**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 MARCH 31, 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** |

 

**Commission File Number** **001-33815**

 

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**Virtual Radiologic Corporation**

(Exactname of registrant as specified in its charter)

 

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

 

**(952) 392-1100**

(Registrant’s telephonenumber, including area code)

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days. Yes x  No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” 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 mark whether the registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct). Yes o  No x

 

As of April 30, 2008, 16,711,444 shares of theregistrant’s common stock were outstanding.

 

 

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**TABLEOF CONTENTS**

 
| **Part I —  Financial Information** |
|-----------------------------------------------|
| Item 1.                                  | Financial Statements | 3 |
| Item 2.                                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 17 |
| Item 3.                                  | Quantitative  and Qualitative Disclosures About Market Risk | 33 |
| Item 4.                                  | Controls and Procedures | 33 |
| **Part II  — Other Information**    |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds | 34 |
| Item 6.                                  | Exhibits | 34 |
| Signatures                                    |   | 37 |

 

2

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**PART I— Financial Information**

 

**ITEM1.****                            ****Financial Statements**

 

**VirtualRadiologic Corporation**

 

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Contents**

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

 

3

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**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(unaudited)**

**(inthousands, except per share data)**

 
| ** **                                                                                                                                                                                                                                 | ** ** | **As of**          | ** ** | **As of**             | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                 | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                                                                 | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                                                 | ** ** | ** **         | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                                                 |       |               |       |                  |       |
| Current assets:                                                                                                                                                                                                                            |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                                  |       | $                  | 33,496     |                  | $          | 33,487 |   |
| Restricted cash                                                                                                                                                                                                                            |       | 700                |       | 700                   |       |
| Accounts receivable, net                                                                                                                                                                                                                   |       | 13,152             |       | 12,486                |       |
| Prepaid expenses                                                                                                                                                                                                                           |       | 1,538              |       | 2,073                 |       |
| Current taxes receivable                                                                                                                                                                                                                   |       | 1,212              |       | 1,995                 |       |
| Other current assets                                                                                                                                                                                                                       |       | 727                |       | 336                   |       |
| Total current assets                                                                                                                                                                                                                       |       | 50,825             |       | 51,077                |       |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Property, plant and  equipment, net                                                                                                                                                                                                        |       | 11,369             |       | 8,013                 |       |
| Intangible assets, net                                                                                                                                                                                                                     |       | 293                |       | 252                   |       |
| Other assets                                                                                                                                                                                                                               |       | 561                |       | 94                    |       |
| Total assets                                                                                                                                                                                                                               |       | $                  | 63,048     |                  | $          | 59,436 |   |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                                             | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                                                                                                                                                                                                                       |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                                                           |       | $                  | 514        |                  | $          | 801 |   |
| Accrued professional services compensation expense                                                                                                                                                                                         |       | 4,963              |       | 4,681                 |       |
| Accrued sales, general and administrative compensation expenses                                                                                                                                                                            |       | 1,432              |       | 1,717                 |       |
| Other accrued expenses                                                                                                                                                                                                                     |       | 1,212              |       | 1,273                 |       |
| Other current liabilities                                                                                                                                                                                                                  |       | 508                |       | 398                   |       |
| Total current liabilities                                                                                                                                                                                                                  |       | 8,629              |       | 8,870                 |       |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Deferred rent                                                                                                                                                                                                                              |       | 196                |       | 204                   |       |
| Other liabilities                                                                                                                                                                                                                          |       | 660                |       | 24                    |       |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Non-controlling interest                                                                                                                                                                                                                   |       | 12                 |       | 8                     |       |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Commitments and  contingencies (Note 6)                                                                                                                                                                                                    |       |               |       |                  |       |
|                                                                                                                                                                                                                                       |       |               |       |                  |       |
| Stockholders’ equity                                                                                                                                                                                                                  |       |               |       |                  |       |
| Common stock, $.001 par value; 100,000,000 shares authorized at  March 31, 2008 and December 31, 2007; 16,689,444 and 16,463,173  shares issued and outstanding at March 31, 2008 and December 31,  2007, respectively |       | 17                 |       | 16                    |       |
| Additional paid-in capital                                                                                                                                                                                                                 |       | 91,386             |       | 90,165                |       |
| Accumulated deficit                                                                                                                                                                                                                        |       | (37,851            | )          | (39,851               | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                       |       | (1                 | )          | —                |       |
| Total stockholders’ equity                                                                                                                                                                                                            |       | 53,551             |       | 50,330                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                            |       | $                  | 63,048     |                  | $          | 59,436 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

4

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(unaudited)**

**(inthousands, except per share data)**

 
| ** **                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                               | ** ** | **2007** | ** ** |
|                                                                       |       |                                   |       |   |   |
| Revenue                                                                    |       | $                                      | 23,320     |   | $ | 18,102 |   |
|                                                                       |       |                                   |       |   |   |
| Operating costs and  expenses                                              |       |                                   |       |   |   |
| Professional services                                                      |       | 10,367                                 |       | 8,599 |   |
| Sales, general and administrative                                          |       | 8,735                                  |       | 6,929 |   |
| Depreciation and amortization                                              |       | 855                                    |       | 498 |   |
| Total operating costs and expenses                                         |       | 19,957                                 |       | 16,026 |   |
|                                                                       |       |                                   |       |   |   |
| Operating income                                                           |       | 3,363                                  |       | 2,076 |   |
|                                                                       |       |                                   |       |   |   |
| Other (expense) income                                                     |       |                                   |       |   |   |
| Interest expense                                                           |       | —                                 |       | (6 | ) |
| Interest income                                                            |       | 176                                    |       | 43 |   |
| Total other income                                                         |       | 176                                    |       | 37 |   |
| Income before non-controlling interest and income tax                      |       | 3,539                                  |       | 2,113 |   |
|                                                                       |       |                                   |       |   |   |
| Non-controlling interest  expense                                          |       | 4                                      |       | 680 |   |
| Income before income tax expense                                           |       | 3,535                                  |       | 1,433 |   |
|                                                                       |       |                                   |       |   |   |
| Income tax expense                                                         |       | 1,535                                  |       | 392 |   |
| Net income                                                                 |       | 2,000                                  |       | 1,041 |   |
|                                                                       |       |                                   |       |   |   |
| Series A Cumulative  Redeemable Convertible Preferred Stock decretion |       | —                                 |       | 4,774 |   |
|                                                                       |       |                                   |       |   |   |
| Net income available to common stockholders                                |       | $                                      | 2,000      |   | $ | 5,815 |   |
|                                                                       |       |                                   |       |   |   |
| Earnings per common share                                                  |       |                                   |       |   |   |
| Basic                                                                      |       | $                                      | 0.12       |   | $ | 0.56 |   |
| Diluted                                                                    |       | $                                      | 0.12       |   | $ | 0.08 |   |
| Weighted average common  shares outstanding                                |       |                                   |       |   |   |
| Basic                                                                      |       | 16,616                                 |       | 6,726 |   |
| Diluted                                                                    |       | 17,268                                 |       | 12,885 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

5

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**

**(inthousands)**

 
| ** **                                                                    | ** ** | **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               |       | —           |       | —     |       | (495            | )          | —          |       | — |   | (495 | ) |
| Equity based compensation for employees                                       |       | —           |       | —     |       | 282             |       | —          |       | — |   | 282 |   |
| Independent contractor physician and employee stock option exercises          |       | 226              |       | 1          |       | 111             |       | —          |       | — |   | 112 |   |
| Excess tax benefit from exercises of stock options                            |       | —           |       | —     |       | 1,381           |       | —          |       | — |   | 1,381 |   |
| Stock issuance costs                                                          |       | —           |       | —     |       | (58             | )          | —          |       | — |   | (58 | ) |
| Net income                                                                    |       | —           |       | —     |       | —          |       | 2,000           |       | — |   | 2,000 |   |
| Other comprehensive loss                                                      |       |             |       |       |       |            |       |            |       |   |   |   |   |
| Foreign currency translation adjustments                                      |       | —           |       | —     |       | —          |       | —          |       | (1 | ) | (1 | ) |
| **Balance at March 31, 2008**                                            |       | 16,689           |       | $          | 17         |            | $          | 91,386          |       | $ | (37,851 | ) | $ | (1 | ) | $ | 53,551 |   |

 

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

 

6

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(unaudited)**

**(inthousands)**

 
| ** **                                                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                        | ** ** | **2008**                               | ** ** | **2007** | ** ** |
| **Cash flows from operating  activities**                                         | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net income                                                                        |       | $                                      | 2,000      |   | $ | 1,041 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities |       |                                   |       |   |   |
| Non-controlling interest                                                          |       | 4                                      |       | 680 |   |
| Provision for doubtful accounts and sales allowance                               |       | —                                 |       | 44 |   |
| Depreciation and amortization                                                     |       | 855                                    |       | 498 |   |
| Loss on disposal of property, plant and equipment                                 |       | 13                                     |       | 12 |   |
| Equity based compensation for independent contractor physicians                   |       | (495                                   | )          | (105 | ) |
| Equity based compensation for employees                                           |       | 282                                    |       | 27 |   |
| Deferred income taxes                                                             |       | 145                                    |       | — |   |
| Changes in operating assets and liabilities                                       |       |                                   |       |   |   |
| Accounts receivable                                                               |       | (665                                   | )          | (1,238 | ) |
| Prepaid expenses                                                                  |       | 488                                    |       | 415 |   |
| Current taxes receivable                                                          |       | 783                                    |       | — |   |
| Other current assets                                                              |       | (57                                    | )          | (66 | ) |
| Accounts payable                                                                  |       | (69                                    | )          | 55 |   |
| Accrued expenses                                                                  |       | 244                                    |       | 572 |   |
| Current taxes payable                                                             |       | —                                 |       | (538 | ) |
| Other current liabilities                                                         |       | (104                                   | )          | 31 |   |
| Deferred rent                                                                     |       | (8                                     | )          | (1 | ) |
| Net cash provided by operating activities                                         |       | 3,416                                  |       | 1,427 |   |
| **Cash flows from investing  activities**                                         | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Purchase of property,  plant and equipment                                        |       | (4,559                                 | )          | (1,077 | ) |
| Proceeds from sale of  property, plant and equipment                              |       | 2                                      |       | — |   |
| Payments to acquire  patents                                                      |       | (51                                    | )          | (13 | ) |
| Net cash used in investing activities                                             |       | (4,608                                 | )          | (1,090 | ) |
| **Cash flows from financing  activities**                                         | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Payments on capital leases                                                        |       | —                                 |       | (18 | ) |
| Payment of offering costs                                                         |       | (291                                   | )          | (328 | ) |
| Proceeds from stock option  exercises                                             |       | 111                                    |       | — |   |
| Excess tax benefit from  exercises of stock options                               |       | 1,381                                  |       | — |   |
| Net cash provided by (used in) financing activities                               |       | 1,201                                  |       | (346 | ) |
| Net increase (decrease) in cash and cash equivalents                              |       | 9                                      |       | (9 | ) |
| **Cash and cash equivalents**                                                     | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Beginning of period                                                               |       | 33,487                                 |       | 5,958 |   |
| End of period                                                                     |       | $                                      | 33,496     |   | $ | 5,949 |   |
|                                                                              |       |                                   |       |   |   |
| **Supplemental disclosure of cash  flow information**                             | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Cash (received) paid for  income taxes                                            |       | $                                      | (780       | ) | $ | 930 |   |

 

The accompanying notes are an integral part of theseconsolidated financial statements.

