, general andadministrative expense has increased each year since our inception primarily asa result of increased employee compensation expenses in connection with themanagement, operations, development and maintenance of our expanding business.In addition to increased employee compensation expense, our sales, general andadministrative expenses have increased due to increases in expenses relating toinformation technology, facilities, licensing and credentialing, sales andmarketing and other general and administrative expense. We expect sales,general and administrative expense to continue to increase in future periods asa result of expenses associated with the management of our expanding businessand as a result of expenses related to being a public company, including legaland accounting fees and costs incurred in complying with the Sarbanes-Oxley Actof 2002. We believe that these expenses will increase as we continue to grow,but will decrease as a percentage of revenue.

 

**Results ofOperations**

 

The following table setsforth selected consolidated statements of operations data for each of theperiods indicated as a percentage of revenue.

 
| ** **                                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenue                                                                    |       | 100.0                                           | %          | 100.0                                         | %          | 100.0 | % | 100.0 | % |
| Operating costs and expenses:                                              |       |                                            |       |                                          |       |   |   |   |   |
| Professional services                                                      |       | 45.9                                            |       | 57.1                                          |       | 45.2 |   | 52.7 |   |
| Physician cash compensation                                                |       | 44.6                                            |       | 45.1                                          |       | 44.7 |   | 45.6 |   |
| Physician stock-based compensation                                         |       | (0.2                                            | )          | 10.2                                          |       | (1.1 | ) | 5.2 |   |
| Medical liability expenses                                                 |       | 1.5                                             |       | 1.8                                           |       | 1.6 |   | 1.9 |   |
| Sales, general and administrative                                          |       | 36.0                                            |       | 34.8                                          |       | 36.7 |   | 36.4 |   |
| Depreciation and amortization                                              |       | 4.7                                             |       | 2.6                                           |       | 4.2 |   | 2.7 |   |
| Total operating costs and expenses                                         |       | 86.6                                            |       | 94.5                                          |       | 86.1 |   | 91.8 |   |
| Operating income                                                           |       | 13.4                                            |       | 5.5                                           |       | 13.9 |   | 8.2 |   |
| Interest income, net                                                       |       | 0.3                                             |       | 0.3                                           |       | 0.5 |   | 0.3 |   |
| Non-controlling interest (income)  expense(1)                              |       | —                                          | (1)        | (1.6                                          | )          | — | (1) | 0.9 |   |
| Income tax expense                                                         |       | (6.0                                            | )          | (4.7                                          | )          | (6.3 | ) | (3.5 | ) |
| Net income                                                                 |       | 7.7                                             |       | 2.7                                           |       | 8.1 |   | 4.1 |   |
| Series A Cumulative Redeemable  Convertible Preferred Stock accretion |       | —                                          |       | (117.6                                        | )          | — |   | (51.2 | ) |
| Net income available to common stockholders                                |       | 7.7                                             | %          | (114.9                                        | )%         | 8.1 | % | (47.1 | )% |

 

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(1) Non-controlling interest for the threeand six months ended June 30, 2008 represents less than 0.1% as apercentage of revenue.

 

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**Comparisonof the Three Months Ended June 30, 2008 and June 30, 2007**

 

***Revenue***

 
| ** **         | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **          | ** ** |
|--------------------|------------|--------------------------------------|------------|------------|------------|---------------------|------------|
| ** **         | ** ** | **June 30,**                    | ** ** | **Change** | ** ** |
| ** **         | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **         | ** ** | **(dollars in thousands)** | ** ** |
| Revenue from reads |       | $                                    | 25,633     |       | $          | 20,932              |       | $ | 4,701 |   | 22.5 | % |
| Other revenue      |       | 288                                  |       | 231        |       | 57                  |       | 24.7 |   |
| Total revenue      |       | $                                    | 25,921     |       | $          | 21,163              |       | $ | 4,758 |   | 22.5 | % |

 

The 22.5% increase inrevenue for the three months ended June 30, 2008, as compared to the threemonths ended June 30, 2007, resulted primarily from an increase in thenumber of customers to whom we provided services and increased volume fromexisting customers, which was partially offset by a 5.6% decline in our averageprice per read. For the three months ended June 30, 2008 and 2007,approximately 78% of our revenue from reads was derived from preliminary readsand approximately 22% from final reads. The number of customers to whom weprovided services increased to 575 as of June 30, 2008, from 436 as of June 30,2007. The number of medical facilities to whom we provide services increased to939 as of June 30, 2008, from 750 as of June 30, 2007. Same sitevolume growth increased approximately 7% for the three months ended June 30,2008, as compared to the three months ended June 30, 2007. Same sitevolume growth measures the percentage increase in the number of reads over thecomparable prior year period generated by a facility that has been undercontract for at least three months at the beginning of the measurement periodand remains a customer throughout that period.

