Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND 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 SEPTEMBER 30, 2008** |
| ** **                                                                                                                                                                                  | ** **                                                                                                                                                     |
| **OR**                                                                                                                                                                                      |
| ** **                                                                                                                                                                                  |
| **o**                                                                                                                                                                                       | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                  |
|                                                                                                                                                                                        | ** **                                                                                                                                                     |
| **For the transition period from              to            ** |

 

**Commission File Number 001-33815**

 

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**VirtualRadiologic Corporation**

(Exact name of registrant as specified in itscharter)

 

| **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 telephone number, includingarea code)

 

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Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes x   No o

 

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

 
| 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 a shell company (asdefined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

As of October 31, 2008, 15,848,074 shares of the registrant’scommon stock were outstanding.

 

 

 

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Table of Contents

 

**TABLE OF CONTENTS**

 
| **Part I  – Financial Information** |
|-----------------------------------------------|
|                                          |   |   |
| Item 1.                                  | Financial Statements | 3 |
| Item 2.                                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 20 |
| Item 3.                                  | Quantitative  and Qualitative Disclosures About Market Risk | 40 |
| Item 4.                                  | Controls and  Procedures | 40 |
|                                          |   |   |
| **Part II – Other  Information**    |
|                                          |   |   |
| Item 1.                                       | Legal Proceedings | 41 |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds | 41 |
| Item 6.                                  | Exhibits | 41 |
| Signatures                                    | 43 |

 

2

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Table of Contents

 

**PART I– Financial Information**

 

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

 

**Virtual Radiologic Corporation**

 

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Contents**

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

 

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Table of Contents

 

**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(unaudited)**

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

 
| ** **                                                                                                                                                                                                                                                                           | ** ** | **As of**         | ** ** | **As of**        | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                                                                                                           | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| **Assets**                                                                                                                                                                                                                                                                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                                                                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                            |       | $                      | 27,755     |                  | $          | 33,487 |   |
| Short-term investments                                                                                                                                                                                                                                                               |       | 7,000                  |       | —                |       |
| Restricted cash                                                                                                                                                                                                                                                                      |       | 700                    |       | 700                   |       |
| Accounts receivable, net                                                                                                                                                                                                                                                             |       | 16,659                 |       | 12,486                |       |
| Prepaid expenses                                                                                                                                                                                                                                                                     |       | 537                    |       | 2,073                 |       |
| Current taxes receivable                                                                                                                                                                                                                                                             |       | 1,075                  |       | 1,995                 |       |
| Other current assets                                                                                                                                                                                                                                                                 |       | 842                    |       | 336                   |       |
| Total current assets                                                                                                                                                                                                                                                                 |       | 54,568                 |       | 51,077                |       |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Property, plant and equipment, net                                                                                                                                                                                                                                                   |       | 11,082                 |       | 8,013                 |       |
| Intangible assets, net                                                                                                                                                                                                                                                               |       | 5,194                  |       | 252                   |       |
| Goodwill                                                                                                                                                                                                                                                                             |       | 677                    |       | —                |       |
| Other assets                                                                                                                                                                                                                                                                         |       | 441                    |       | 94                    |       |
| Total assets                                                                                                                                                                                                                                                                         |       | $                      | 71,962     |                  | $          | 59,436 |   |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                                                                        |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                                                                                                     |       | $                      | 501        |                  | $          | 801 |   |
| Accrued professional services compensation  expense                                                                                                                                                                                                                                  |       | 6,294                  |       | 4,681                 |       |
| Accrued sales, general and administrative  compensation expenses                                                                                                                                                                                                                     |       | 1,224                  |       | 1,717                 |       |
| Other accrued expenses                                                                                                                                                                                                                                                               |       | 1,486                  |       | 1,273                 |       |
| Other current liabilities                                                                                                                                                                                                                                                            |       | 658                    |       | 398                   |       |
| Total current liabilities                                                                                                                                                                                                                                                            |       | 10,163                 |       | 8,870                 |       |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Deferred rent                                                                                                                                                                                                                                                                        |       | 167                    |       | 204                   |       |
| Non-current deferred tax liability                                                                                                                                                                                                                                                   |       | 1,160                  |       | —                |       |
| Other liabilities                                                                                                                                                                                                                                                                    |       | 365                    |       | 24                    |       |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Non-controlling interest                                                                                                                                                                                                                                                             |       | 18                     |       | 8                     |       |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Commitments and contingencies (Note 9)                                                                                                                                                                                                                                               |       |                   |       |                  |       |
|                                                                                                                                                                                                                                                                                 |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                           |       |                   |       |                  |       |
| Common stock, $.001 par value; 100,000,000  shares authorized at September 30, 2008 and December 31, 2007;  16,784,273 and 16,463,173 shares issued and 16,586,850 and 16,463,173 shares  outstanding at September 30, 2008 and December 31, 2007,  respectively |       | 17                     |       | 16                    |       |
| Additional paid-in capital                                                                                                                                                                                                                                                           |       | 94,243                 |       | 90,165                |       |
| Treasury stock at cost, 197,423 and zero  shares at September 30, 2008 and December 31, 2007, respectively                                                                                                                                                                 |       | (1,879                 | )          | —                |       |
| Accumulated deficit                                                                                                                                                                                                                                                                  |       | (32,287                | )          | (39,851               | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                                                                 |       | (5                     | )          | —                |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                      |       | 60,089                 |       | 50,330                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                      |       | $                      | 71,962     |                  | $          | 59,436 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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Table of Contents