 

7

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**VIRTUAL RADIOLOGIC CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

**(unaudited)**

** **

***1. Business Overview***

 

Virtual Radiologic Corporation, or VRC, a Delawarecorporation, is a provider of radiologic interpretations, or reads, viateleradiology for emergency and routine care coverage to radiology practices,hospitals, clinics and diagnostic imaging centers primarily located within theUnited States. Virtual Radiologic Professionals, LLC, or VRP, a Delawarelimited liability company, is VRC’s affiliated physician-owned medical practicethat contracts with the Company’s affiliated radiologists for the provision oftheir services to fulfill customer contracts held by VRC or the otherAffiliated Medical Practices (as defined below).

 

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.”

 

VRCalso has a wholly owned and consolidated subsidiary, Virtual RadiologicLimited, or VRL, formed under the laws of England and Wales and located inLondon, England. VRL was formed to facilitate the possible internationalexpansion of the Company’s business to provide teleradiology services andproducts to customers located outside of the United States.

 

Theterm “Company” as used in this report refers to VRC, its Affiliated MedicalPractices and VRL.

 

The Company is involved in the application of variousconvergent technologies that allow radiologists to remotely diagnose patientsand enhance the overall productivity of the radiology profession through adistributed diagnostic network that has been developed by the Company and isintegrated into its nationwide virtual private network. The Company servesradiology practices, hospitals, clinics and diagnostic imaging centers byproviding diagnostic image interpretations, or reads, 24 hours a day,365 days a year. The Company’s distributed operating model provides itsteam of American Board of Radiology-certified radiologists with the flexibilityto choose the location from which they work, primarily within the UnitedStates, and allows the Company to serve customers located throughout thecountry. The Company’s services include both preliminary reads, which areperformed for emergent care purposes, and final reads, which are performed forboth emergent and non-emergent care. The Company provides these servicesthrough a scalable communications network incorporating encrypted broadbandinternet connections and proprietary workflow management software.

 

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

 

***Interim FinancialStatements***

 

The Company has prepared the unaudited interimconsolidated financial statements and related unaudited financial informationin the footnotes in accordance with accounting principles generally accepted inthe United States of America, or GAAP, and the rules and regulations ofthe Securities and Exchange Commission, or the SEC, for interim financialstatements. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with GAAP have been condensed oromitted pursuant to such rules and regulations. These interim financialstatements reflect all adjustments consisting of normal recurring accruals,which, in the opinion of management, are necessary to present fairly theCompany’s consolidated financial position, the results of its operations andits cash flows for the interim periods. These interim consolidated financialstatements should be read in conjunction with the consolidated annual financialstatements and the notes thereto included in our 2007 Annual Report on Form 10-Kfiled with the SEC on March 17, 2008. The nature of the Company’s businessis such that the results of any interim period may not be indicative of theresults to be expected for the entire year.

 

The December 31, 2007 balance sheet data has beenderived from audited financial statements as of that date.

 

8

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

***Principles ofConsolidation and Basis of Presentation***

 

The Company consolidates its financial results inaccordance with Financial Accounting Standards 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. The Company hasdetermined that the Affiliated Medical Practices are VIEs and that VRC is theprimary beneficiary of such VIEs, as defined by FIN 46R. The AffiliatedMedical Practices were created as the Company’s business expanded for thepurpose of facilitating compliance with corporate practice of medicine laws inthe various states in which VRC operates. The management of VRC was involvedsignificantly in the design and creation of the VIEs and, with the exception ofrendering medical judgments, holds significant influence over their continuingoperations. Although VRC holds no legal ownership in the VIEs, as a result ofthe pricing structure inherent in the management agreements that exist betweenthe entities, VRC will absorb a majority of the VIEs expected future losses andreceive a majority of the VIEs expected residual returns. As such, the Companyhas concluded that VRC is required to consolidate the VIEs. As of March 31,2008, VRC has funded losses of the VIEs totaling approximately$7.4 million and expects to continue to fund the majority of the lossesfor the foreseeable future. VRC will only receive residual returns up to theamount of previously recognized losses.

 

As of March 31, 2008 and December 31, 2007and for the three months ended March 31, 2008 and 2007, the financialstatements of VRC have been presented on a consolidated basis to include itsvariable interests in the Affiliated Medical Practices. In addition, as of March 31,2008 and December 31, 2007 and for the three months ended March 31,2008, VRC consolidated VRL, its wholly owned subsidiary.

 

The effect of the VIEs’ consolidation on the Company’sconsolidated balance sheet at March 31, 2008, was an increase in theCompany’s assets and liabilities of approximately $18.7 million and$5.1 million, respectively. At December 31, 2007, as a result ofconsolidating the VIEs, the Company’s assets and liabilities increased byapproximately $9.8 million and $4.9 million, respectively. Theliabilities of the VIEs consolidated by the Company do not represent additionalclaims on the Company’s general assets; rather they represent claims againstthe specific assets of the VIEs. Likewise, the assets of the VIEs consolidatedby the Company do not represent additional assets available to satisfy claimsagainst the Company’s general assets. For the three months ended March 31,2008, the revenue of the VIEs represented approximately 44%, or $10.2 millionof the consolidated revenue of the Company. For the three months ended March 31,2007, the revenue of the VIEs represented approximately 46%, or$8.3 million, of the consolidated revenue of the Company. Throughconsolidation, the Company recognizes all net losses of each VIE in excess ofthe equity of that VIE. The Company recognizes net earnings of each VIE only tothe extent it is recovering losses previously recognized with respect to thatVIE. Earnings of each VIE in excess of the Company’s previously recognizedlosses with respect to that VIE are eliminated from the Company’s earnings andare attributed to the respective equity owners of that VIE by recording suchearnings as non-controlling interest on the Company’s consolidated financial statements.During the three months ended March 31, 2007, one of the VIEs experiencednet income and another experienced a net loss that decreased its positiveequity position. This created a positive equity position for the VIEs and, as aresult, the Company recognized non-controlling interest expense ofapproximately $680,000. During the three months ended March 31, 2008, oneof the same VIEs experienced net income that increased its positive equityposition. As a result, for the three months ended March 31, 2008, theCompany recognized non-controlling interest expense of approximately $4,000.

 

The consolidated financial statements and the relatedfootnote information presented as of and for the three months ended March 31,2008 and 2007 and as of December 31, 2007, represent the consolidatedoperations of the Company.

 

9

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

***Recent AccountingPronouncements***

 

In September 2006, the FASB issued Statement ofFinancial 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 FASB Staff Position, or FSP, FAS 157-2, *Effective Date of FASB Statement No. 157*or FSP FAS 157-2. FSP FAS 157-2 defers the implementation of SFAS No. 157for certain nonfinancial assets and nonfinancial liabilities. The portion ofSFAS No. 157 that has been deferred by FSP FAS 157-2 will beeffective for the Company beginning in the first quarter of fiscal year 2009.The portion not deferred was adopted with no impact as the Company does nothold any financial assets or financial liabilities that are covered by thispronouncement.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities,* or SFAS No. 159. This standardprovides companies with an option to report selected financial assets andliabilities at fair value and establishes presentation and disclosurerequirements designed to facilitate comparisons between companies that choosedifferent measurement attributes for similar types of assets and liabilities.SFAS No. 159 was effective in the first quarter of 2008. The Company hasnot elected the fair value option for eligible items that existed as of January 1,2008.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), *Business Combinations,*or SFAS No. 141R. SFAS No. 141R establishes principles and requirementsfor how an acquirer recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, any noncontrollinginterests in the acquiree and the goodwill acquired. Some of the key changesunder SFAS No. 141R will change the accounting treatment for certain specificacquisition related items including: (1) accounting for acquired in processresearch and development as an indefinite-lived intangible asset until approvedor discontinued rather than as an immediate expense; (2) expensing acquisitioncosts 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) recording at the date of an acquisition the fair value of contingentliabilities that are more likely than not to occur. SFAS No. 141R also includesa substantial number of new disclosure requirements. SFAS No. 141R appliesprospectively to business combinations for which the acquisition date is on orafter the beginning 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, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements*, *anamendment of ARB 51*, or SFAS No. 160, which changes theaccounting and reporting for minority interests. Minority interests will berecharacterized as noncontrolling interests and will be reported as a componentof equity separate from the parent’s equity, and purchases or sales of equityinterests that do not result in a change in control will be accounted for asequity transactions. In addition, net income attributable to the noncontrollinginterest will be included in consolidated net income on the face of the incomestatement and, upon a loss of control, the interest sold, as well as anyinterest retained, will be recorded at fair value with any gain or lossrecognized in earnings. SFAS No. 160 is effective for fiscal yearsbeginning on or after December 15, 2008. The statement shall be appliedprospectively as of the beginning of the fiscal year in which it is initiallyapplied, except for the presentation and disclosure requirement which shall beapplied retrospectively for all periods presented. Early adoption of thisstatement is prohibited. The Company is currently evaluating the impact of thisstatement.

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures About Derivative Instruments andHedging Activities, an amendment of SFAS No. 133*, which changesthe disclosure requirements for derivative instruments and hedging activities.Entities will be required to provide enhanced disclosures about (a) howand why an entity uses derivative instruments, (b) how derivativeinstruments 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 statementsissued for fiscal years beginning after November 15, 2008.  The Company is currently evaluating theimpact of this statement.

 

10

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

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

 

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

 
| ** **                                      | ** ** | **As of**          | ** ** | **As of**             | ** ** |
|-------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                      | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Equipment                                       |       | $                  | 9,342      |                  | $          | 6,390 |   |
| Software                                        |       | 4,345              |       | 3,575                 |       |
| Furniture and fixtures                          |       | 1,651              |       | 1,648                 |       |
| Leasehold improvements                          |       | 342                |       | 345                   |       |
| Assets not yet placed in  service               |       | 302                |       | 141                   |       |
| Total property, plant and  equipment            |       | 15,982             |       | 12,099                |       |
| Less: Accumulated depreciation and amortization |       | 4,613              |       | 4,086                 |       |
| Property, plant and  equipment, net             |       | $                  | 11,369     |                  | $          | 8,013 |   |

 

Depreciation and amortization related to the property,plant and equipment of the Company for the three months ended March 31,2008 and 2007 was approximately $850,000 and $494,000, respectively.

 

***4. Preferred Stock***

 

On May 2, 2005, the Company closed on a sale ofshares of its Series A Cumulative Redeemable Convertible Preferred Stock,or Series A Preferred Stock. In connection with the preparation of theCompany’s financial statements for the three months ended March 31, 2007the Company’s Board of Directors established what it believed to be a fairmarket value of the Company’s Series A Preferred Stock. This determinationwas based on a variety of factors, including consideration of the Company’smost recent financial performance and future financial projections,consideration of the Company’s position in the industry relative to itscompetitors, consideration of external factors impacting the value of theCompany in its marketplace, consideration of the stock volatility of comparablecompanies in its industry, general economic trends and the application ofvarious valuation methodologies. The decrease in the market value of the Series APreferred Stock at March 31, 2007 was recorded in the consolidatedstatements of changes in stockholders’ equity as Decretion of Series ACumulative Redeemable Convertible Preferred Stock in additional paid-in capitaland as an increase in net income available to common stockholders in the consolidatedstatements of operations as Series A Cumulative Redeemable ConvertiblePreferred Stock decretion. Each share of Series A Preferred Stock wasautomatically converted into shares of the Company’s common stock on November 20,2007, upon the closing of the initial public offering of the Company’s commonstock, pursuant to a registration statement on Form S-1 at a publicoffering price of $17.00 per share. As a result, dividends no longeraccumulate, and previously accumulated, undeclared and unpaid dividends are nolonger payable by the Company.