 

***Operating Costs and Expenses***

 

***Professional Services***

 
| ** **                                          | ** ** | **Three Months Ended**     | ** ** | **Percentage**      | ** ** | **Three Months Ended** | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                          | ** ** | **June 30, 2008**          | ** ** | **of Revenue** | ** ** | **June 30, 2007**      | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                                          | ** ** | **(dollars in thousands)** | ** ** |
| Physician cash compensation expense                 |       | $                                    | 11,573     |                | 44.6       | %                                | $          | 9,552               |       | 45.1                | %          | $ | 2,021 |   | 21.2 | % |
| Physician stock-based compensation (income) expense |       | (64                                  | )          | (0.2                | )          | 2,159                            |       | 10.2                |       | (2,223              | )          | (103.0 | ) |
| Medical liability expense                           |       | 401                                  |       | 1.5                 |       | 376                              |       | 1.8                 |       | 25                  |       | 6.6 |   |
| Professional services                               |       | $                                    | 11,910     |                | 45.9       | %                                | $          | 12,087              |       | 57.1                | %          | $ | (177 | ) | (1.5 | )% |

 

The 1.5% decrease inprofessional services expense for the three months ended June 30, 2008,compared to the three months ended June 30, 2007, resulted primarily froma decrease in non-cash physician stock-based compensation which resulted fromthe declining price of our stock in the quarter ended June 30, 2008. Thisdecrease was offset by increases in physician cash compensation expenseassociated with our increased number of affiliated radiologists and asignificant increase in the total number of reads performed by ourradiologists. For the three months ended June 30, 2008, the number ofphysicians performing reads increased 40.9%, from 88 as of June 30, 2007to 124 as of June 30, 2008. The decrease in physician cash compensationexpense as a percentage of revenue from 45.1% for the three months ended June 30,2007 to 44.6% for the three months ended June 30, 2008 resulted primarilyfrom improved radiologist efficiency due to continuing advancements in both ourdistributed network infrastructure and our radiologist support services. Webelieve that physician cash compensation expense will increase as we continueto grow, but will decrease as a percentage of revenue.

 

***Sales, General and Administrative***

 
| ** **                        | ** ** | **Three Months Ended**     | ** ** | **Percentage**      | ** ** | **Three Months Ended** | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|---------------------|------------|----------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | **June 30, 2008**          | ** ** | **of Revenue** | ** ** | **June 30, 2007**      | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                        | ** ** | **(dollars in thousands)** | ** ** |
| Sales, general and administrative |       | $                                    | 9,332      |                | 36.0       | %                                | $          | 7,366               |       | 34.8                | %          | $ | 1,966 |   | 26.7 | % |
|                                   |            |                                      |            |                     |            |                                  |            |                     |            |                     |            |  |  |  |  |  |

 

The 26.7% increase in sales,general and administrative expense for the three months ended June 30,2008, compared to the three months ended June 30, 2007, resulted fromincreased expenses for employee

 

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compensation, sales and marketing,information technology and other general and administrative expense, partiallyoffset by a decrease in licensing and credentialing costs.

 

·                  ***EmployeeCompensation.***  Our employee compensation expense increasedfrom $4.1 million for the three months ended June 30, 2007 to$4.6 million for the three months ended June 30, 2008. The 12.2%increase resulted primarily from the hiring of additional administrative andoperations personnel to manage, operate and maintain our business, and from anincrease in non-cash employee stock-based compensation expense.  The increase in non-cash employee stock-basedcompensation expense relates primarily to an increase in the number of optionsoutstanding as of June 30, 2008 and the increase in the fair value ofthose options when they were granted. These increases were partially offset by a decrease in performance-basedbonus compensation. As of June 30, 2008, the number of non-sales andmarketing employees increased 20.3% over June 30, 2007. Employeecompensation expense as a percentage of revenue was 17.7% and 19.2% for thethree months ended June 30, 2008 and 2007, respectively.

 

·                  ***Sales andMarketing.***  Our sales and marketing expenses increasedfrom $844,000 for the three months ended June 30, 2007 to $1.0 million forthe three months ended June 30, 2008. The 18.5% increase resultedprimarily from additional compensation expense related to an increased number ofsales and marketing personnel. As of June 30, 2008, the number of salesand marketing personnel increased 47.8%, over June 30, 2007. Sales andmarketing expenses as a percentage of revenue were 3.9% and 4.0% for the threemonths ended June 30, 2008 and 2007, respectively.

 

·                  ***InformationTechnology.***  Our information technology expense increasedfrom $467,000 for the three months ended June 30, 2007 to $673,000 for thethree months ended June 30, 2008. The 44.1% increase resulted fromadditional provisioning costs for communications bandwidth and additionalsoftware transactional costs associated with increased study volumes.Information technology expense as a percentage of revenue was 2.6% and 2.2% forthe three months ended June 30, 2008 and 2007, respectively.

 

·                  ***Licensingand Credentialing.***  Our licensing and credentialing relatedexpenses decreased from $494,000 for the three months ended June 30, 2007to $356,000 for the three months ended June 30, 2008. The 27.9% decreaserelates primarily to the amount and timing of initial and renewal licenseapplications for our affiliated radiologists, and was aided by thecomparatively lower costs of renewal applications. Licensing and credentialingrelated expenses as a percentage of revenue were 1.4% and 2.3% for the threemonths ended June 30, 2008 and 2007, respectively.