 

**VIRTUAL RADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(unaudited)**

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

 
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Revenue                                                                    |       | $                                                    | 29,025     |                                                | $          | 24,033 |   | $ | 78,266 |   | $ | 63,298 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Operating costs and expenses                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Professional services                                                      |       | 12,899                                               |       | 11,748                                              |       | 35,176 |   | 32,434 |   |
| Sales, general and administrative                                          |       | 9,600                                                |       | 7,842                                               |       | 27,667 |   | 22,137 |   |
| Depreciation and amortization                                              |       | 1,286                                                |       | 654                                                 |       | 3,357 |   | 1,701 |   |
| Total operating costs and expenses                                         |       | 23,785                                               |       | 20,244                                              |       | 66,200 |   | 56,272 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income                                                           |       | 5,240                                                |       | 3,789                                               |       | 12,066 |   | 7,026 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Other income (expense)                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense                                                           |       | —                                               |       | (435                                                | )          | — |   | (442 | ) |
| Interest income                                                            |       | 185                                                  |       | 138                                                 |       | 450 |   | 252 |   |
| Total other income (expense)                                               |       | 185                                                  |       | (297                                                | )          | 450 |   | (190 | ) |
| Income before non-controlling interest and  income tax                     |       | 5,425                                                |       | 3,492                                               |       | 12,516 |   | 6,836 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Non-controlling interest expense                                           |       | 2                                                    |       | 1,752                                               |       | 10 |   | 2,091 |   |
| Income before income tax expense                                           |       | 5,423                                                |       | 1,740                                               |       | 12,506 |   | 4,745 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax expense                                                         |       | 1,859                                                |       | 1,192                                               |       | 4,942 |   | 2,579 |   |
| Net income                                                                 |       | 3,564                                                |       | 548                                                 |       | 7,564 |   | 2,166 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Series A Cumulative Redeemable  Convertible Preferred Stock accretion |       | —                                               |       | (4,950                                              | )          | — |   | (25,068 | ) |
| Cash Dividends Paid:                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Series A Preferred Stock                                              |       | —                                               |       | (13,596                                             | )          | — |   | (13,596 | ) |
| Net income (loss) available to common  stockholders                        |       | $                                                    | 3,564      |                                                | $          | (17,998 | ) | $ | 7,564 |   | $ | (36,498 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Earnings (loss) per common share                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                      |       | $                                                    | 0.21       |                                                | $          | (2.22 | ) | $ | 0.45 |   | $ | (4.91 | ) |
| Diluted                                                                    |       | $                                                    | 0.21       |                                                | $          | (2.22 | ) | $ | 0.44 |   | $ | (4.91 | ) |
| Weighted average common shares outstanding                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                                      |       | 16,733                                               |       | 8,122                                               |       | 16,689 |   | 7,436 |   |
| Diluted                                                                    |       | 17,186                                               |       | 8,122                                               |       | 17,218 |   | 7,436 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**

**(in thousands)**

 
| ** **                                                                    | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** **     | ** ** | **Accumulated** | ** ** | ** **      | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------|------------|------------|------------|----------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **      | ** ** | ** **      | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | **Paid-In**    | ** ** | **Treasury**    | ** ** | **Accumulated** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                    | ** ** | **Shares**            | ** ** | **Amount** | ** ** | **Capital**    | ** ** | **Stock**       | ** ** | **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              |       | —                |       | —     |       | (978           | )          | —          |       | —          |       | — |   | (978 | ) |
| Equity based compensation for employees                                       |       | —                |       | —     |       | 1,121          |       | —          |       | —          |       | — |   | 1,121 |   |
| Independent contractor physician and  employee stock option exercises         |       | 321                   |       | 1          |       | 267            |       | —          |       | —          |       | — |   | 268 |   |
| Excess tax benefit from exercises of stock  options                           |       | —                |       | —     |       | 3,726          |       | —          |       | —          |       | — |   | 3,726 |   |
| Stock issuance costs                                                          |       | —                |       | —     |       | (58            | )          | —          |       | —          |       | — |   | (58 | ) |
| Repurchase of common shares                                                   |       | (197                  | )          | —     |       | —         |       | (1,879          | )          | —          |       | — |   | (1,879 | ) |
| Net income                                                                    |       | —                |       | —     |       | —         |       | —          |       | 7,564           |       | — |   | 7,564 |   |
| Other comprehensive loss                                                      |       |                  |       |       |       |           |       |            |       |            |       |   |   |   |   |
| Foreign currency translation adjustments                                      |       | —                |       | —     |       | —         |       | —          |       | —          |       | (5 | ) | (5 | ) |
| **Balance at September 30, 2008**                                        |       | 16,587                |       | $          | 17         |           | $          | 94,243          |       | $               | (1,879     | ) | $ | (32,287 | ) | $ | (5 | ) | $ | 60,089 |   |

 

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

 

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**VIRTUALRADIOLOGIC CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(unaudited)**