 

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

 

On September 7, 2007, the Company’s Board ofDirectors adopted the Amended and Restated Equity Incentive Plan (the “Plan”)to consolidate and replace, upon effectiveness of the Company’s initial publicoffering, equity-based plans previously maintained by the Company.  The primary purpose of combining these planswas to ease the administrative burden associated with administering the Company’sequity-based compensation program. The Plan became effective on November 14,2007 and increased the total shares authorized and reserved for future issuanceto 5,475,000 shares. The Plan provides for the grant of incentive stockoptions, nonqualified stock options, stock appreciation rights and restrictedstock to the Company’s officers, employees and independent contractors. As of March 31,2008, there were 2,103,561 options outstanding, which includes 120,000 optionsgranted in May 2007 to members of the Company’s Board of Directors thatwere not issued pursuant to the Plan.

 

11

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

Stock option activity for employees, directors andindependent contractor physicians during the three months ended March 31,2008 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                                 |       | (67,000       | )          | 67,000          |       | 17.32               |       | $16.46  - $17.75    |       |
| Exercised                               |       | —        |       | (226,271        | )          | 1.42                |       | 1.00  - 17.00       |       |
| Forfeited                               |       | 22,074        |       | (22,074         | )          | 7.77                |       | 1.00  - 17.00       |       |
| **Balance at March 31, 2008**      | ** ** | **571,665**   | ** ** | **2,103,561**   | ** ** | **10.05**           | ** ** | ** **          | ** ** |
| **Exercisable at March 31,  2008** | ** ** | ** **    | ** ** | **349,534**     | ** ** | **4.96**            | ** ** | **1.00 - 17.00**    | ** ** |
|                                         |            |               |            |                 |            |                     |            |                     |            |  |

----

(1)                                The number of options outstandingincludes 120,000 options granted in May 2007 to members of the Company’sBoard of Directors that were not issued pursuant to the Plan.

 

(2)                                Prior to the Company’s shares trading onthe NASDAQ Global Market, which trading commenced on November 15, 2007,the exercise 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-BasedCompensation—Employees***

 

For the three months ended March 31, 2008 and2007, the Company issued 41,000 and zero options, respectively, to certainemployees and directors. The Company recorded approximately $282,000 and$27,000 for the three months ended March 31, 2008 and 2007, respectively,in stock-based compensation expense related to employee and director options.

 

SFAS No. 123R requires that the cash retained asa result of the tax deductibility of employee and director share-based awardsbe presented as a component of cash flows from financing activities in theconsolidated statement of cash flows. During the three months ended March 31,2008 and 2007, the Company realized approximately $1.4 million and zero,respectively, as a result of the tax deductibility of employee and directorshare-based awards exercised during the period.

 

***Stock-BasedCompensation—Physicians***

 

For the three months ended March 31, 2008 and2007, the Company issued 26,000 and zero options, respectively, to itsaffiliated radiologists, who are independent contractor physicians. The Companyrecorded stock-based compensation income related to these independentcontractor physicians’ options of approximately $495,000 and $105,000 for thethree months ended March 31, 2008 and 2007, respectively.

 

***6. Commitments and Contingencies***

 

On January 22, 2008, the Company entered into twonew license agreements for the provision of network related services that alsoallow the Company to utilize approximately 1,000 square feet of space in abuilding in Minnetonka, Minnesota, which will house the Company’s data centers.The license agreements commence on February 15, 2008 and June 1, 2008and have 36 month terms, expiring in February 2011 and May 2011,respectively. Both license agreements have monthly minimum usage requirementsof $10,000 for which the Company is obligated to pay if actual services used donot exceed these minimums. These service minimums have been recorded as aliability as of March 31, 2008, in accordance with FASB Interpretation No. 45,

 

12

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness 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 $705,000 and the current portion of this obligation is $220,000.This obligation will become due immediately if the Company prematurelyterminates either of these license agreements.

 

***Litigation***

 

On July 31, 2007, Merge eMed, Inc., orMerge, filed a complaint against the Company in the United States DistrictCourt for the Northern District of Georgia, Atlanta Division, alleging that theCompany has willfully infringed on certain of Merge’s patents relating to teleradiology.Merge is seeking treble damages as well as its costs and legal fees in pursuingthe action. Merge has asked the court for an injunction, ordering the Companyto cease the alleged infringement of their patents, and also that the case betried before a jury. While the Company is continuing to evaluate Merge’sallegations, it intends to defend against this claim and may incur substantialcosts in doing so. On September 14, 2007, the Company filed a Request forReexamination with the United States Patent and Trademark Office, or PTO, forthe patents that Merge has asserted against the Company, asking the PTO toreexamine the validity of the Merge patents based upon certain prior art. ThePTO granted the Company’s reexamination request in November 2007. Also in September 2007,the Company filed a motion with the United States District Court for theNorthern District of Georgia, Atlanta Division, asking the court to stay theproceeding that Merge has commenced in that court pending the outcome of the PTOreexamination. On December 11, 2007, the court granted the Company’smotion to stay the patent suit pending the outcome of the reexamination. In February 2008,subsequent to the grant of the stay by the court, the Company filed anadditional Request for Reexamination with the PTO for these same patents basedon additional prior art. There is no assurance that the PTO will grant thisadditional request. The Company has not recognized any expense related to thesettlement of this matter as an adverse outcome of this claim is not probableand cannot be reasonably estimated.

 

The Company is involved in various other litigation inthe normal course of business. Although the results of litigation and claimscannot be predicted with certainty, as of March 31, 2008 and December 31,2007 the Company’s management believed that the final outcome of these matterswould not have a material adverse effect on the Company’s business,consolidated financial position, results of operations or cash flows.

 

***7. Related Party Transactions***

 

The Company has entered into a non-exclusive,non-transferable license agreement for the use of certain image managementsoftware from a minority stockholder of the Company. For the three months endedMarch 31, 2008 and 2007, the Company incurred licensing fees under thiscontract of approximately $243,000 and $188,000, respectively.

 

The following table illustrates the revenues, expensesand cash flows that result from the management and professional serviceagreements between the related parties described in Note 1.

 
| ** **                                                                   | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                              | ** ** | **2007** | ** ** |
| ** **                                                                   | ** ** | **(in thousands)**                    | ** ** |
| ** **                                                                   | ** ** | ** **                            | ** ** | ** ** | ** ** |
| VRP professional services  revenue from VRC                                  |       | $                                     | 5,266      |   | $ | 5,357 |   |
| VRC professional services  expense to VRP                                    |       | 5,266                                 |       | 5,357 |   |
| VRP professional services  revenue from the Professional Corporations        |       | 5,074                                 |       | 5,507 |   |
| Professional Corporations  professional services expense to VRP              |       | 5,074                                 |       | 5,507 |   |
| VRC management fee revenue  from the Professional Corporations               |       | 5,024                                 |       | 4,009 |   |
| Professional Corporations  management fee expense to VRC                     |       | 5,024                                 |       | 4,009 |   |
| Cash paid for professional  services by VRC to VRP                           |       | 5,266                                 |       | 5,357 |   |
| Cash paid for professional  services by the Professional Corporations to VRP |       | 5,074                                 |       | 5,507 |   |
| Cash paid for management  fees by the Professional Corporations to VRC       |       | 5,024                                 |       | 4,009 |   |
|                                                                              |            |                                       |            |  |  |  |  |

 

13

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**VIRTUAL RADIOLOGIC CORPORATION**

 

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

**FOR THE THREE MONTHS ENDED MARCH 31, 2008 AND 2007**

 

***8. Earnings Per Share***

 

The Company calculates earnings per share inaccordance with EITF Issue No. 03-6, *ParticipatingSecurities and the two-class method under FASB Statement No. 128,*or EITF Issue No. 03-6. In calculating basic earnings per share, thismethod requires net income to be reduced by the amount of dividends declared inthe current period for each class of stock and by the contractual amount ofdividends or other participation payments that are paid or accumulated for thecurrent period. Undistributed earnings for the period are allocated to participatingsecurities based on the contractual participation rights of the security toshare in those current earnings assuming all earnings for the period aredistributed. Prior to the conversion of the Company’s Series A PreferredStock, preferred stockholders had contractual participation rights on aconverted basis that were equivalent to those of common stockholders.Therefore, the Company allocated undistributed earnings to preferred and commonstockholders based on their respective ownership percentage, on a convertedbasis, as of the end of the period.

 

EITF Issue No. 03-6 also requires companies withparticipating securities to calculate diluted earnings per share using theif-converted method. This method requires net income to be adjusted by the amountof dividends declared or accumulated and by the accretion or decretionassociated with convertible securities, subject to the antidilution provisionsof SFAS No. 128 *Earnings per Share,*or SFAS No. 128. The if-converted method also requires the denominator toinclude the additional shares issued upon the assumed conversion of theconvertible securities along with the additional share equivalents from theassumed conversion of stock options and warrants calculated using the treasurystock method, again subject to the antidilution provisions of SFAS No. 128.Prior period earnings per share amounts have been presented to comply with theprovisions of EITF Issue No. 03-6.

 

14

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**VIRTUAL RADIOLOGICCORPORATION**

** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS – (CONTINUED)**

**FOR THE THREE MONTHS ENDEDMARCH 31, 2008 AND 2007**

 

The following table presents the computation ofearnings per share:

 
| ** **                                                                       | ** ** | **Three Months Ended March 31,**     | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                       | ** ** | **2008**                                  | ** ** | **2007** | ** ** |
| ** **                                                                       | ** ** | **(in thousands, except per share data)** | ** ** |
| **Basic and Diluted Earnings per Share (Two-class  Method)**                     | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net income                                                                       |       | $                                         | 2,000      |   | $ | 1,041 |   |
| Less:                                                                            |       |                                      |       |   |   |
| Series A Cumulative  Redeemable Convertible Preferred Stock decretion       |       | —                                    |       | 4,774 |   |
| Undistributed income                                                             |       | $                                         | 2,000      |   | $ | 5,815 |   |
|                                                                             |       |                                      |       |   |   |
| **Distributed Earnings per Share**                                               | ** ** | ** **                                | ** ** | ** ** | ** ** |
| **Basic and Diluted - None**                                                     | ** ** | ** **                                | ** ** | ** ** | ** ** |
|                                                                             |       |                                      |       |   |   |
| **Undistributed Earnings per  Share**                                            | ** ** | ** **                                | ** ** | ** ** | ** ** |
| **Basic**                                                                        | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Undistributed income                                                             |       | $                                         | 2,000      |   | $ | 5,815 |   |
| Series A Preferred  ownership on a converted basis                          |       | 0                                         | %          | 35 | % |
| Series A Preferred  stockholders interest in undistributed income           |       | $                                         | —     |   | $ | 2,035 |   |
| Weighted average  Series A Preferred shares                                 |       | —                                    |       | 3,627 |   |
| Undistributed earnings per  share - Series A Preferred Stock                |       | $                                         | —     |   | $ | 0.56 |   |
| Undistributed income                                                             |       | $                                         | 2,000      |   | $ | 5,815 |   |
| Common ownership                                                                 |       | 100                                       | %          | 65 | % |
| Common stockholders  interest in undistributed income                            |       | $                                         | 2,000      |   | $ | 3,780 |   |
| Weighted average common  shares outstanding - Basic                              |       | 16,616                                    |       | 6,726 |   |
| Total basic earnings per  share - Common                                         |       | $                                         | 0.12       |   | $ | 0.56 |   |
|                                                                             |       |                                      |       |   |   |
| **Diluted Earnings per Share (If-converted Method)**                             | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net income available to  common stockholders                                     |       | $                                         | 2,000      |   | $ | 5,815 |   |
| Less: Series A  Cumulative Redeemable Convertible Preferred Stock decretion |       | —                                    |       | 4,774 |   |
| Net income used in diluted  earnings per share                                   |       | $                                         | 2,000      |   | $ | 1,041 |   |
| Weighted average common  shares outstanding - Basic                              |       | 16,616                                    |       | 6,726 |   |
| Convertible preferred  stock                                                     |       | —                                    |       | 3,627 |   |
| Common share equivalents                                                         |       | 652                                       |       | 2,532 |   |
| Shares used to compute  earnings per common share - Diluted                      |       | 17,268                                    |       | 12,885 |   |
| Total diluted earnings per  share                                                |       | $                                         | 0.12       |   | $ | 0.08 |   |