 

·                  ***OtherGeneral and Administrative.***  Our other general and administrative expensesincreased from $1.5 million for the three months ended June 30, 2007to $2.7 million for the three months ended June 30, 2008. The 80.0%increase resulted primarily from the payment of a deductible on a malpracticeclaim and a bad debt charge that were recognized during the quarter.  Additionally, we experienced increases inoutside accounting expenses and board of director fees related to the costs ofbeing a public company, as well as increases in hiring expenses, corporateinsurance expense, travel expenses and facilities related expenses resultingfrom the growth in our business. Other general and administrative expenses as apercentage of revenue were 10.4% and 7.1% for the three months ended June 30,2008 and 2007, respectively.

 

The increase in sales,general and administrative expense as a percentage of revenue is due primarilyto the charges for bad debt and the payment of an insurance deductible relatingto the settlement of a medical malpractice claim during the quarter ended June 30,2008.  We believe that sales, general andadministrative expenses, including the costs related to being a public company,will increase as we continue to grow, but will decrease as a percentage ofrevenue over time.

 

***Depreciation and Amortization Expense.*** Depreciation and amortization expense increased from $549,000 for thethree months ended June 30, 2007 to $1.2 million for the three monthsended June 30, 2008. This 118.6% increase was primarily due to theincrease in depreciation expense related to additional capital equipmentpurchased for our operations and the amortization of customer relationship andnon-compete intangible assets, which resulted from our acquisition of Diagna.We believe that depreciation and amortization

 

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expense will increase in the future.Depreciation and amortization expense as a percentage of revenue was 4.7% and2.6% for the three months ended June 30, 2008 and 2007, respectively.

 

***Non-Controlling Interest Expense.*** Through consolidation, we recognize all net losses of the AffiliatedMedical Practices in excess of the equity of the Affiliated Medical Practices.During the three months ended June 30, 2007, VRP experienced net lossesthat reduced its positive equity position and, as a result we recognizednon-controlling interest income of $341,000. During the three months ended June 30,2008, one of the Affiliated Medical Practices experienced net income thatincreased its positive equity position. As a result, for the three months endedJune 30, 2008, we recognized non-controlling interest expense of $4,000.

 

***Income Tax Expense.*** Income tax expense increased from $995,000 for the three months ended June 30,2007 to $1.5 million for the three months ended June 30, 2008, whichresulted primarily from an increase in pre-tax net income for VRC ofapproximately $2.6 million for the three months ended June 30, 2007 toapproximately $3.8 million for the three months ended June 30, 2008.As previously discussed, we consolidate our financial results in accordancewith FIN 46R. However, for income tax purposes, VRC is a single tax entitythat is taxed as a corporation and is not included in a tax consolidated groupwith the Affiliated Medical Practices. As a result, tax losses of theAffiliated Medical Practices are not available to offset taxable income of VRC.The difference in the consolidated group for financial statement purposes andtax purposes, combined with the valuation allowances established for deferredtax assets related to net operating loss carryforwards of certain of theAffiliated Medical Practices, resulted in the increase in income tax expensefor the three months ended June 30, 2008 compared to the three monthsended June 30, 2007. The totality of these factors resulted in aneffective tax rate of 43.6% for the three months ended June 30, 2008compared to a rate of 63.3% for the three months ended June 30, 2007.

 

***Preferred Stock Accretion.*** Preferred stock accretion decreased from $24.9 million for thethree months ended June 30, 2007 to zero for the three months ended June 30,2008. The accretion for the three months ended June 30, 2007 related toour Series A Preferred Stock, which was issued on May 2, 2005, andwas calculated based on the difference between the estimated fair value of the Series APreferred Stock as of the consolidated balance sheet date compared to the fairvalue of the stock on the previous consolidated balance sheet date. All sharesof our Series A Preferred Stock were converted to common stock uponclosing of our initial public offering in November 2007, and as a result,there was no further recognition of preferred stock accretion or decretion forthe three months ended June 30, 2008.

 

**Comparisonof the Six Months Ended June 30, 2008 and June 30, 2007**

 

***Revenue***

 
| ** **         | ** ** | **Six Months Ended**       | ** ** | ** ** | ** ** | ** **          | ** ** |
|--------------------|------------|--------------------------------------|------------|------------|------------|---------------------|------------|
| ** **         | ** ** | **June 30,**                    | ** ** | **Change** | ** ** |
| ** **         | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **         | ** ** | **(dollars in thousands)** | ** ** |
| Revenue from reads |       | $                                    | 48,562     |       | $          | 38,707              |       | $ | 9,855 |   | 25.5 | % |
| Other revenue      |       | 679                                  |       | 558        |       | 121                 |       | 21.7 |   |
| Total revenue      |       | $                                    | 49,241     |       | $          | 39,265              |       | $ | 9,976 |   | 25.4 | % |

 

The 25.4% increase inrevenue for the six months ended June 30, 2008, as compared to the sixmonths ended June 30, 2007, resulted primarily from an increase in thenumber of customers to whom we provided services and increased volume fromexisting customers, which was partially offset by a 4.8% decline in our averageprice per read. For the six months ended June 30, 2008, approximately 78%of our revenue from reads was derived from preliminary reads and approximately22% from final reads, compared with approximately 75% from preliminary readsand approximately 25% from final reads for the six months ended June 30,2007. The number of customers to whom we provided services increased to 575 asof June 30, 2008, from 436 as of June 30, 2007. The number of medicalfacilities to whom we provide services increased to 939 as of June 30,2008, from 750 as of June 30, 2007. Same site volume growth increasedapproximately 10% for the six months ended June 30, 2008, as compared tothe six months ended June 30, 2007.