**(inthousands)**

 
| ** **                                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| **Cash flows from operating activities**                                          |       |                                                |       |   |   |
| Net income                                                                        |       | $                                                   | 7,564      |   | $ | 2,166 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities |       |                                                |       |   |   |
| Non-controlling interest                                                          |       | 10                                                  |       | 2,091 |   |
| Provision for doubtful accounts and sales  allowance                              |       | 450                                                 |       | 188 |   |
| Depreciation and amortization                                                     |       | 3,357                                               |       | 1,701 |   |
| Interest and discount amortization                                                |       | —                                              |       | 26 |   |
| Loss on disposal of property, plant and  equipment                                |       | 49                                                  |       | 12 |   |
| Equity based compensation for independent  contractor physicians                  |       | (978                                                | )          | 2,928 |   |
| Equity based compensation for employees                                           |       | 1,121                                               |       | 408 |   |
| Deferred income taxes                                                             |       | 925                                                 |       | (52 | ) |
| Changes in operating assets and  liabilities, net of acquisition impact:          |       |                                                |       |   |   |
| Accounts receivable                                                               |       | (4,059                                              | )          | (5,177 | ) |
| Prepaid expenses                                                                  |       | 1,536                                               |       | 1,189 |   |
| Current taxes receivable                                                          |       | 920                                                 |       | (1,913 | ) |
| Other current assets                                                              |       | (214                                                | )          | (114 | ) |
| Other assets                                                                      |       | —                                              |       | (5 | ) |
| Accounts payable                                                                  |       | (124                                                | )          | 135 |   |
| Accrued expenses                                                                  |       | 1,573                                               |       | 2,100 |   |
| Current taxes payable                                                             |       | —                                              |       | (608 | ) |
| Other current liabilities                                                         |       | 230                                                 |       | 130 |   |
| Deferred rent                                                                     |       | (37                                                 | )          | (11 | ) |
| Net cash provided by operating activities                                         |       | 12,323                                              |       | 5,194 |   |
| **Cash flows from investing activities**                                          |       |                                                |       |   |   |
| Purchases of property, plant and equipment                                        |       | (6,226                                              | )          | (3,560 | ) |
| Proceeds from sale of property, plant and  equipment                              |       | 36                                                  |       | — |   |
| Payments to acquire patents                                                       |       | (72                                                 | )          | (14 | ) |
| Cash paid for acquisition, net of cash  acquired                                  |       | (6,531                                              | )          | — |   |
| Purchase of short-term investments                                                |       | (7,000                                              | )          | — |   |
| Net cash used in investing activities                                             |       | (19,793                                             | )          | (3,574 | ) |
| **Cash flows from financing activities**                                          |       |                                                |       |   |   |
| Payments on capital leases                                                        |       | —                                              |       | (21 | ) |
| Payments of offering costs                                                        |       | (306                                                | )          | (674 | ) |
| Proceeds from stock option exercises                                              |       | 197                                                 |       | 1,185 |   |
| Payments for the re-purchase of common  stock                                     |       | —                                              |       | (10,010 | ) |
| Proceeds from the re-issuance of common  stock                                    |       | —                                              |       | 10,010 |   |
| Excess tax benefit from exercises of stock  options                               |       | 3,726                                               |       | 3,565 |   |
| Repurchases of common stock                                                       |       | (1,879                                              | )          | — |   |
| Proceeds from the issuance of debt                                                |       | —                                              |       | 41,000 |   |
| Payment of debt issuance costs                                                    |       | —                                              |       | (1,249 | ) |
| Cash dividends paid                                                               |       | —                                              |       | (39,909 | ) |
| Net cash provided by financing activities                                         |       | 1,738                                               |       | 3,897 |   |
| Net (decrease) increase in cash and cash  equivalents                             |       | (5,732                                              | )          | 5,517 |   |
| **Cash and cash equivalents**                                                     |       |                                                |       |   |   |
| Beginning of period                                                               |       | 33,487                                              |       | 5,958 |   |
| End of period                                                                     |       | $                                                   | 27,755     |   | $ | 11,475 |   |
|                                                                              |       |                                                |       |   |   |
| **Supplemental disclosure of cash flow  information**                             |       |                                                |       |   |   |
| Cash (received) paid for interest                                                 |       | $                                                   | (400       | ) | $ | 385 |   |
| Cash (received) paid for income taxes                                             |       | (662                                                | )          | 1,391 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

**(unaudited)**

 

***1. Business Overview***

 

Virtual Radiologic Corporation, or VRC, aDelaware corporation, provides 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).

 

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

 

VRC also has a wholly owned andconsolidated subsidiary, Virtual Radiologic Limited, or VRL, formed under thelaws of England and Wales and located in London, England. VRL was formed tofacilitate the international expansion of the Company’s business providingteleradiology services and products to customers located outside of the UnitedStates.

 

On October 21, 2008, VRCformed a wholly owned subsidiary, vRad Professional Insurance Ltd., or VPIL,for purposes of insuring the Company’s self insured retention under its medicalmalpractice insurance policy. VPIL was formed as an exempted Company in theCayman Islands with limited liability.

 

The term “Company” as used inthis report refers to VRC, its Affiliated Medical Practices and VRL.  VPIL is not yet included with the Company asit was formed subsequent to September 30, 2008.

 

The Company is involved in the application ofvarious convergent technologies that allow radiologists to remotely diagnosepatients and enhance the overall productivity of the radiology professionthrough a distributed diagnostic network that has been developed by the Companyand is integrated into its international virtual private network. The Companyserves radiology practices, hospitals, clinics and diagnostic imaging centersby providing 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 AccountingPolicies***

 

***Interim Financial Statements***

 

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

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

The December 31, 2007 balance sheet datahas been derived from audited financial statements as of that date, but doesnot include all footnote disclosures required by GAAP.  However, the Company believes that thedisclosures presented are adequate to make the information presented notmisleading.