 

 

15

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**VIRTUAL RADIOLOGICCORPORATION**

** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS – (CONTINUED)**

**FOR THE THREE MONTHS ENDEDMARCH 31, 2008 AND 2007**

 

***9. Subsequent Events***

 

**               **On April 14, 2008, the Company entered into a Membership InterestPurchase Agreement with Diagna Radiology, LLC, or Diagna, and Diagna’s owners,pursuant to which the Company purchased all of the membership interests ofDiagna.  Diagna’s owners received fromthe Company aggregate consideration of $6 million in cash paid at the closing,and will receive additional cash consideration of $2.2 million to be paid as anearnout within 45 days of the end of each of the first two yearly anniversariesof the closing. The earnout payments are to be calculated based upon revenuesgenerated by Diagna customers during those two periods, and are subject tocertain minimum gross profit requirements. Of the $6 million cash payment at the closing, $5.25 million was paid toor for the account of the sellers at closing, $600,000 was deposited in anescrow account as a source of funds to satisfy the sellers’ indemnificationobligations under the Membership Interest Purchase Agreement, and $150,000 wasdeposited into an escrow account to serve as a source of funds to satisfy apotential post-closing change of control payment to a radiologist affiliatedwith Diagna.

 

                Diagnais a teleradiology provider who offers 24-hour a day emergent and non-emergentservices. Diagna offers subspecialty expertise in neuroradiology,musculoskeletal and nuclear medicine. Diagna has 44 customers located in 17states and a total of seven radiologists providing services.

 

 

16

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**ITEM 2.****                            ****Management’s Discussionand Analysis 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.

 

Factorsthat could cause our actual results to differ materially from those expressedor implied in such forward-looking statements include, but are not limited tothe following:

 

·                  the competition in theteleradiology market, including the possibility of pricing pressure resultingfrom that competition;

 

·                  our ability to effectivelymanage our growth and development;

 

·                  the outcome of theintellectual property claim against us by Merge eMed, Inc., and any otherfuture intellectual property claims;

 

·                  our ability to recruit andretain qualified radiologists;

 

·                  the loss of key members ofmanagement and personnel;

 

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

 

·                  the regulation of thecorporate practice of medicine;

 

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

 

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

 

·                  new technologies;

 

·                  the breach of our securitymeasures that safeguard patient and customer data;

 

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

 

·                  our ability to comply withgovernment regulations; and

 

·                  other risk factors listedfrom time to time in our reports filed with the SEC, including withoutlimitation, the section entitled “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

Giventhese uncertainties, you should not place undue reliance on theseforward-looking statements.

 

Inthis report, 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 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.

 

 

17

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**Overview**

 

We provide radiologic interpretations, or reads, viateleradiology for emergency and routine care coverage.  We believe we are the second largest providerof teleradiology services in the United States. We serve our customers—radiologypractices, hospitals, clinics and diagnostic imaging centers—by providing reads24 hours a day, 365 days a year. Our unique distributed operatingmodel provides our qualified team of American Board of Radiology-certifiedradiologists with the flexibility to choose the location from which they work,primarily within the United States, and allows us to serve customers locatedthroughout the country. Our services include both preliminary reads, which areperformed for emergent care purposes, and final reads, which are performed forboth emergent and non-emergent care. We provide these services through arobust, highly scalable communications network incorporating encryptedbroadband internet connections and proprietary workflow management software.

 

We have continued to focus our growth initiatives onthe core teleradiology business through the expansion of our unique distributedoperating model and enhancements to our proprietary workflow managementsoftware through the first 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.

 

We contracted with 22 net new customers during thethree months ended March 31, 2008, which resulted in an additional 34hospitals and other medical facilities to whom we provide service. This 19%year-over-year growth in customers brought the total number of customers thatwe serve to 491 as of March 31, 2008. In addition, we ended the quarterproviding service to 838 medical facilities including 784 hospitals, whichrepresents approximately 13% of all hospitals in the United States and a 14%year-over-year growth in the number of facilities that we serve.

 

During the three months ended March 31, 2008, weadded 6 radiologists under contract and 4 radiologists providing serviceresulting in 138 radiologists under contract and 116 radiologists providingservice as of March 31, 2008. We believe that the benefits of ourdistributed operating model, such as flexible choice of location, predictableschedules and competitive compensation, have allowed us to successfully recruitand retain radiologists. We have experienced radiologist retention rates(excluding those radiologists we have elected to terminate for non-compliancewith the terms of their contracts) of 94% and 97% for the three months ended March 31,2008 and 2007, respectively.

 

In addition to our customer and radiologist growth,our read volume grew by 34% to 470,694 total reads during the three monthsended March 31, 2008, compared to approximately 352,149 total reads duringthe three months ended March 31, 2007. The increase in read volumes wasdue primarily to 15% same-site volume growth. Approximately 23% of our revenuefrom reads for the three months ended March 31, 2008 was derived fromfinal reads and the remaining 77% was derived from preliminary reads.

 

Subsequent to the three months ended March 31,2008, we acquired Diagna Radiology, LLC, or Diagna, located in Post Falls,Idaho on April 14, 2008 for $6 million in up-front cash and an additional$2.2 million in potential earn-out payments to be made over the next two years.Diagna is a teleradiology provider who offers 24-hour a day emergent and non-emergentservices. Diagna offers subspecialty expertise in neuroradiology,musculoskeletal and nuclear medicine. Diagna has 44 customers located in 17states and a total of seven radiologists providing services.  We expect the acquisition to contributebetween $3.0 million and $3.5 million in annual revenue during 2008, and tocontribute between $4.0 million and $4.5 million in annual revenue during 2009.

 

Leonard Purkis was also appointed the Company’s ChiefFinancial Officer effective April 14, 2008. Mr. Purkis previouslyserved as Chief Financial Officer of E*Trade Financial Corporation from 1998through 2003, and Chief Financial Officer of Iomega Corp. from 1993 through1998. Before joining Iomega, Purkis spent 12 years in senior management roleswith General Electric’s Capital, Lighting and Plastics businesses in both theUnited States and Europe. Mr. Purkis is a Fellow Member of the Instituteof Chartered Accountants in England and Wales.

 

The following discussion pertains to our financialposition as of March 31, 2008 and December 31, 2007, and our resultsof operations for the three months ended March 31, 2008 and 2007. Resultsof the periods are not necessarily indicative of the results to be expected forthe complete year.

 

 

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**Basisof Presentation**

 

We consolidate our financial results under theprinciples of Financial Accounting Standards 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 March 31, 2008, VRC funded losses of certainAffiliated Medical Practices totaling $7.4 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 losses previouslyrecognized by us with respect to that Affiliated Medical Practice. Earnings ofeach Affiliated Medical Practice in excess of losses previously recognized byus with respect to that Affiliated Medical Practice are excluded from ourearnings and are attributed to the respective equity owners of that AffiliatedMedical Practice by recording such earnings as non-controlling interest in ourconsolidated financial statements. For the three months ended March 31,2008 certain of our Affiliated Medical Practices experienced net income thatresulted in a non-controlling interest expense of approximately $4,000.

 

VRL was formed on November 23, 2007 and islocated in London, England. VRL is a wholly owned and consolidated subsidiaryof VRC and was established to facilitate the possible international expansionof our business to provide teleradiology services and products to customerslocated outside of the United States. Currently, VRL has one employee and animmaterial amount of operating assets and liabilities. VRL’s functionalcurrency is the British Pound.

 

**CriticalAccounting Policies**

 

The discussion and analysis of our financial conditionand results of operations are based on our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America, or GAAP. The preparation of thesefinancial statements in accordance with GAAP requires us to utilize accountingpolicies and make certain estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingencies as of thedate of the financial statements and the reported amounts of revenue andexpenses during a fiscal period. The SEC considers an accounting policy to becritical if it is important to a company’s financial condition and results ofoperations, and if it requires the exercise of significant judgment and the useof estimates on the part of management in its application. We believe thefollowing to be our critical accounting policies because they are important tothe presentation of our financial condition and results of operations, andrequire critical management judgment and estimates about matters that areuncertain:

 

·                  principles of consolidation;

 

·                  revenue recognition and allowance for doubtfulaccounts;

 

·                  accounting for stock-based compensation; and

 

·                  income taxes.

 

If actual results or events differ materially fromthose contemplated by us in making these estimates, our reported financialcondition and results of operations for future periods could be materiallyaffected.

 

 

19

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***Principles ofConsolidation***

 

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 and statements of operations as of March 31,2008 and December 31, 2007, and for the three months ended March 31,2008.

 

Asdescribed above, we consolidate our financial results in accordance with FIN46R, which requires a primary beneficiary to consolidate entities determined tobe VIEs.  We have determined that VRC isthe primary beneficiary of the Affiliated Medical Practices, as defined by FIN46R, and as a result is required to consolidate the Affiliated MedicalPractices.

 

Thefollowing tables show the unaudited condensed consolidating balance sheets asof March 31, 2008 and December 31, 2007, and the unaudited condensedconsolidating statements of operations for the three months ended March 31,2008 and 2007.  The amounts reflected inthe eliminations columns of the condensed consolidating financial statementsrepresent affiliated party management and professional fees and non-controllinginterest.  The following tables should beread together with our consolidated financial statements and related footnotesincluded elsewhere in this report.