 

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***Operating Costs and Expenses***

 

***Professional Services***

 
| ** **                                          | ** ** | **Six Months Ended**       | ** ** | **Percentage**      | ** ** | **Six Months Ended** | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                          | ** ** | **June 30, 2008**          | ** ** | **of Revenue** | ** ** | **June 30, 2007**    | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                                          | ** ** | **(dollars in thousands)** | ** ** |
| Physician cash compensation expense                 |       | $                                    | 22,025     |                | 44.7       | %                              | $          | 17,882              |       | 45.6                | %          | $ | 4,143 |   | 23.2 | % |
| Physician stock-based compensation (income) expense |       | (559                                 | )          | (1.1                | )          | 2,053                          |       | 5.2                 |       | (2,612              | )          | (127.2 | ) |
| Medical liability expense                           |       | 811                                  |       | 1.6                 |       | 751                            |       | 1.9                 |       | 60                  |       | 8.0 |   |
| Professional services                               |       | $                                    | 22,277     |                | 45.2       |                           | $          | 20,686              |       | 52.7                |       | $ | 1,591 |   | 7.7 | % |

 

The 7.7% increase inprofessional services expense for the six months ended June 30, 2008,compared to the six months ended June 30, 2007, resulted from increases inphysician cash compensation expense associated with our increased number ofaffiliated radiologists and a significant increase in the number of readsperformed by radiologists together with additional medical liability insurancepremiums. These increases were partially offset by the decrease in non-cashphysician stock-based compensation expense. This decrease in non-cash physicianstock-based compensation expense relates primarily to the decreased fair valueof our common stock during the first six months of 2008. For the six monthsended June 30, 2008, the number of physicians performing reads increased40.9%, from 88 as of June 30, 2007 to 124 as of June 30, 2008. Thedecrease in physician cash compensation expense as a percentage of revenue from45.6% for the six months ended June 30, 2007 to 44.7% for the six monthsended June 30, 2008 resulted primarily from improved radiologistefficiency due to continuing advancements in both our distributed networkinfrastructure and our radiologist support services. We believe that physiciancash compensation expense will increase as we continue to grow, but willdecrease as a percentage of revenue.

 

***Sales, General and Administrative***

 
| ** **                        | ** ** | **Six Months Ended**       | ** ** | **Percentage**      | ** ** | **Six Months Ended** | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | **June 30, 2008**          | ** ** | **of Revenue** | ** ** | **June 30, 2007**    | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                        | ** ** | **(dollars in thousands)** | ** ** |
| Sales, general and administrative |       | $                                    | 18,067     |                | 36.7       | %                              | $          | 14,295              |       | 36.4                | %          | $ | 3,772 |   | 26.4 | % |
|                                   |            |                                      |            |                     |            |                                |            |                     |            |                     |            |  |  |  |  |  |

 

The 26.4% increase in sales,general and administrative expense for the six months ended June 30, 2008,compared to the six months ended June 30, 2007, resulted from increasedexpenses for employee compensation, sales and marketing, information technologyand other general and administrative expense, partially offset by a decrease inlicensing and credentialing costs.

 

·                  ***EmployeeCompensation.***  Our employee compensation expense increasedfrom $8.1 million for the six months ended June 30, 2007 to$9.5 million for the six months ended June 30, 2008. The 17.3%increase resulted primarily from the hiring of additional administrative andoperations personnel to manage, operate and maintain our business, partiallyoffset by a decrease in performance-based bonus compensation. As of June 30,2008, the number of non-sales and marketing employees increased 20.3% over June 30,2007. Employee compensation expense as a percentage of revenue was 19.3% and20.5% for the six months ended June 30, 2008 and 2007, respectively.

 

·                  ***Sales andMarketing.***  Our sales and marketing expenses increasedfrom $1.5 million for the six months ended June 30, 2007 to $1.8 millionfor the six months ended June 30, 2008. The 20.0% increase resultedprimarily from additional compensation expense related to an increased numberof sales and marketing personnel. As of June 30, 2008, the number of salesand marketing personnel increased 47.8%, over June 30, 2007. Sales andmarketing expenses as a percentage of revenue were 3.7% and 3.8% for the sixmonths ended June 30, 2008 and 2007, respectively.

 

·                  ***InformationTechnology.***  Our information technology expense increasedfrom $926,000 for the six months ended June 30, 2007 to $1.2 million forthe six months ended June 30, 2008. The 29.6% increase resulted fromadditional provisioning costs for communications bandwidth and additional

 

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software transactional costsassociated with increased study volumes. Information technology expense as apercentage of revenue was 2.5% and 2.4% for the six months ended June 30,2008 and 2007, respectively.