 

***Principles of Consolidation and Basis of Presentation***

 

The Company consolidates its financialresults in accordance with Financial Accounting Standards Board, or FASB,Interpretation No. 46R, *Consolidationof Variable Interest Entities,* or FIN 46R, which requires aprimary beneficiary to consolidate entities determined to be variable interestentities, or VIEs. The Company has determined that the Affiliated MedicalPractices are VIEs and that VRC is the primary beneficiary of such VIEs, as definedby FIN 46R. The Affiliated Medical Practices were created as the Company’sbusiness expanded for the purpose of facilitating compliance with corporatepractice of medicine laws in the various states in which VRC operates. Themanagement of VRC was involved significantly in the design and creation of theVIEs and, with the exception of rendering medical judgments, holds significantinfluence over their continuing operations. Although VRC holds no legalownership in the VIEs, as a result of the pricing structure inherent in themanagement agreements that exist between the entities, VRC will absorb amajority of the VIEs expected future losses and receive a majority of the VIEsexpected residual returns. As such, the Company has concluded that VRC is requiredto consolidate the VIEs. As of September 30, 2008, VRC has funded lossesof the VIEs totaling approximately $8.0 million and expects to continue tofund the majority of the losses for the foreseeable future. VRC will onlyreceive residual returns up to the amount of previously recognized losses.

 

As of September 30, 2008 and December 31,2007 and for the three and nine months ended September 30, 2008 and 2007,the financial statements of VRC have been presented on a consolidated basis toinclude its variable interests in the Affiliated Medical Practices. Inaddition, as of September 30, 2008 and December 31, 2007, and for thethree and nine months ended September 30, 2008, VRC consolidated VRL, itswholly owned subsidiary.

 

The effect of the VIEs’ consolidation on theCompany’s consolidated balance sheet at September 30, 2008, was anincrease in the Company’s assets and liabilities of approximately$9.8 million and $6.7 million, respectively. At December 31,2007, as a result of consolidating the VIEs, the Company’s assets andliabilities increased by approximately $9.8 million and $4.9 million,respectively. The liabilities of the VIEs consolidated by the Company do notrepresent additional claims on the Company’s general assets; rather theyrepresent claims against the specific assets of the individual or respectiveVIEs. Likewise, the assets of the VIEs consolidated by the Company do notrepresent additional assets available to satisfy claims against the Company’sgeneral assets. For the three months ended September 30, 2008, the revenueof the VIEs represented approximately 46%, or $13.3 million of theconsolidated revenue of the Company. For the three months ended September 30,2007, the revenue of the VIEs represented approximately 46%, or$11.1 million, of the consolidated revenue of the Company. For the ninemonths ended September 30, 2008, the revenue of the VIEs representedapproximately 45%, or $35.3 million of the consolidated revenue of theCompany. For the nine months ended September 30, 2007, the revenue of theVIEs represented approximately 47%, or $29.4 million, of the consolidatedrevenue of the Company. Through consolidation, the Company recognizes all netlosses of each VIE in excess of the equity of that VIE. The Company recognizes netearnings of each VIE only to the extent it is recovering losses previouslyrecognized with respect to that VIE. Earnings of each VIE in excess of theCompany’s previously recognized losses with respect to that VIE are eliminatedfrom the Company’s earnings and are attributed to the respective equity ownersof that VIE by recording such earnings as non-controlling interest on theCompany’s consolidated financial statements. During the three and nine monthsended September 30, 2007, one of the VIEs experienced net income thatincreased its positive equity position. As a result, for the three and ninemonths ended September 30, 2007, the Company recognized non-controllinginterest expense of approximately $1.8 million and $2.1 million, respectively.During the three and nine months ended September 30, 2008, one of the VIEsexperienced net income that increased its positive equity position. As aresult, for the three and nine months ended September 30, 2008, theCompany recognized non-controlling interest expense of approximately $2,000 and$10,000, respectively.

 

The consolidated financial statements and therelated footnote information presented as of September 30, 2008 and December 31,2007 and for the three and nine months ended September 30, 2008 and 2007,represent the consolidated operations of the Company.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

***Recent Accounting Pronouncements***

 

In September 2006, the FinancialAccounting Standards Board, or FASB, issued Statement of Financial AccountingStandard, or SFAS, No. 157, *Fair ValueMeasurements,* or SFAS No. 157. This standard clarified theprinciple that fair value should be based on the assumptions that marketparticipants would use when pricing an asset or liability. Additionally, itestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. On February 12, 2008 the FASB issued FASB StaffPosition, or FSP, FAS 157-2, *EffectiveDate of FASB Statement No. 157,* or FSP FAS 157-2. FSPFAS 157-2 defers the implementation of SFAS No. 157 for certainnonfinancial assets and nonfinancial liabilities. The portion of SFAS No. 157that has been deferred by FSP FAS 157-2 will be effective for the Companybeginning in the first quarter of fiscal year 2009. The portion not deferredwas adopted with no material impact to the Company’s financial assets andfinancial liabilities that 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. 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 requirements for how an acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, any noncontrolling interests in the acquireeand the goodwill acquired. Some of the key changes under SFAS No. 141Rwill change the accounting treatment for certain specific acquisition relateditems including: (1) accounting for acquired in-process research anddevelopment as an indefinite-lived intangible asset until approved ordiscontinued rather than as an immediate expense; (2) expensingacquisition costs rather than adding them to the cost of an acquisition; (3) expensingrestructuring costs in connection with an acquisition rather than adding themto the cost of an acquisition; (4) including the fair value of contingentconsideration at the date of an acquisition in the cost of an acquisition; and (5) recordingat the date of an acquisition the fair value of contingent liabilities that aremore likely than not to occur. SFAS No. 141R also includes a substantialnumber of new disclosure requirements. SFAS No. 141R applies prospectivelyto business combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008, and interim periods within those fiscal years. Early application of thisstatement is prohibited. The Company is currently evaluating the impact of thisstatement.