 

 

20

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**Condensed Consolidating Balance Sheets**

**(unaudited)**

 
| ** **                                      | ** ** | **As of March 31, 2008**     | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                      | ** ** | ** **                        | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                        | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **VRC**                           | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                | ** ** |
| Cash and cash equivalents                       |       | $                                 | 22,081     |   | $ | 11,415 |   | $ | — |   | $ | 33,496 |   |
| Other current assets                            |       | 42,342                            |       | 51,738 |   | (76,751 | ) | 17,329 |   |
| Non-current assets                              |       | 12,223                            |       | 19 |   | (19 | ) | 12,223 |   |
| Total assets                                    |       | $                                 | 76,646     |   | $ | 63,172 |   | $ | (76,770 | ) | $ | 63,048 |   |
|                                            |       |                              |       |   |   |   |   |   |   |
| Current liabilities                             |       | $                                 | 14,832     |   | $ | 70,548 |   | $ | (76,751 | ) | $ | 8,629 |   |
| Other non-current  liabilities                  |       | 875                               |       | — |   | (19 | ) | 856 |   |
| Total liabilities                               |       | 15,707                            |       | 70,548 |   | (76,770 | ) | 9,485 |   |
| Non-controlling interest                        |       | —                            |       | — |   | 12 |   | 12 |   |
| Total stockholders’ equity  (deficiency)   |       | 60,939                            |       | (7,376 | ) | (12 | ) | 53,551 |   |
| Total liabilities and stockholders’ equity |       | $                                 | 76,646     |   | $ | 63,172 |   | $ | (76,770 | ) | $ | 63,048 |   |
|                                            |       |                              |       |   |   |   |   |   |   |
|                                            |       |                              |       |   |   |   |   |   |   |
|                                            | ** ** | **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 March 31, 2008**  | ** ** |
|--------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                   | ** ** | ** **                                  | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | ** **                                  | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **VRC**                                     | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **(in thousands)**                          | ** ** |
| Revenue                                                      |       | $                                           | 18,189     |   | $ | 20,495 |   | $ | (15,364 | ) | $ | 23,320 |   |
| Operating costs and  expenses                                |       | 14,551                                      |       | 20,770 |   | (15,364 | ) | 19,957 |   |
| Operating income (loss)                                      |       | 3,638                                       |       | (275 | ) | — |   | 3,363 |   |
| Other income                                                 |       | 176                                         |       | — |   | — |   | 176 |   |
| Income (loss) before non-controlling interest and income tax |       | 3,814                                       |       | (275 | ) | — |   | 3,539 |   |
| Non-controlling interest  expense                            |       | —                                      |       | — |   | 4 |   | 4 |   |
| Income tax expense                                           |       | 1,533                                       |       | 2 |   | — |   | 1,535 |   |
| Net income (loss)                                            |       | $                                           | 2,281      |   | $ | (277 | ) | $ | (4 | ) | $ | 2,000 |   |
|                                                         |       |                                        |       |   |   |   |   |   |   |
|                                                         |       |                                        |       |   |   |   |   |   |   |
| ** **                                                   | ** ** | **Three  months ended March 31, 2007** | ** ** |
| ** **                                                   | ** ** | ** **                                  | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | ** **                                  | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | **VRC**                                     | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                   | ** ** | **(in  thousands)**                         | ** ** |
| Revenue                                                      |       | $                                           | 13,782     |   | $ | 19,192 |   | $ | (14,872 | ) | $ | 18,102 |   |
| Operating costs and  expenses                                |       | 12,848                                      |       | 18,050 |   | (14,872 | ) | 16,026 |   |
| Operating income                                             |       | 934                                         |       | 1,142 |   | — |   | 2,076 |   |
| Other income                                                 |       | 37                                          |       | — |   | — |   | 37 |   |
| Income before non-controlling interest and income tax        |       | 971                                         |       | 1,142 |   | — |   | 2,113 |   |
| Non-controlling interest  expense                            |       | —                                      |       | — |   | 680 |   | 680 |   |
| Income tax expense                                           |       | 392                                         |       | — |   | — |   | 392 |   |
| Net income                                                   |       | $                                           | 579        |   | $ | 1,142 |   | $ | (680 | ) | $ | 1,041 |   |

 

***Revenue Recognitionand Allowance for Doubtful Accounts***

 

We sell our services to radiology practices,hospitals, clinics and diagnostic imaging centers, and recognize revenue when aread or service has been completed and we determine that payment for the reador service is reasonably assured. Accounts receivable are recorded at theinvoiced amount and generally do not bear interest.

 

We maintain an allowance for doubtful accounts at alevel that our management estimates to be sufficient to absorb future lossesdue to accounts that are potentially uncollectible. The allowance is based onthe current aging of past due accounts, our historical experience, thefinancial condition of the customer and the general economic conditions of eachcustomer’s market place. Management uses all information available to them inestablishing what we believe is an adequate allowance to absorb future losses.While our historical credit losses have not differed materially from ourestimates, and we do not currently believe any material changes in estimatesare likely in the near future, actual future results could differ materiallyfrom current estimates resulting in an increase or decrease in cash flows fromreceivable collections and/or in the allowance for doubtful accounts and thecorresponding provision for bad debt expense. Any such changes in estimatescould have a material impact on our consolidated balance sheets, statements ofoperations and/or cash flows in subsequent periods. We maintained an allowancefor doubtful accounts of approximately $186,000 and $247,000 as of March 31,2008 and 2007, respectively.

 

 

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We record an allowance for sales credits that ourmanagement estimates to be adequate to cover future sales credits granted whichrelate primarily to maintaining customer satisfaction with our services. Theallowance is based on our historical experience related to sales creditsgranted. Although we have not historically made any material adjustments toprior period estimates, and we do not anticipate any material impact on futureresults of operations or cash flows, actual results could differ materially fromthese estimates resulting in an increase in the allowance for sales credits andthe corresponding provision for sales credits. We maintained an allowance forsales credits of approximately $16,000 and $14,000 as of March 31, 2008and 2007, respectively.

 

***Accounting forStock-Based Compensation***

 

***PhysicianStock-Based Compensation.***  We recordstock-based compensation expense in connection with any equity instrumentawarded to our affiliated radiologists in accordance with Emerging Issues TaskForce Issue No. 96-18, *Accounting forEquity Instruments that are Issued to Other than Employees for Acquiring, or inConjunction with Selling, Goods or Services,* or EITF Issue No. 96-18.We calculate the stock-based compensation expense related to such issuance by determiningthe then current fair value of the award using a Black-Scholes model at thedate of grant and at the end of each subsequent financial reporting periodthereafter. Physician stock-based compensation expense is included inprofessional services expense.

 

***EmployeeStock-Based Compensation.***  We also recordstock-based compensation expense in connection with any award of stock optionsto employees and directors. We calculate the stock-based compensation expenseassociated with such awards to our employees and directors granted prior to January 1,2006, in accordance with Accounting Principles Board No. 25, *Accounting for Stock Issued to Employees*,or APB No. 25, using the intrinsic value method and in accordance withStatement of Financial Accounting Standards No. 123R, *Accounting for Stock Based Compensation*,or SFAS No. 123R, for awards granted on or after January 1, 2006, bydetermining the fair value using a Black-Scholes model. We calculate thestock-based compensation expense related to awards to our employees anddirectors based on the fair value of awards on the date granted. Employeestock-based compensation expense is included in sales, general andadministrative expense.

 

***Determination ofFair Value of Our Stock Options.***  As discussedabove, we record stock-based compensation expense associated with our awards ofstock options in accordance with SFAS No. 123R and EITF Issue No. 96-18,as applicable, which require us to calculate the expense associated with suchawards by determining their fair value. To determine the fair value, we use aBlack-Scholes model that takes into account the exercise price of the award,the fair value and volatility of the common stock underlying the award, therisk-free interest rate and the contractual life of the award as determined atthe date of grant.

 

Prior to our shares trading on the NASDAQ GlobalMarket, which commenced on November 15, 2007, our Board of Directorsconsidered a number of relevant factors, including arm’s length equitytransactions, current developments in the business, our financial prospects,the market performance of our primary competitor and our Board’s independentjudgment to establish the exercise price of our stock options at various grantdates. Subsequent to November 14, 2007, we use the closing price of ourcommon stock on the NASDAQ Global Market on the date of grant to determine theexercise price of such options.

 

The following table shows the fair value of one shareof our common stock and the exercise price of one option granted on all of thestock option grant dates during the quarter ended March 31, 2008. Therewere no options granted during the quarter ended March 31, 2007.

 
| **Grant Date**         | ** ** | **Fair Value of One  Share of  Common Stock** | ** ** | **Exercise Price  of One Option  Granted** | ** ** |
|------------------------|------------|-----------------------------------------------|------------|--------------------------------------------|------------|
| 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                                      |       |
|                        |            |                                               |            |                                            |            |  |  |

 

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***Income Taxes***

 

VRC recognizes income taxes under the asset andliability method. As such, deferred taxes are based on the temporarydifferences, if any, between the financial statement and tax bases of assetsand liabilities that will result in future taxable or deductible amounts. Thedeferred taxes are determined using the enacted tax rates that are expected toapply when the temporary differences reverse. Income tax expense is the taxpayable for the period plus the change during the period in deferred incometaxes. Valuation allowances are established when necessary to reduce deferredtax assets to the amount expected to be realized.

 

Developing a provision for income taxes, including theeffective tax rate and the analysis of potential tax exposure items, if any,requires significant judgment and expertise in federal, state and foreignincome tax laws, regulations and strategies, including the determination ofdeferred tax assets. Our judgment and tax strategies are subject to audit byvarious taxing authorities. While we believe we have provided adequately forour income tax liabilities in the consolidated financial statements, adversedeterminations by these taxing authorities could have a material adverse effecton our consolidated financial condition, results of operations, and/or cashflows.

 

As previously noted, we consolidate our financialresults under the provisions of FIN 46R. For income tax purposes, however,we are not considered a consolidated entity. As a result, income generated bythe Affiliated Medical Practices, as well as any losses they are able to fund,are excluded from VRC’s calculation of income tax liability. In addition,losses generated by the Affiliated Medical Practices that are funded by VRCresult in temporary differences between VRC’s book and tax bases of accounting.These temporary differences will reverse in future periods to the extent thoselosses are able to be recovered by VRC.

 

**FactorsAffecting Our Results of Operations**

 

***Revenue***

 

We generate substantially all of our revenue from theradiology services that we provide to our customers. We provide these servicespursuant to contracts that typically have a one-year term and automaticallyrenew for successive one-year terms unless terminated by the customer or by us.The amount that we charge for our radiology services varies by customer and isbased upon a number of factors, including the hours of coverage, the number ofreads, whether the reads are preliminary reads or final reads, and thetechnical and administrative services provided. We recognize revenue when aread has been completed and we determine that payment for the read isreasonably assured. We typically bill our customers at the beginning of themonth following the month in which the services were provided. Because wecontract directly with our customers and are paid directly by our customers, wedo not currently depend upon payment by third party payers such as Medicare,Medicaid, private insurance or patients.

 

We have 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, ourrevenue grew from $18.1 million for the three months ended March 31, 2007to $23.3 million for the three months ended March 31, 2008. This growth inrevenue resulted from:

 

·                  an increase in our customer base;

 

·                  an increase in utilization of ourservices by our customers;

 

·                  an expansion of our service hours;

 

·                  an increase in provision of higher-pricedfinal reads; and

 

·                  high customer retention rates.

 

As of March 31, 2008, our affiliated radiologistsprovided services to 491 customers serving 838 medical facilities, whichincludes 784 hospitals representing approximately 13% of hospitals in theUnited States.

 

24

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***Operating Expenses***

 

Our operating expenses consist of professionalservices expense, sales, general and administrative expense and depreciationand amortization.