 

·                  ***Licensingand Credentialing.***  Our licensing and credentialing relatedexpenses decreased from $952,000 for the six months ended June 30, 2007 to$731,000 for the six months ended June 30, 2008. The 23.2% decreaserelates primarily to the amount and timing of initial and renewal licenseapplications for our affiliated radiologists, and was aided by thecomparatively lower costs of renewal applications. Licensing and credentialingrelated expenses as a percentage of revenue were 1.5% and 2.4% for the six monthsended June 30, 2008 and 2007, respectively.

 

·                  ***OtherGeneral and Administrative.***  Our other general and administrative expensesincreased from $2.9 million for the six months ended June 30, 2007 to$4.8 million for the six months ended June 30, 2008. The 65.5%increase resulted primarily from the payment of a deductible on a malpracticeclaim and a bad debt charge that were recognized during the second quarter of2008.  Additionally, we experiencedincreases in outside accounting, legal expenses and board of director feesrelating to the costs of being a public company, as well as increases in hiringexpenses, corporate insurance expense, travel expenses and facilities relatedexpenses resulting from the growth in our business. Other general andadministrative expenses as a percentage of revenue were 9.8% and 7.3% for thesix months ended June 30, 2008 and 2007, respectively.

 

The increase in sales,general and administrative expense as a percentage of revenue is due primarilyto the charges for bad debt and the payment of an insurance deductible relatingto the settlement of a medical malpractice claim during the six months ended June 30,2008.  We believe that sales, general andadministrative expenses, including the costs related to being a public company,will increase as we continue to grow, but will decrease as a percentage ofrevenue over time.

 

***Depreciation and Amortization Expense.*** Depreciation and amortization expense increased from $1.0 million forthe six months ended June 30, 2007 to $2.1 million for the six monthsended June 30, 2008. This 110.0% increase was primarily due to theincrease in depreciation expense related to additional capital equipmentpurchased for our operations and the amortization of customer relationship andnon-compete intangible assets resulting from our acquisition of Diagna. Webelieve that depreciation and amortization expense will increase in the future.Depreciation and amortization expense as a percentage of revenue was 4.2% and2.7% for the six months ended June 30, 2008 and 2007, respectively.

 

***Interest Income, Net.*** Interest income, net, increased from income of $107,000 for the sixmonths ended June 30, 2007 to income of $265,000 for the six months ended June 30,2008. This increase in interest income relates primarily to the interest earnedon our proceeds from our initial public offering.

 

***Non-Controlling Interest Expense.*** Through consolidation we recognize all net losses of the AffiliatedMedical Practices in excess of the equity of the Affiliated Medical Practices.During the six months ended June 30, 2007, VRP experienced net income thatchanged VRP’s equity position to a positive equity position and, as a result werecognized non-controlling interest expense of $339,000. During the six monthsended June 30, 2008, one of the Affiliated Medical Practices experiencednet income that increased its positive equity position. As a result, for thesix months ended June 30, 2008, we recognized non-controlling interestexpense of $8,000.

 

***Income Tax Expense.*** Income tax expense increased from $1.4 million for the six months ended June 30,2007 to $3.1 million for the six months ended June 30, 2008, whichresulted primarily from an increase in pre-tax net income for VRC ofapproximately $3.5 million for the six months ended June 30, 2007 toapproximately $7.7 million for the six months ended June 30, 2008. Aspreviously discussed, we consolidate our financial results in accordance withFIN 46R. However, for income tax purposes, VRC is a single tax entity thatis taxed as a corporation and is not included in a tax consolidated group withthe Affiliated Medical Practices. As a result, tax losses of the AffiliatedMedical Practices are not available to offset taxable income of VRC. Thedifference in the consolidated group for financial statement purposes and taxpurposes, combined with the valuation allowances established for deferred taxassets related to net operating loss carryforwards of certain of the AffiliatedMedical Practices, resulted in the increase in income tax expense for the sixmonths ended June 30, 2008 compared to the six months ended June 30,2007. The totality of these factors resulted in an effective tax rate of 43.5%for the six months ended June 30, 2008 compared to a rate of 46.2% for thesix months ended June 30, 2007.

 

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***Preferred Stock Accretion.*** Preferred stock accretion decreased from $20.1 million for the sixmonths ended June 30, 2007 to zero for the six months ended June 30,2008. All shares of our Series A Preferred Stock were converted to commonstock upon closing of our initial public offering in November 2007, and asa result, there was no further recognition of preferred stock accretion ordecretion for the six months ended June 30, 2008.

 

**Liquidityand Capital Resources**

 

***Cash, Cash Equivalents and Short-Term Investments***

 

Our financial positionincluded cash and cash equivalents of $32.4 million and $8.4 millionat June 30, 2008 and 2007, respectively. We have historically funded ouroperations from cash flows generated by our operating activities, by proceedsgenerated from the sale of our stock, and to a lesser extent from borrowingsunder our previous revolving credit facilities.