 

In December 2007, 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 being 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 initially applied,except for the presentation and disclosure requirement which shall be appliedretrospectively for all periods presented. Early adoption of this statement isprohibited. The Company is currently evaluating the impact of this statement.

 

In April 2008, the FASB issued FSP No. FAS142-3, *Determination of the Useful Like of IntangibleAssets*, this FASB Staff Position amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset. This is effective for fiscalyears beginning after December 15, 2008. The Company is currentlyevaluating the impact of this statement.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

***3. Selected Consolidated FinancialStatement Information***

 

***Short-term Investments***

 

The Company’s short-term investments are classified as held-to-maturityinvestments. The Company intends and has the ability to hold these investmentsto maturity, and therefore carries such investments at cost in accordance withthe provisions of SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*. Costapproximates fair value due to the highly liquid nature of this investment.

 
| ** **               | ** ** | **As of**          | ** ** | **As of**        | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
| ** **               | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **               | ** ** | **(in thousands)** | ** ** |
| Due in one year or less: |       |                    |       |                  |       |
| Certificates of deposit  |       | $                       | 7,000      |                  | $          | — |   |
|                          |            |                         |            |                       |            |  |  |

 

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

 
| ** **                                       | ** ** | **As of**          | ** ** | **As of**        | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
| ** **                                       | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Equipment                                        |       | $                       | 10,136     |                  | $          | 6,390 |   |
| Software                                         |       | 5,404                   |       | 3,575                 |       |
| Furniture and fixtures                           |       | 1,657                   |       | 1,648                 |       |
| Leasehold improvements                           |       | 343                     |       | 345                   |       |
| Other                                            |       | 312                     |       | 141                   |       |
| Total property, plant and equipment              |       | 17,852                  |       | 12,099                |       |
| Less: Accumulated depreciation and  amortization |       | 6,770                   |       | 4,086                 |       |
| Property, plant and equipment, net               |       | $                       | 11,082     |                  | $          | 8,013 |   |

 

Depreciation and amortization related to the property, plant andequipment of the Company was approximately $1.1 million and $650,000 for thethree months ended September 30, 2008 and 2007, respectively andapproximately $3.0 million and $1.7 million for the nine months ended September 30,2008 and 2007, respectively.

 

***4. Acquisition***

 

On April 14, 2008, the Company entered into a Membership InterestPurchase Agreement with Diagna Radiology, LLC, or Diagna, and Diagna’s owners, pursuantto which the Company purchased all of the membership interests of Diagna.  Diagna is a teleradiology provider thatoffers 24-hour a day emergent and non-emergent services including subspecialtyexpertise in neuroradiology, musculoskeletal and nuclear medicine.  Total consideration for the transaction wasapproximately $6.6 million, which includes $6.0 million of initial purchaseprice, $504,000 based on preliminary working capital and $93,000 of initialdirect acquisition costs. Diagna’s owners may also receive additional cashconsideration of up to an aggregate of $2.2 million to be paid as an earnoutwithin 45 days of the end of each of the first two yearly anniversaries of theclosing of the transaction. The earnout payments are to be calculated basedupon certain gross profit requirements generated from revenues of Diagnacustomers during those two periods.

 

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

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

The allocation of the purchase price has been prepared based onpreliminary estimates of fair values, including acquired customer relationshipsand non-compete agreements. Management determined the fair values usingassistance of an independent valuation firm. These allocations are preliminary and are subject to possibleadjustments.  We expect the finalvaluation to be complete on or before December 31, 2008 and therefore theactual amounts recorded upon the finalization may differ materially from theamounts presented below.

 

The following table presents the preliminary allocation of the purchaseprice to the acquired assets and liabilities:

 
| ** **                                | ** ** | **(in thousands)** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| Current assets, including cash of $57,000 |       | $                       | 650        |   |
| Property, plant and equipment             |       | 184                     |       |
| Intangible assets                         |       | 5,198                   |       |
| Goodwill                                  |       | 677                     |       |
| Total assets acquired                     |       | 6,709                   |       |
|                                      |       |                    |       |
| Current liabilities                       |       | 107                     |       |
| Total liabilities assumed                 |       | 107                     |       |
|                                      |       |                    |       |
| Net assets acquired                       |       | $                       | 6,602      |   |

 

The acquisition ofDiagna results in the assets acquired and liabilities assumed being recordedbased on their estimated fair values on the acquisition date. Of theapproximately $5.2 million of acquired intangible assets, approximately$300,000 was assigned to non-compete agreements with a preliminary estimatedeconomic life of two years and $4.9 million was assigned to customerrelationships with a preliminary estimated economic life of ten years.  The economic life attributed to our acquiredcustomer relationships is based on the Company’s historically low attritionrates as well as historically low attrition rates within the industry. Goodwillof $677,000 represents the excess of the purchase price over the fair value oftangible and identifiable intangible assets acquired and liabilitiesassumed.  Goodwill will not be amortizedbut instead will be tested at least annually for impairment consistent with theguidance in SFAS No. 142, *Goodwill andOther Intangible Assets*, or SFAS No. 142.