 

***ProfessionalServices Expense.***  Professional services expenseis our most significant expense as a percentage of revenue. Our professional servicesexpense consists of the fees we pay to our affiliated radiologists for theirservices, physician stock-based compensation and medical liability expense,which consists of medical liability insurance premiums expense.

 

·                  ***PhysicianCash Compensation Expense.***  Physician cashcompensation expense is the result of engaging independent radiologists toprovide reads for our customers. Each of our affiliated radiologists providesand is compensated for reads in accordance with his or her independent physicianagreement. We structure our relationships with our affiliated radiologists suchthat they generally have control over their schedule and the location fromwhich they work. We compensate our affiliated radiologists using a formula thatincludes a base level of compensation and additional amounts with regard to thenumber of hours worked and the number and type of reads performed. We recognizephysician cash compensation expense in the month in which our affiliatedradiologists perform the reads for our customers. Physician cash compensationalso includes amounts paid for quality assurance services.

 

·                  ***PhysicianStock-Based Compensation Expense.***  We recordstock-based compensation expense in connection with any award of stock optionsor other compensatory 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 No. 96-18,by determining the fair value using a Black-Scholes model. EITF Issue No. 96-18requires that the cost of equity instruments issued to these affiliatedradiologists be initially measured at their fair value at the date the equityinstruments were issued and adjusted over the service period, until vested orforfeited, to their then-current fair value in every subsequent reportingperiod. Accordingly, if the value of our common stock increases over a givenperiod, this accounting treatment will generally result in physicianstock-based compensation expense that exceeds the expense we would haverecorded if these individuals were employees.

 

·                  ***MedicalLiability Expense.***  Medical liability expenserelates to the procurement of medical malpractice insurance coverage. Weamortize medical liability insurance premiums over the term of the policy towhich they relate.

 

***Sales, General andAdministrative Expense.***  Sales, generaland administrative expense is our second most significant expense as apercentage of revenue. Sales, general and administrative expense consistsprimarily of employee compensation expense, sales and marketing expense,information technology expense, the costs associated with the licensing andcredentialing of our affiliated radiologists and costs associated withmaintaining our facilities.

 

***Other (Expense) Income***

 

Other (expense) income consists of non-operatingexpenses and income, such as interest expense incurred from our borrowings andfrom equipment financing, and interest income earned on cash balances andinvestments held in demand deposit accounts.

 

***Redeemable Preferred Stock Decretion***

 

On May 2, 2005, we issued shares of our Series ACumulative Redeemable Convertible Preferred Stock, or Series A PreferredStock, which were redeemable on or after March 31, 2010, at the greater ofthe Redemption Price, as defined in our certificate of incorporation that wasin effect prior to the closing of our initial public offering, or the fairvalue of the Series A Preferred Stock. As a result, we adjusted the valueof the Series A Preferred Stock to its fair value at each reporting date.Upon the closing of our initial public offering in November 2007, alloutstanding shares of our Series A Preferred Stock were automaticallyconverted into shares of our common 

 

25

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stock and the rights of the holders of Series A Preferred Stock toexercise redemption rights terminated. As a result, there will be no furtherrecognition of accretion or decretion related to our Series A PreferredStock.

 

**Trendsin Our Business and Results of Operations**

 

***Revenue***

 

Our business has grown rapidly since inception. Thisgrowth has been driven by an increase in the demand for our services and a correspondingincrease in our customer base. We have also experienced an increase in theutilization of our services by our existing customers, through expansion of ourservice hours, the provision of final reads, a high customer retention rate andthe growth in the use of diagnostic imaging technologies and procedures in thehealthcare market. Our revenue growth has resulted primarily from increasedvolumes across a growing customer base and favorable read mix. We expect thatour customers will continue to contract with us for additional services,including the performance of final reads, as well as to contract for additionalhours of service coverage.

 

The total number of reads we performed has continuedto grow on a quarter-by-quarter basis for the past eight quarters as follows:

 
| ** **                                | ** ** | **Three  Months Ended** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **March 31,**      | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
| ** **                                | ** ** | **2008**                | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2006** | ** ** | **2006** | ** ** | **2006** | ** ** |
| Total reads                               |       | 470,694                 |       | 453,280 |   | 473,263 |   | 413,167 |   | 352,149 |   | 309,151 |   | 302,497 |   | 237,271 |   |
| Percentage growth over prior year quarter |       | 33.7                    | %          | 46.6 | % | 56.5 | % | 74.1 | % | 90.8 | % | 99.8 | % | 105.9 | % | 107.3 | % |

 

Our revenues are affected by seasonality. While ourrevenues have continued to grow each year, we typically experience increaseddemand for our services and higher revenue growth during the later half of theyear. We believe that during that time there are an increased amount of outdoorand transportation activities, which leads to more hospital visits, as well asthere being more frequent vacation time taken by our customers’ radiologists.During the first quarter of each year, when weather conditions are colder for alarge portion of the United States, we have historically experienced lowerrevenue growth than that experienced during the later half of the year. Weexpect this seasonality with respect to our revenues to continue. Our operatingresults may be subject to seasonal fluctuations, which makes our resultsdifficult to predict and could cause our performance to fall short of quarterlyexpectations. We also expect to derive revenue in the future from contracts wehave recently entered into for the licensing of our technology infrastructureand the provision of management and support services.

 

In addition, our revenues are affected by fluctuationsin the price per study charged to the customers to whom we provide service. Wehave historically seen the greatest amount of price volatility in plain filmreads.  We expect recent pricing trendsto continue, however we anticipate there will be continued quarterly variationsand that any negative price trends will be offset by improvements in operatingefficiencies. The table below illustrates the quarter-by-quarter percentagechange in the average revenue per read for lower price plain film reads and allother modalities for the past eight quarters:

 
| ** **                      | ** ** | **Three  Months Ended**  | ** ** |
|---------------------------------|------------|--------------------------|------------|
| ** **                      | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** | **September 30,  2007** | ** ** | **June 30,  2007** | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** | **September 30,  2006** | ** ** | **June 30,  2006** | ** ** |
| Plain film (1)                  |       | (3.1                     | )%         | (1.9 | )% | (2.0 | )% | 1.5 | % | (3.0 | )% | (3.6 | )% | (3.3 | )% | 4.4 | % |
| All other modalities  (2)  |       | (0.9                     | )%         | (1.1 | )% | (0.7 | )% | 0.1 | % | (0.2 | )% | (0.3 | )% | 1.0 | % | 0.4 | % |

----

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

(2)  All other modalities are primarilycomprised of CT, MRI and ultrasound images.

 

***Physician CashCompensation Expense***

 

Since our inception, our physician cash compensationexpense has increased each year as we have added more affiliated radiologiststo fulfill the increased demand for our services as our business and customerbase has grown. However, physician cash compensation expense as a percentage ofrevenue has decreased due to the increased productivity of our affiliatedradiologists. The increases in productivity by the existing affiliatedradiologists have been, and may continue to be, offset, in part, by significantincreases in newly engaged

 

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affiliated radiologists and the costs associated with the typical 90-to 180-day period during which newly engaged affiliated radiologists obtainnecessary state licenses and hospital credentials, and thereafter becomeaccustomed to our workflow technology. We expect that our physician cashcompensation expense will continue to increase, but will decrease as apercentage of revenues as our expanding base of independent radiologistscontinues to grow.

 

***PhysicianStock-Based Compensation Expense***

 

Physician stock-based compensation expense is anon-cash expense that fluctuates based upon the fair value of our common stockunderlying the awards at the close of each reporting period as required by EITFIssue No. 96-18. As the value of an award is based on the underlying valueof the common stock, we may record additional expense or income based onfluctuations in that value. Our physician stock-based compensation expense mayincrease in future periods if we issue additional options and other stock-basedawards to our affiliated radiologists and/or if the value of our common stockincreases. However, the amount of expense, or income for any periodattributable to physician stock-based compensation fluctuates and is difficultto predict.

 

***Medical LiabilityExpense***

 

Our medical liability expense has increased each yearsince inception due to the increases in our medical liability insurancepremiums primarily associated with the increased volume of reads our affiliatedradiologists performed.

 

***Sales, General andAdministrative Expense***

 

Our sales, general and administrative expense hasincreased each year since our inception as a result of increased employeecompensation expenses in connection with the management, operations,development and maintenance of our expanding business. In addition to increasedemployee compensation expense, our sales, general and administrative expenseshave increased due to increases in expenses relating to information technology,facilities, licensing and credentialing, sales and marketing and other generaland administrative expense. We expect sales, general and administrative expenseto continue to increase in future periods as a result of expenses associatedwith the performance of management and support services we have recently begunto provide to some of our customers and as a result of expenses related tobeing a public company, including legal and accounting fees and costs incurredin complying with the Sarbanes-Oxley Act of 2002. We believe that theseexpenses will increase as we continue to grow, but will decrease as apercentage of revenue.

 

**Resultsof Operations**

 

The following table sets forth selected consolidatedstatements of operations data for each of the periods indicated as a percentageof revenue.

 

| ** **                                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                              | ** ** | **2007** | ** ** |
| Revenue                                                                    |       | 100.0                                 | %          | 100.0 | % |
| Operating costs and  expenses:                                             |       |                                  |       |   |   |
| Professional services                                                      |       | 44.5                                  |       | 47.5 |   |
| Physician cash compensation                                                |       | 44.8                                  |       | 46.0 |   |
| Physician stock-based compensation                                         |       | (2.1                                  | )          | (0.6 | ) |
| Medical liability expenses                                                 |       | 1.8                                   |       | 2.1 |   |
| Sales, general and  administrative                                         |       | 37.4                                  |       | 38.3 |   |
| Depreciation and  amortization                                             |       | 3.7                                   |       | 2.7 |   |
| Total operating costs and  expenses                                        |       | 85.6                                  |       | 88.5 |   |
| Operating income                                                           |       | 14.4                                  |       | 11.5 |   |
| Interest income, net                                                       |       | 0.8                                   |       | 0.2 |   |
| Non-controlling interest  expense (1)                                      |       | —                                |       | 3.8 |   |
| Income tax expense                                                         |       | (6.6                                  | )          | (2.2 | ) |
| Net income                                                                 |       | 8.6                                   |       | 5.7 |   |
| Series A Cumulative  Redeemable Convertible Preferred Stock decretion |       | —                                |       | 26.4 |   |
| Net income available to  common stockholders                               |       | 8.6                                   | %          | 32.1 | % |

----

(1) Non-controlling interest for thethree months ended March 31, 2008 represents less than 0.1% as apercentage of revenue.

 

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**Comparisonof the Three Months Ended March 31, 2008 and March 31, 2007**

 

***Revenue***

 
| ** **         | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **     | ** ** |
|--------------------|------------|----------------------------|------------|------------|------------|----------------|------------|
| ** **         | ** ** | **March 31,**         | ** ** | **Change** | ** ** |
| ** **         | ** ** | **2008**                   | ** ** | **2007**   | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **         | ** ** | **(dollars in thousands)** | ** ** |
| Revenue from reads |       | $                          | 22,929     |       | $          | 17,775         |       | $ | 5,154 |   | 29.0 | % |
| Other revenue      |       | 391                        |       | 327        |       | 64             |       | 19.6 |   |
| Total revenue      |       | $                          | 23,320     |       | $          | 18,102         |       | $ | 5,218 |   | 28.8 |   |

 

The 28.8% increase in revenue for the three monthsended March 31, 2008, as compared to the three months ended March 31,2007, resulted primarily from an increase in the number of customers to whom weprovided services and increased volume from existing customers, which waspartially offset by a 3.7% decline in our average price per read. For the threemonths ended March 31, 2008 and 2007, approximately 77% of our revenuefrom reads was derived from preliminary reads and approximately 23% from finalreads. The number of customers to whom we provided services increased to 491 asof March 31, 2008, from 411 as of March 31, 2007. The number of medicalfacilities to whom we provide services increased to 838 as of March 31,2008, from 736 as of March 31, 2007. Same site volume growth increasedapproximately 15% for the three months ended March 31, 2008, as comparedto the three months ended March 31, 2007. Same site volume growth measuresthe percentage increase in the number of reads over the comparable prior yearperiod generated by a facility that has been under contract for at least threemonths at the beginning of the measurement period and remains a customerthroughout that period.