 

The reported changes in cashand cash equivalents for the six months ended June 30, 2008 and 2007 aresummarized below:

 
| ** **                                        | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                           | ** ** |
| Net cash provided by operating activities         |       | $                                                 | 8,829      |   | $ | 276 |   |
| Net cash used in investing activities             |       | (11,645                                           | )          | (2,278 | ) |
| Net cash provided by financing activities         |       | 1,752                                             |       | 4,394 |   |
| (Decrease) increase in cash and cash  equivalents |       | $                                                 | (1,064     | ) | $ | 2,392 |   |

 

***Cash Flows from Operating Activities***

 

For the six months ended June 30,2008, we generated $8.8 million of net cash from operating activities fromnet income of $4.0 million. Our net cash from operating activitiesduring this period included cash inflows of $1.0 million as a result of adecrease in prepaid expenses related to the amortization of prepaid medicalliability insurance premiums, $860,000 as a result of a decrease in currenttaxes receivable and $848,000 as a result of an increase in accrued expensesrelated primarily to an increase in accrued professional services expense.  These inflows were partially offset by cashoutflows of $1.6 million related to an increase in accounts receivableresulting primarily from the growth in our business. In addition, we hadnon-cash charges of $2.1 million for depreciation and amortization, $1.1 millionas a result of an increase in deferred income taxes and $145,000 forstock-based compensation.

 

For the six months ended June 30,2007, we generated $276,000 of net cash from operating activities from netincome of $1.6 million. Our net cash from operating activities during this period included an increase inour receivables of $3.9 million resulting primarily from the growth in ourbusiness and an increase in current taxes receivable of $3.5 million resultingfrom the tax benefit generated by the disqualifying disposition of stockoptions during the period. In addition, the net cash from operating activitiesincluded a decrease in current taxes payable of $608,000 as a result of taxpayments made during the second quarter of 2007, an increase in accrued expenseof $2.2 million resulting primarily from an increase in professional servicescompensation, and a decrease in prepaid expenses of $836,000 resultingprimarily from the amortization of our prepaid medical liability insurancepremiums.

 

***Cash Flows from Investing Activities***

 

Net cash used in investingactivities was $11.6 million for the six months ended June 30, 2008,which was comprised primarily of the acquisition of Diagna and capitalexpenditures associated with purchases of equipment and continued investment inour information technology infrastructure.

 

Net cash used in investingactivities was $2.3 million for the six months ended June 30, 2007.The cash used was primarily for capital expenditures associated with thepurchase of equipment and continued investment in our information technologyinfrastructure.

 

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***Cash Flows from Financing Activities***

 

Net cash provided byfinancing activities was $1.8 million for the six months ended June 30,2008. Our net cash provided by financing activities included retained cash of$1.9 million as a result of tax benefits generated by the disqualifieddisposition of stock options during the period, $141,000 of net proceeds fromthe issuance of common stock relating to the exercise of stock options and$306,000 for payments of costs related to our initial public offering.

 

Net cash used in financingactivities was $4.4 million for the six months ended June 30, 2007. Ournet cash from financing activities included an increase of $3.9 million as aresult of tax benefits generated by the disqualified disposition of stockoptions during the period. In addition, cash flows from financing activitiesincluded net proceeds from the issuance of common stock of $911,000 thatresulted from the exercise of stock options and warrants during the period, andpayments related to the costs associated with our initial public offering of$441,000.

 

***Future Liquidity Requirements***

 

We believe that our cashbalances, including the proceeds from our recent initial public offering andthe expected cash flow from operations, will be sufficient to fund ouroperating activities, working capital and capital expenditure requirements forthe foreseeable future. We expect our long-term liquidity needs to consistprimarily of working capital and capital expenditure requirements. We intend tofund these long-term liquidity needs from cash generated from operations alongwith cash generated by potential future financing transactions. However, ourability to generate cash is subject to our performance, general economicconditions, industry trends and other factors. Many of these factors are beyondour control and cannot be anticipated at this time. To the extent that existingcash and securities and cash from operations are insufficient to fund ourfuture activities, we may need to raise additional funds through public orprivate equity or debt financing. If additional funds are obtained by issuingequity securities, substantial dilution to existing stockholders may result.

 

**ContractualObligations and Commitments**

 

On January 22, 2008, weentered into two new license agreements for the provision of network related servicesthat allow us to utilize approximately 1,000 square feet of space in a buildingin Minnetonka, Minnesota, which will house our data centers. The licenseagreements commenced on February 15, 2008 and June 1, 2008 and have36 month terms, expiring in February 2011 and May 2011, respectively.Both license agreements have monthly minimum usage requirements of $10,000 forwhich we are obligated to pay if actual services used do not exceed theseminimums. These service minimums have been recorded as a liability as of June 30,2008, in accordance with FASB Interpretation No. 45, *Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others*, and FASB Staff Position, orFSP, FIN 45-3, *Application of FASB Interpretation No. 45to Minimum Revenue Guarantees Granted to a Business or Its Owners*.The maximum potential amount of future payments is $665,000 and the currentportion of this obligation is $240,000, which is recorded in other currentliabilities on the consolidated balance sheet as of June 30, 2008.  The non-current portion is recorded in otherliabilities on the consolidated balance sheet as of June 30, 2008. Thisobligation will become due immediately if we prematurely terminate either ofthe license agreements.

 

We did not have any currentor future capital lease commitments as of June 30, 2008.