 

The acquisitionwas completed on April 15, 2008 and the financial position and results ofoperations of Diagna have been consolidated with the Company’s consolidatedbalance sheet, statements of operations and cash flows as of and for the threeand nine months ended September 30, 2008. Assuming the acquisition ofDiagna had been completed at the beginning of the respective reporting periods,pro-forma revenue would have been $25.3 million and $67.2 million for the threeand nine months ended September 30, 2007, respectively, and $29.0 millionand $79.7 million for the three and nine months ended September 30, 2008,respectively.  The resulting pro-formanet income would have been $0.5 million and $2.2 million for the three and ninemonths ended September 30, 2007, respectively, and $3.6 million and $7.4million for the three and nine months ended September 30, 2008,respectively.  Pro-forma diluted (loss)earnings per common share would have been $(2.22) and $(4.91) for the three andnine months ended September 30, 2007, respectively, and $0.21 and $0.43for the three and nine months ended September 30, 2008, respectively.  The pro forma information gives effect toactual operating results prior to the acquisition, and makes adjustment for,among other things, additional intangible asset amortization. The actualoperating results prior to the acquisition, including the additional intangibleasset amortization are tax-effected at the Company’s effective tax rate duringthe applicable period. These adjustments are subject to change as these initialestimates are refined over time. No effect has been given to cost reductions oroperating synergies in this presentation. These pro forma amounts are notnecessarily indicative of the results that would have been obtained if theacquisition had occurred as of the beginning of the periods presented or thatmay occur in the future, and does not reflect future synergies, integrationcosts, or other such costs or savings. The unaudited pro forma financialinformation is presented for informational purposes only.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

***5. Goodwill and Other IntangibleAssets***

 

The Company recognized $677,000 of goodwill as a result of theacquisition of Diagna.  In accordancewith SFAS No. 142, goodwill will not be amortized, but instead will betested for impairment at least annually and more frequently if indicators ofimpairment are present.

 

A summary of intangible assets is as follows:

 
| ** **                         | ** ** | ** **                 | ** ** | **As of September 30, 2008** | ** ** | **As of December 31, 2007** | ** ** |
|------------------------------------|------------|----------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                         | ** ** | ** **                 | ** ** | **(in thousands)**                          | ** ** |
| ** **                         | ** ** | **Estimated  Useful Life** | ** ** | **Original  Cost**                               | ** ** | **Accumulated  Amortization**                   | ** ** | **Carrying  Value** | ** ** | **Original  Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Carrying  Value** | ** ** |
| Amortized  intangible assets:      |       |                       |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Patents                            |       | 15 years                   |       | $                                                | 347        |                                            | $          | (49 | ) | $ | 298 |   | $ | 284 |   | $ | (32 | ) | $ | 252 |   |
| Non-compete  agreements            |       | 2 years                    |       | 298                                              |       | (68                                             | )          | 230 |   | — |   | — |   | — |   |
| Customer  relationships            |       | 10 years                   |       | 4,900                                            |       | (234                                            | )          | 4,666 |   | — |   | — |   | — |   |
| Total  amortized intangbile assets |       |                       |       | $                                                | 5,545      |                                            | $          | (351 | ) | $ | 5,194 |   | $ | 284 |   | $ | (32 | ) | $ | 252 |   |

 

The Company records amortization related to patents and non-competeagreements on a straight line basis over their estimated useful lives of 15years and 2 years, respectively. The Company also records amortization relatedto customer relationships over their estimated useful life of 10 years based onthe expected future economic benefits of those customer relationships on anaccelerated basis. Amortization expense related to intangible assets wasapproximately $171,000 and $4,000 for the three months ended September 30,2008 and 2007, respectively, and $319,000 and $12,000 for the nine months endedSeptember 30, 2008 and 2007, respectively.

 

A summary of estimated future amortization expense is as follows:

 
| ** **                                  | ** ** | **Amount**              | ** ** |
|---------------------------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **(in thousands)** | ** ** |
|                                        |       |                    |       |
| Three months  ending December 31, 2008 |       | $                       | 171        |   |
| Year ending  December 31, 2009         |       | 1,103                   |       |
| Year ending  December 31, 2010         |       | 867                     |       |
| Year ending  December 31, 2011         |       | 682                     |       |
| Year ending  December 31, 2012         |       | 566                     |       |
| Thereafter                                  |       | 1,805                   |       |
| Total                                       |       | $                       | 5,194      |   |

 

***6. Preferred Stock***

 

On May 2, 2005, the Company closed on asale of shares of its Series A Cumulative Redeemable Convertible PreferredStock, or Series A Preferred Stock. In connection with the preparation ofthe Company’s financial statements for the three and nine months ended September 30,2007 the 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 of variousvaluation methodologies. The increase in the market value of the Series APreferred Stock at September 30, 2007 was recorded in the consolidatedstatements of changes in stockholders’ equity as accretion of Series ACumulative Redeemable Convertible Preferred Stock in additional paid-in capitaland as a decrease in net income available to common stockholders in theconsolidated statements of operations as Series A Cumulative RedeemableConvertible Preferred Stock accretion. Each share of Series A PreferredStock was automatically 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 

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

Form S-1 at a public offering price of $17.00 per share. As aresult, dividends no longer accumulate, and previously accumulated, undeclaredand unpaid dividends are no longer payable by the Company.