 

***Operating Costs and Expenses***

 

***ProfessionalServices***

 
| ** **                                | ** ** | **Three Months Ended** | ** ** | ** **      | ** ** | **Three Months Ended** | ** ** | ** **      | ** ** | ** **      | ** ** | ** **     | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|-----------------|------------|----------------------------------|------------|-----------------|------------|-----------------|------------|----------------|------------|
| ** **                                | ** ** | **March 31,**               | ** ** | **Percentage**  | ** ** | **March 31,**               | ** ** | **Percentage**  | ** ** | **Change**      | ** ** |
| ** **                                | ** ** | **2008**                         | ** ** | **of  Revenue** | ** ** | **2007**                         | ** ** | **of  Revenue** | ** ** | **In  Dollars** | ** ** | **Percentage** | ** ** |
| ** **                                | ** ** | **(dollars in thousands)**       | ** ** |
| Physician cash compensation expense       |       | $                                | 10,452     |            | 44.8       | %                                | $          | 8,329           |       | 46.0            | %          | $              | 2,123      |   | 25.5 | % |
| Physician stock-based compensation income |       | (495                             | )          | (2.1            | )          | (105                             | )          | (0.6            | )          | (390            | )          | 371.4          |       |
| Medical liability expense                 |       | 410                              |       | 1.8             |       | 375                              |       | 2.1             |       | 35              |       | 9.3            |       |
| Professional services                     |       | $                                | 10,367     |            | 44.5       |                             | $          | 8,599           |       | 47.5            |       | $              | 1,768      |   | 20.6 |   |

 

The 20.6% increase in professional services expensefor the three months ended March 31, 2008, compared to the three monthsended March 31, 2007, resulted from increases in physician cashcompensation expense associated with our increased number of affiliatedradiologists and a significant increase in the number of reads performed byradiologists together with additional medical liability insurance premiums. Theincrease in income from non-cash physician stock-based compensation relatedprimarily to the decreased fair value of our common stock during the firstquarter of 2008. For the three months ended March 31, 2008, the number ofphysicians performing reads increased 54.7%, from 75 for the three months endedMarch 31, 2007 to 116 for the three months ended March 31, 2008. Thedecrease in physician cash compensation expense as a percentage of revenue from46.0% for the three months ended March 31, 2007 to 44.8% for the threemonths ended March 31, 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.

 

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***Sales, General andAdministrative***

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | ** **     | ** ** | **Three Months Ended** | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
|-----------------------------------|------------|----------------------------------|------------|----------------|------------|----------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                        | ** ** | **March 31,**               | ** ** | **Percentage** | ** ** | **March 31,**               | ** ** | **Percentage** | ** ** | **Change**     | ** ** |
| ** **                        | ** ** | **2008**                         | ** ** | **of Revenue** | ** ** | **2007**                         | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                        | ** ** | **(dollars in thousands)**       | ** ** |
| Sales, general and administrative |       | $                                | 8,735      |           | 37.4       | %                                | $          | 6,929          |       | 38.3           | %          | $              | 1,806      |   | 26.1 | % |
|                                   |            |                                  |            |                |            |                                  |            |                |            |                |            |                |            |  |  |  |

 

The 26.1% increase in sales, general andadministrative expense for the three months ended March 31, 2008, comparedto the three months ended March 31, 2007, resulted from increased expensesfor employee compensation, sales and marketing, information technology andother general and administrative expense, partially offset by a decrease inlicensing and credentialing costs.

 

·                  ***EmployeeCompensation.***  Our employee compensation expense increasedfrom $4.0 million for the three months ended March 31, 2007 to$4.9 million for the three months ended March 31, 2008. The 22.5% increaseresulted primarily from the hiring of additional administrative and operationspersonnel to manage, operate and maintain our business, and fromperformance-based bonus compensation. As of March 31, 2008, the number ofemployees increased 26.6% from 184 as of March 31, 2007 to 233 as of March 31,2008. Employee compensation expense as a percentage of revenue was 21.0% and22.1% for the three months ended March 31, 2008 and 2007, respectively.

 

·                  ***Salesand Marketing.***  Our sales and marketing expenses increasedfrom $665,000 for the three months ended March 31, 2007 to $831,000 forthe three months ended March 31, 2008. The 25.0% increase resultedprimarily from additional compensation expense related to an increased numberof sales and marketing personnel. As of March 31, 2008, the number ofsales and marketing personnel increased 7.7%, from 26 as of March 31, 2007to 28 as of March 31, 2008. Sales and marketing expenses as a percentageof revenue were 3.5% and 3.7% for the three months ended March 31, 2008and 2007, respectively.

 

·                  ***InformationTechnology.***  Our information technology expense increasedfrom $459,000 for the three months ended March 31, 2007 to $541,000 forthe three months ended March 31, 2008. The 17.9% 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 2.3% and 2.5% forthe three months ended March 31, 2008 and 2007, respectively.

 

·                  ***Licensingand Credentialing.***  Our licensing and credentialingrelated expenses decreased from $459,000 for the three months ended March 31,2007 to $375,000 for the three months ended March 31, 2008. The 18.3%decrease relates primarily to the amount and timing of initial and renewallicense applications for our affiliated radiologists, and was aided by thecomparatively lower costs of renewal applications. Licensing and credentialingrelated expenses as a percentage of revenue were 1.6% and 2.5% for the threemonths ended March 31, 2008 and 2007, respectively.

 

·                  ***OtherGeneral and Administrative.***  Our othergeneral and administrative expenses increased from $1.3 million for thethree months ended March 31, 2007 to $2.1 million for the threemonths ended March 31, 2008. The 61.5% increase resulted from increases inoutside accounting and legal expenses primarily related to the costs of being apublic company, as well as from increases in hiring expenses, corporateinsurance expense and facilities related expenses resulting from the growth inour business. Other general and administrative expenses as a percentage ofrevenue were 9.0% and 7.5% for the three months ended March 31, 2008 and2007, respectively.

 

We believe that sales, general and administrativeexpenses, including the costs related to being a public company, will increaseas we continue to grow, but will decrease as a percentage of revenue.

 

***Depreciation andAmortization Expense.***  Depreciation and amortizationexpense increased from $498,000 for the three months ended March 31, 2007to $855,000 for the three months ended March 31, 2008. This 71.7% increasewas primarily due to the increase in depreciation expense related to additionalcapital equipment purchased for our operations. We believe that depreciationand amortization expense will increase in 

 

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the future. Depreciation and amortization expense as a percentage ofrevenue was 3.7% and 2.7% for the three months ended March 31, 2008 and2007, respectively.

 

***Interest Income,Net.***  Interest income, net, increased from incomeof $37,000 for the three months ended March 31, 2007 to income of $176,000for the three months ended March 31, 2008. This increase in interestincome relates primarily to the interest earned on our proceeds from theinitial public offering.

 

***Non-ControllingInterest Expense.***  Through consolidation, werecognize all net losses of the Affiliated Medical Practices in excess of theequity of the Affiliated Medical Practices. During the three months ended March 31,2007, one of the Affiliated Medical Practices experienced net income andanother experienced a net loss that decreased its positive equity position,this created a positive equity position for the Affiliated Medical Practicesand, as a result we recognized non-controlling interest expense of $680,000.During the three months ended March 31, 2008, one of the same AffiliatedMedical Practices experienced net income that increased its positive equity position.As a result, for the three months ended March 31, 2008, we recognizednon-controlling interest expense of $4,000.

 

***Income Tax Expense.*** Income tax expense increased from $392,000 for the three months ended March 31,2007 to $1.5 million for the three months ended March 31, 2008, whichresulted primarily from an increase in pre-tax net income for VRC ofapproximately $971,000 for the three months ended March 31, 2007 toapproximately $3.8 million for the three months ended March 31, 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 March 31, 2008 compared to the three monthsended March 31, 2007. There were no operating loss carry-forwards to beutilized for the year ended December 31, 2007. The totality of thesefactors resulted in an effective tax rate of 43.4% for the three months ended March 31,2008 compared to a rate of 27.4% for the three months ended March 31,2007.

 

***Preferred StockDecretion.***  Preferred stock decretion decreased from$4.8 million for the three months ended March 31, 2007 to zero forthe three months ended March 31, 2008. This decretion relates to our Series APreferred Stock, which was issued on May 2, 2005, and is calculated basedon 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 March 31, 2008.

 

**Liquidityand Capital Resources**

 

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

 

Our financial position included cash and cashequivalents of $33.5 million and $5.9 million at March 31, 2008and 2007, respectively. We have historically funded our operations from cashflows generated by our operating activities, by proceeds generated from thesale of our Series A Preferred Stock and common stock, and to a lesserextent from borrowings under our previous revolving credit facilities.

 

The reported changes in cash and cash equivalents forthe three months ended March 31, 2008 and 2007 are summarized below:

 
| ** **                                           | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                           | ** ** | **2008**                              | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                    | ** ** |
| Net cash provided by  operating activities           |       | $                                     | 3,416      |   | $ | 1,427 |   |
| Net cash used in investing  activities               |       | (4,608                                | )          | (1,090 | ) |
| Net cash provided by (used  in) financing activities |       | 1,201                                 |       | (346 | ) |
| Increase (decrease) in  cash and cash equivalents    |       | $                                     | 9          |   | $ | (9 | ) |

 

30

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***Cash Flows from Operating Activities***

 

For the three monthsended March 31, 2008, we generated $3.4 million of net cash fromoperating activities from net income of $2.0 million. Our net cashfrom operations during this period included cash inflows of $783,000 as aresult of a decrease in current taxes receivable, $488,000 as a result of adecrease in prepaid expenses related to the amortization of prepaid medicalexpenses and $244,000 as a result of an increase in accrued expenses relatedprimarily to an increase in accrued professional services expense.  These inflows were partially offset by cashoutflows of $665,000 related to an increase in accounts receivable resultingprimarily from the growth in our business. In addition, we had non-cash chargesof $855,000 for depreciation and amortization and ($213,000) for stock-basedcompensation.

 

For the three months ended March 31, 2007, wegenerated $1.4 million of net cash from operating activities from netincome of $1.0 million. Our net cash from operations during this periodincluded an increase in our receivables of $1.2 million, which resultedprimarily from the growth in our business. In addition, the net cash fromoperating activities included a decrease in current taxes payable of $538,000as a result of tax payments made during the first quarter of 2007, an increasein accrued expenses of $572,000 resulting primarily from an increase inprofessional services compensation and a decrease in prepaid assets of $415,000resulting primarily from the amortization of our prepaid medical malpracticeinsurance. In addition, we had non-cash charges of $498,000 for depreciationand amortization and ($78,000) for stock-based compensation.