 

**RecentAccounting Pronouncements**

 

In September 2006, theFASB issued Statement of Financial Accounting Standard, or SFAS, No. 157, *Fair Value Measurements,* or SFAS No. 157.This standard clarified the principle that fair value should be based on theassumptions that market participants would use when pricing an asset orliability. Additionally, it establishes a fair value hierarchy that prioritizesthe information used to develop those assumptions. On February 12, 2008the FASB issued FSP FAS 157-2, *EffectiveDate of FASB Statement No. 157* or FSP FAS 157-2. FSPFAS 157-2 defers the implementation of SFAS No. 157 for certainnonfinancial assets and nonfinancial liabilities. The portion of SFAS No. 157that has been deferred by FSP FAS 157-2 will be effective for the Companybeginning in the first quarter of fiscal year 2009. The Company is currentlyevaluating the impact of this portion of the statement. The portion notdeferred was adopted with no impact as the Company does not hold any financialassets or financial liabilities that are covered by this pronouncement.

 

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In February 2007, theFASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities,* or SFASNo. 159. This standard provides companies with an option to report selectedfinancial assets and liabilities at fair value and establishes presentation anddisclosure requirements designed to facilitate comparisons between companiesthat choose different measurement attributes for similar types of assets andliabilities. SFAS No. 159 was effective in the first quarter of 2008. TheCompany has not elected the fair value option for eligible items that existedas of January 1, 2008.

 

In December 2007, theFASB issued SFAS No. 141 (revised 2007), *BusinessCombinations*, or SFAS No. 141R. SFAS No. 141R establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,any noncontrolling interests in the acquiree and the goodwill acquired. Some ofthe key changes under SFAS No. 141R will change the accounting treatmentfor certain specific acquisition related items including: (1) accounting foracquired in-process research and development as an indefinite-lived intangibleasset until approved or discontinued rather than as an immediate expense; (2) expensingacquisition costs rather than adding them to the cost of an acquisition; (3) expensingrestructuring costs in connection with an acquisition rather than adding themto the cost of an acquisition; (4) including the fair value of contingentconsideration at the date of an acquisition in the cost of an acquisition; and (5) recordingat the date of an acquisition the fair value of contingent liabilities that aremore likely than not to occur. SFAS No. 141R also includes a substantialnumber of new disclosure requirements. SFAS No. 141R applies prospectivelyto business combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008, and interim periods within those fiscal years. Early application of thisstatement is prohibited. The Company is currently evaluating the impact of thisstatement.

 

In December 2007, theFASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements*, *an amendment of ARB 51*, or SFAS No. 160,which changes the accounting and reporting for minority interests. Minorityinterests will be recharacterized as noncontrolling interests and will bereported as a component of equity separate from the parent’s equity, andpurchases or sales of equity interests that do not result in a change incontrol will be accounted for as equity transactions. In addition, net incomeattributable to the noncontrolling interest will be included in consolidatednet income on the face of the income statement and, upon a loss of control, theinterest being sold, as well as any interest retained, will be recorded at fairvalue with any gain or loss recognized in earnings. SFAS No. 160 iseffective for fiscal years beginning on or after December 15, 2008. Thestatement shall be applied prospectively as of the beginning of the fiscal yearin which it is initially applied, except for the presentation and disclosurerequirement which shall be applied retrospectively for all periods presented.Early adoption of this statement is prohibited. The Company is currentlyevaluating the impact of this statement.

 

In March 2008, the FASBissued SFAS No. 161, *Disclosures AboutDerivative Instruments and Hedging Activities, an amendment of SFAS No. 133*,which changes the disclosure requirements for derivative instruments andhedging activities. Entities will be required to provide enhanced disclosuresabout (a) how and why an entity uses derivative instruments, (b) howderivative instruments and related hedged items are accounted for under SFAS No. 133and its related interpretations, and (c) how derivative instruments andrelated hedged items affect an entity’s financial position, financialperformance and cash flows. This statement is effective for financialstatements issued for fiscal years beginning after November 15, 2008.  The Company is currently evaluating theimpact of this statement.

 

In May 2008, the FASBissued SFAS No. 162, *The Hierarchy of GenerallyAccepted Accounting Principles*, which changed the framework forselecting accounting principles in conformity with GAAP.  The GAAP hierarchy will now be included inthe accounting literature established by the FASB.  This statement is not expected to impactcurrent practice.

 

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**ITEM 3.****                            ****Quantitative and QualitativeDisclosure About Market Risk**

 

***Foreign Currency Exchange Risk***

 

As of June 30, 2008, we did not havesignificant exposure to foreign currency exchange rates as substantially all ofour transactions are denominated in U.S. dollars. VRL’s functional currency isthe British pound; however, as of and for the three and six months ended June 30,2008, VRL’s operations were not significant and did not have a material impacton our consolidated results of operations or financial position.

 

***Interest Rate Market Risk***

 

Our cash is invested in bank deposits anddemand deposit accounts denominated in U.S. dollars. The carrying value of ourcash, restricted cash, accounts receivable, other current assets, tradeaccounts payable, accrued expenses and customer deposits approximate fair valuebecause of the short period of time to their maturity.