 

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

 

On September 7, 2007, the Company’sBoard of Directors adopted the Amended and Restated Equity Incentive Plan, orthe Plan, to consolidate and replace, upon effectiveness of the Company’sinitial public offering, equity-based plans previously maintained by theCompany.  The primary purpose ofcombining these plans was to ease the administrative burden associated withadministering the Company’s equity-based compensation program. The Plan becameeffective on November 14, 2007 and increased the total shares authorizedand reserved for future issuance to 5,475,000 shares. The Plan provides for thegrant of incentive stock options, nonqualified stock options, stockappreciation rights and restricted stock to the Company’s officers, employeesand independent contractors. As of September 30, 2008, there were2,162,477 options outstanding, which includes 120,000 options granted in May 2007to members of the Company’s Board of Directors that were not issued pursuant tothe Plan.

 

Stock option activity for employees, directors and independentcontractor physicians during the nine months ended September 30, 2008 was asfollows:

 
| ** **                                 | ** ** | ** **         | ** ** | **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                                    |       | (323,000           | )          | 323,000         |       | 15.55                    |       | $10.20 - $17.75 |   |
| Exercised                                  |       | —             |       | (321,100        | )          | 1.68                     |       | 1.00 - 17.00 |   |
| Forfeited                                  |       | 124,329            |       | (124,329        | )          | 10.78                    |       | 1.00 - 17.75 |   |
| **Balance at September 30, 2008**     | ** ** | **417,920**        | ** ** | **2,162,477**   | ** ** | **10.92**                |       |   |   |
| **Exercisable at September 30, 2008** | ** ** | ** **         | ** ** | **562,481**     | ** ** | **6.22**                 | ** ** | **2.00 - 19.23** | ** ** |
|                                            |            |                    |            |                 |            |                          |            |  |  |  |

 

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| (1)    | The number of options outstanding includes 120,000 options granted in  May 2007 to members of the Company’s Board of Directors that were not  issued pursuant to the Plan.                                                                                                                                                                                                                                                                                                                                                   |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| (2)    | Prior to the Company’s shares trading on the NASDAQ Global Market,  which trading commenced on November 15, 2007, the exercise prices of all  options were determined by the Company’s Board of Directors, based on the  estimated fair value of the common stock on the date of grant. For all stock  options granted subsequent to November 14, 2007, the Company uses the  closing price of its common stock on the NASDAQ Global Market on the date of  grant to determine the exercise price of such options. |

 

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

 

For the three and nine months ended September 30,2008, the Company issued 30,000 and 281,000 options, respectively, to certainemployees and directors. The Company recorded approximately $417,000 and $1.1million in stock-based compensation expense related to employee and directoroptions for the three and nine months ended September 30, 2008,respectively.

 

SFAS No. 123R requires that the cashretained as a result of the tax deductibility of employee and directorshare-based awards be presented as a component of cash flows from financingactivities in the consolidated statements of cash flows. During the nine monthsended September 30, 2008, the Company realized approximately $3.7 millionas a result of the tax deductibility of employee and director share-basedawards exercised during the period.

 

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

 

For the three and nine months ended September 30,2008, the Company issued 11,000 and 42,000 options, respectively, to itsaffiliated radiologists, who are independent contractor physicians. The Company

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

recordedstock-based compensation income related to these independent contractorphysicians’ options of approximately $418,000 and $978,000 for the three andnine months ended September 30, 2008, respectively.

 

***8. Stock Repurchase Program***

 

In August 2008,the Company’s Board of Directors authorized the repurchase of up to $8.0million of the Company’s outstanding common stock. During the three monthsended September 30, 2008, the Company repurchased 197,423 shares of commonstock at an average price of $9.49 per share. Total cash consideration for therepurchased stock was approximately $1.9 million. As of September 30,2008, the remaining authorization under the Company’s stock repurchase programwas approximately $6.1 million.

 

On October 24, 2008 the Companycompleted this stock repurchase program. The Company repurchased an aggregate of 944,760 shares at an averagepurchase price of $8.44 per share. Repurchases took place in the open market and pursuantto trading plans meeting the requirements of Rule 10b5-1 of the SecuritiesExchange Act of 1934.

 

***9. Commitments and Contingencies***

 

On January 22, 2008, the Company enteredinto two new license agreements for the provision of network related servicesthat also allow the Company to utilize space in a building in Minnetonka,Minnesota, that houses one of the Company’s data centers. The license agreementscommenced on February 15, 2008 and June 1, 2008 and have 36 monthterms, expiring in February 2011 and May 2011, respectively. Bothlicense agreements have monthly minimum usage requirements of $10,000 for whichthe Company is obligated to pay if actual services used do not exceed theseminimums. As of September 30, 2008, these service minimums have beenrecorded as a liability, in accordance with FASB Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others*, and FSP FIN45-3, *Application of FASB Interpretation No. 45 toMinimum Revenue Guarantees Granted to a Business or Its Owners*. Themaximum potential amount of future payments is $605,000 and the current portionof this obligation is $240,000, which is recorded in other current liabilitieson the consolidated balance sheet as of September 30, 2008. Thenon-current portion is recorded in other liabilities on the consolidatedbalance sheet as of September 30, 2008. This obligation will become dueimmediately if the Company prematurely terminates either of these licenseagreements.