 

***Cash Flows from Investing Activities***

 

Net cash used in investing activities was$4.6 million for the three months ended March 31, 2008, which wascomprised primarily of capital expenditures associated with purchases ofequipment and continued investment in our information technologyinfrastructure.

 

Net cash used in investing activities was$1.1 million for the three months ended March 31, 2007, which wascomprised primarily of capital expenditures associated with purchases ofequipment and continued investment in our information technologyinfrastructure.

 

***Cash Flows from Financing Activities***

 

Net cash provided by financing activities was$1.2 million for the three months ended March 31, 2008. Our net cashprovided by financing activities included retained cash of $1.4 million as aresult of tax benefits generated by the disqualified disposition of stockoptions during the period, $111,000 of net proceeds from the issuance of commonstock relating to the exercise of stock options and $291,000 for payments ofcosts related to our initial public offering.

 

Net cash used in financing activities was $346,000 forthe three months ended March 31, 2007. The activities included paymentsrelated to the costs associated with our initial public offering of $328,000and payments on capital leases of $18,000.

 

***Future Liquidity Requirements***

 

We believe that our cash balances, including theproceeds from our recent initial public offering, and the expected cash flowfrom operations, will be sufficient to fund our operating activities, workingcapital and capital expenditure requirements for the foreseeable future. Weexpect our long-term liquidity needs to consist primarily of working capitaland capital expenditure requirements. We intend to fund these long-termliquidity needs from cash generated from operations along with cash generatedby potential future financing transactions. However, our ability to generatecash is subject to our performance, general economic conditions, industrytrends and other factors. Many of these factors are beyond our control andcannot be anticipated at this time. To the extent that existing cash andsecurities and cash from operations are insufficient to fund our futureactivities, we may need to raise additional funds through public or privateequity or debt financing. If additional funds are obtained by issuing equitysecurities, substantial dilution to existing stockholders may result.

 

On April 14, 2008 we entered into an agreement topurchase Diagna Radiology, LLC, an Idaho-based teleradiology provider for $6.0million in up front cash and an additional $2.2 million in potential earn-outpayments to be made over two years. We used cash proceeds from our initialpublic offering to finance this purchase. We are not otherwise a party to anyother agreement or binding letters of intent with respect to potential 

 

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investments in, or acquisitions of, complementary businesses, servicesor technologies, although we may enter into these types of arrangements in thefuture, which could also require us to seek additional debt or equityfinancing. Additional funds may not be available on terms favorable to us or atall.

 

**ContractualObligations and Commitments**

 

On January 22, 2008, we entered into two newlicense agreements for the provision of network related services that allow usto utilize approximately 1,000 square feet of space in a building inMinnetonka, Minnesota, which will house our data centers. The licenseagreements commence on February 15, 2008 and June 1, 2008 and have 36month 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 March 31,2008, 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 $705,000 and the currentportion of this obligation is $220,000. This obligation will become dueimmediately if we prematurely terminate either of the license agreements.

 

We did not have any current or future capital leasecommitments as of March 31, 2008.

 

**RecentAccounting Pronouncements**

 

In September 2006, the FASB issued Statement ofFinancial Accounting Standards, or SFAS, No. 157, *Fair Value Measurements,* or SFAS No. 157.This standard clarifies 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 us beginningin the first quarter of fiscal year 2009. The portion not deferred was adoptedwith no impact as we do not hold any financial assets or financial liabilitiesthat are covered by this pronouncement.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Financial Liabilities,* or SFAS No. 159. This standardprovides companies with an option to report selected financial assets andliabilities at fair value and establishes presentation and disclosurerequirements designed to facilitate comparisons between companies that choosedifferent measurement attributes for similar types of assets and liabilities.SFAS No. 159 was effective in the first quarter of 2008. We have notelected the fair value option for eligible items that existed as of January 1,2008.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), *Business Combinations,*or SFAS No. 141R. SFAS No. 141R establishes principles and requirementsfor how an acquirer recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, any noncontrollinginterests in the acquiree and the goodwill acquired. Some of the key changesunder SFAS No. 141R will change the accounting treatment for certain specificacquisition related items including: (1) accounting for acquired in processresearch and development as an indefinite-lived intangible asset until approvedor discontinued rather than as an immediate expense; (2) expensing acquisitioncosts 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) recording at the date of an acquisition the fair value of contingentliabilities that are more likely than not to occur. SFAS No. 141R also includesa substantial number of new disclosure requirements. SFAS No. 141R appliesprospectively to business combinations for which the acquisition date is on orafter the beginning 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. We are currently evaluating the impact of thisstatement.

 

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in ConsolidatedFinancial Statements*, *anamendment of ARB 51*, or SFAS No. 160, which changes theaccounting and reporting for minority interests. Minority interests will berecharacterized as noncontrolling interests and will be reported as a componentof equity separate from the parent’s equity, and purchases or sales of equityinterests that do not result in a change in control will be accounted for asequity transactions. In addition, net income attributable to the noncontrollinginterest will be included in consolidated net income on the face of the incomestatement and, upon a loss of control, the interest sold, as well as anyinterest retained, will be recorded at fair value with any gain or lossrecognized in earnings. SFAS No. 160 is effective for fiscal yearsbeginning on or after December 15, 2008. 

 

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The statement shall be applied prospectively as of the beginning of thefiscal year in which it is initially applied, except for the presentation anddisclosure requirement which shall be applied retrospectively for all periodspresented. Early adoption of this statement is prohibited. We are currentlyevaluating the impact of this statement.

 

In March 2008, the FASB issued SFAS No. 161,*Disclosures About Derivative Instruments andHedging Activities, an amendment of SFAS No. 133*, which changesthe disclosure requirements for derivative instruments and hedging activities.Entities will be required to provide enhanced disclosures about (a) howand why an entity uses derivative instruments, (b) how derivativeinstruments 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.  We are currently evaluating the impact ofthis statement.

 

**ITEM 3.****                            ****Quantitative andQualitative Disclosure About Market Risk**

 

***Foreign Currency Exchange Risk***

 

As of March 31, 2008, we did not have significantexposure to foreign currency exchange rates as substantially all of ourtransactions are denominated in U.S. dollars. VRL’s functional currency is theBritish pound; however, as of and for the three months ended March 31,2008, VRL’s operations were immaterial and did not have a material impact onour consolidated results of operations or financial position.

 

***Interest Rate Market Risk***

 

Our cash is invested in bank deposits and demanddeposit accounts denominated in U.S. dollars. The carrying value of our cash,restricted cash, accounts receivable, other current assets, trade accountspayable, accrued expenses and customer deposits approximate fair value becauseof the short period of time to their maturity.

 

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

 

***Evaluation ofDisclosure Controls and Procedures***

 

As of the end of the period covered by this report(the “Evaluation Date”), we carried out an evaluation, under the supervisionand with the participation of management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof 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 and procedureswere effective to ensure that information required to be disclosed in thereports 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, there has beenno change in our internal control over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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**PART II— Other Information**

 

**ITEM 2.****                            ****Unregistered Sales ofEquity Securities and Use of Proceeds**

 

On November 14, 2007, we completed an initialpublic offering of 4,600,000 shares of our common stock. Gross proceeds fromthe offering were $78.2 million, including $68.0 million to the Company and$10.2 million to selling stockholders.

 

On April 14, 2008 we entered into an agreement topurchase Diagna Radiology, LLC, an Idaho-based teleradiology provider for $6.0million in up front cash and an additional $2.2 million in earn-out payments tobe made over two years. We used cash proceeds from our initial public offeringto finance this purchase.

 

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

 

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

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                            |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Amendment No. 2 to  Professional and Management Services Agreement and License, dated as of  January 30, 2008, by and between Virtual Radiologic Professionals, LLC  and Virtual Radiologic Corporation. (Incorporated by reference to  Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed  February 1, 2008) |
| 10.2                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of California, P.A. and Virtual  Radiologic Corporation. (Incorporated by reference to Exhibit 10.2 to  the registrant’s Current Report on Form 8-K filed February 1, 2008)                |
| 10.3                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of Illinois, S.C. and Virtual  Radiologic Corporation. (Incorporated by reference to Exhibit 10.3 to  the registrant’s Current Report on Form 8-K filed February 1, 2008)                  |
| 10.4                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of Michigan, P.C. and Virtual  Radiologic Corporation. (Incorporated by reference to Exhibit 10.4 to  the registrant’s Current Report on Form 8-K filed February 1, 2008)                  |
| 10.5                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of Minnesota, P.A. and Virtual  Radiologic Corporation. (Incorporated by reference to Exhibit 10.5 to  the registrant’s Current Report on Form 8-K filed February 1, 2008)                 |
| 10.6                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of New York, P.A. and Virtual  Radiologic Corporation. (Incorporated by reference to Exhibit 10.6 to  the registrant’s Current Report on Form 8-K filed February 1, 2008)                  |
| 10.7                 |       | Amendment No. 1 to  Management Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals of Texas, P.A. and Virtual Radiologic  Corporation. (Incorporated by reference to Exhibit 10.7 to the  registrant’s Current Report on Form 8-K filed February 1, 2008)                     |
| 10.8                 |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals, LLC and Virtual Radiologic  Professionals of California, P.A. (Incorporated by reference to  Exhibit 10.8 to the registrant’s Current Report on Form 8-K filed  February 1, 2008)       |
| 10.9                 |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals, LLC and Virtual Radiologic  Professionals of Illinois, S.C. (Incorporated by reference to  Exhibit 10.9 to the registrant’s Current Report on Form 8-K filed  February 1, 2008)         |
| 10.10                |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals, LLC and Virtual Radiologic  Professionals of Michigan, P.C. (Incorporated by reference to  Exhibit 10.10 to the registrant’s Current Report on Form 8-K filed  February 1, 2008)        |
| 10.11                |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals, LLC and Virtual Radiologic  Professionals of Minnesota, P.A. (Incorporated by reference to  Exhibit 10.11 to the registrant’s Current Report on Form 8-K filed  February 1, 2008)       |
| 10.12                |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and  between Virtual Radiologic Professionals, LLC and Virtual Radiologic  Professionals of New York, P.A. (Incorporated by reference to  Exhibit 10.12 to the registrant’s Current Report on Form 8-K filed  February 1, 2008)        |
| 10.13                |       | Amendment No. 2 to  Professional Services Agreement, dated as of January 30, 2008, by and between  Virtual Radiologic Professionals, LLC and Virtual Radiologic Professionals of  Texas, P.A. (Incorporated by reference to Exhibit 10.13 to the  registrant’s Current Report on Form 8-K filed February 1, 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.***                                                                                                                   |

 

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| 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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***                           Filed herewith.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**            | ** ** | **Title**                                                                                      | ** ** | **Date**         |
|--------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------|
|                     |       |                                                                                           |       |             |
| /s/ Sean O.  Casey, M.D. |       | Chief  Executive Officer and Chairman of the Board of Directors (Principal Executive  Officer) |       | May 2, 2008 |
| **Sean  O. Casey, M.D.** |
|                     |       |                                                                                           |       |             |
| /s/ Leonard C.  Purkis   |       | Chief  Financial Officer (Principal Financial and Accounting Officer)                          |       | May 2, 2008 |
| **Leonard  C. Purkis**   |

 

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