 

**ITEM 4.****                            ****Controls and Procedures**

 

***Evaluation of DisclosureControls and Procedures***

 

As of the end of the period covered by thisreport (the “Evaluation Date”), we carried out an evaluation, under thesupervision and with the participation of management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Basedupon that evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that, as of the Evaluation Date, our disclosure controls andprocedures were effective to ensure that information required to be disclosedin the reports that we file or submit under the Exchange Act is (i) recorded,processed, summarized and reported within the time periods specified in theapplicable rules and forms, and (ii) accumulated and communicated toour management, including our Chief Executive Officer and Chief FinancialOfficer, to allow timely decisions regarding required disclosure.

 

***Changes in Internal Controls***

 

During the most recent fiscal quarter, therehas been no change in our internal control over financial reporting (as definedin Rule 13a-15(f) under the Exchange Act) that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II– Other Information**

 

**ITEM 2.****                            ****Unregistered Sales of EquitySecurities and Use of Proceeds**

 

On November 14, 2007, we completed aninitial public offering of 4,600,000 shares of our common stock. Gross proceedsfrom the offering were $78.2 million, including $68.0 million to the Companyand $10.2 million to selling stockholders.

 

On April 14, 2008 we entered into anagreement to purchase Diagna Radiology, LLC, an Idaho-based teleradiologyprovider for total consideration of approximately $6.6 million, which includes$6.0 million of initial purchase price, $504,000 for estimated working capitaland $93,000 in initial direct acquisition costs.  Diagna’s owners may also receive additional cashconsideration of up to an aggregate of $2.2 million to be paid as earn-outpayments to be made over two years. We used cash proceeds from our initialpublic offering to finance this purchase.

 

**ITEM 4.****                            ****Submission of Matters to aVote of Security Holders**

 

At the AnnualMeeting of Stockholders of Virtual Radiologic Corporation held on May 7,2008, the following matters set forth in our Proxy Statement dated April 4,2008, which was filed with the Securities and Exchange Commission pursuant toRegulation 14A under the Securities Exchange Act of 1934, were voted upon withthe results indicated below.

 

1.               The nominees listedbelow were elected as Class I directors to the Board of Directors, each toserve a three-year term, with the respective votes set forth opposite theirnames:

 
| ** **                 | ** ** | **For**    | ** ** | **Withhold Authority** | ** ** |
|----------------------------|------------|------------|------------|-----------------------------|------------|
| Eduard Michel, M.D., Ph.D. |       | 14,044,736 |       | 752,977                     |       |
| Andrew P. Hertzmark        |       | 13,941,475 |       | 856,238                     |       |

 

2.               A proposal seeking ratification of theappointment of PricewaterhouseCoopers LLP as our registered independent publicaccounting firm for fiscal year 2008 was approved, with 14,786,894 votes castFOR, 10,205 votes cast AGAINST, and 614 abstentions.

 

**ITEM 6.****                            ****Exhibits**

 

Exhibits are incorporatedherein by reference or are filed with this quarterly report as set forth below:

 

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                         |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Employment Agreement between the Company and Leonard Purkis,  effective April 14, 2008 (Incorporated by reference to Exhibit 10.1  to the registrant’s Current Report on Form 8-K filed April 8,  2008).                                                                                                                       |
| 10.2                 |       | Membership Interest Purchase Agreement between the Company, Diagna  Radiology, LLC, and the owners of Diagna Radiology, LLC dated April 14,  2008 (Incorporated by reference to Exhibit 10.1 to the registrant’s  Current Report on Form 8-K filed April 15, 2008).                                                            |
| 10.3                 |       | Amendment to Amendment No. 2 to Professional and Management  Services Agreement and License, dated as of April 22, 2008, by and  between Virtual Radiologic Professionals, LLC, and the Company (Incorporated  by reference to Exhibit 10.1 to the registrant’s Current Report on  Form 8-K filed April 25, 2008). † |
| 31.1                 |       | Certification by Principal Executive Officer pursuant to  Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of  1934, as amended, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                |
| 31.2                 |       | Certification of Principal Financial Officer pursuant to  Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of  1934, as amended, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                |
| 32.1                 |       | Certification by Chief Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                       |
| 32.2                 |       | Certification by Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                       |

 

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| † | Confidential treatment has been requested for certain portions of  this exhibit, which portions have been omitted and filed separately with the  Securities and Exchange Commission. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ***    | Filed herewith.                                                                                                                                                                      |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**            | ** ** | **Title**                                        | ** ** | **Date**           |
|--------------------------|------------|--------------------------------------------------|------------|--------------------|
| ** **               | ** ** | ** **                                       | ** ** | ** **         |
| /s/ Sean O. Casey, M.D.  |       | Chief Executive Officer and Chairman             |       |               |
| **Sean O.  Casey, M.D.** |       |   of the Board of Directors (Principal |       | July 31, 2008 |
| ** **               |       |   Executive Officer)                   |       |               |
| ** **               |       |                                             |       |               |
| /s/ Leonard C. Purkis    |       | Chief Financial Officer (Principal               |       |               |
| **Leonard  C. Purkis**   |       |   Financial and Accounting Officer)    |       | July 31, 2008 |

 

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