 

***Litigation***

 

On July 31, 2007, Merge eMed, Inc.,or Merge, filed a complaint against the Company in the United States DistrictCourt for the Northern District of Georgia, Atlanta Division, alleging that theCompany willfully infringed on certain of Merge’s patents relating toteleradiology. Merge is seeking treble damages as well as its costs and legalfees in pursuing the action. Merge has asked the court for an injunction,ordering the Company to cease the alleged infringement of their patents, andalso that the case be tried before a jury. While the Company is continuing toevaluate Merge’s allegations, it intends to defend against this claim and mayincur substantial costs in doing so. On September 14, 2007, the Companyfiled a Request for Reexamination with the United States Patent and TrademarkOffice, or PTO, for the patents that Merge has asserted against the Company,asking the PTO to reexamine the validity of the Merge patents based uponcertain prior art. The PTO granted the Company’s reexamination request in November 2007.Also in September 2007, the Company filed a motion with the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, askingthe court to stay the proceeding that Merge has commenced in that court pendingthe outcome of the PTO reexamination. On December 11, 2007, the courtgranted the Company’s motion to stay the patent suit pending the outcome of thereexamination. In February 2008, subsequent to the grant of the stay bythe court, the Company filed an additional Request for Reexamination with thePTO for these same patents based on additional prior art. On August 28,2008, the PTO ruled invalid all of the claims in the patents upon which Mergehad sued the Company. Merge has not yet responded to the PTO action. Thejudicial stay of proceedings in the lawsuit continues in effect at this time.The Company has not recognized any expense related to the settlement of thismatter as an adverse outcome of this claim is not probable and cannot bereasonably estimated.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

During the quarter ended September 30,2008, the Company reserved for a medical malpractice lawsuit to which theCompany and one if its affiliated radiologists are parties. The Company’spotential obligation with regard to this claim is estimated to exceed the fullamount of the Company’s deductible under its professional malpractice liabilityinsurance policy. As a result the Company has recorded a reserve of $350,000 toaccount for the Company’s obligation under its deductible. This amount isrecorded in accrued expenses on the consolidated balance sheet and in sales,general and administrative expense on the consolidated statements of operationsas of and for the three and nine months ended September 30, 2008.

 

During the nine months ended September 30,2008 the Company received notice of a settlement in a medical malpracticelawsuit to which the Company and one of its’ affiliated radiologists wereparties. The Company’s obligation with regard to this settlement totaled$350,000. This amount is recorded in sales, general and administrative expenseon the consolidated statements of operations for the nine months ended September 30,2008. This case is closed and the Company has no further obligations withregard to this matter.

 

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

 

***10. 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 endedSeptember 30, 2008 and 2007, the Company incurred licensing fees underthis contract of approximately $279,000 and $239,000, respectively.  For the nine months ended September 30,2008 and 2007, the Company incurred licensing fees under this contract ofapproximately $772,000 and $636,000, respectively.

 

The following table illustrates the revenues,expenses and cash flows that result from the management and professionalservice agreements between the related parties described in Note 1.

 
| ** **                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                        | ** ** | **(in thousands)**                              | ** ** |
| ** **                                                                        | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| VRP professional services revenue from VRC                                        |       | $                                                    | 6,274      |                                                | $          | 6,682 |   | $ | 17,186 |   | $ | 17,581 |   |
| VRC professional services expense to VRP                                          |       | 6,274                                                |       | 6,682                                               |       | 17,186 |   | 17,581 |   |
| VRP professional services revenue from the  Professional Corporations             |       | 6,672                                                |       | 6,749                                               |       | 17,646 |   | 18,418 |   |
| Professional Corporations professional  services expense to VRP                   |       | 6,672                                                |       | 6,749                                               |       | 17,646 |   | 18,418 |   |
| VRC management fee revenue from the  Professional Corporations                    |       | 6,605                                                |       | 5,346                                               |       | 17,469 |   | 14,214 |   |
| Professional Corporations management fee  expense to VRC                          |       | 6,605                                                |       | 5,346                                               |       | 17,469 |   | 14,214 |   |
| Cash paid for professional services by VRC  to VRP                                |       | 6,274                                                |       | 6,682                                               |       | 17,186 |   | 17,581 |   |
| Cash paid for professional services by the  Professional Corporations to VRP |       | 6,672                                                |       | 6,749                                               |       | 17,646 |   | 18,418 |   |
| Cash paid for management fees by the  Professional Corporations to VRC            |       | 6,605                                                |       | 5,346                                               |       | 17,469 |   | 14,214 |   |
|                                                                                   |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

***11. Earnings Per Share***

 

The Company calculates earnings per share inaccordance with Emerging Issues Task Force Issue No. 03-6, *Participating Securities and the two-class methodunder FASB Statement No. 128,* or EITF Issue No. 03-6. Incalculating basic earnings per share, this method requires net income to bereduced by the amount of dividends declared in the current period for eachclass of stock and by the contractual amount of dividends or otherparticipation payments that are paid or accumulated for the current period. Undistributedearnings for the period are allocated to participating securities based on thecontractual participation rights of the security to share in those currentearnings assuming all earnings for the period are distributed. Prior to theconversion of the Company’s Series A Preferred Stock, preferredstockholders had contractual participation rights on a converted basis thatwere equivalent to those of common stockholders. Therefore, the Companyallocated undistributed 

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

earningsto preferred and common stockholders based on their respective ownershippercentage, on a converted basis, as of the end of the period.

 

EITF Issue No. 03-6 also requirescompanies with participating securities to calculate diluted earnings per shareusing the if-converted method. This method requires net income to be adjustedby the amount of dividends declared or accumulated and by the accretion ordecretion associated with convertible securities, subject to the antidilutionprovisions of SFAS No. 128 *Earnings perShare,* or SFAS No. 128. The if-converted method also requiresthe denominator to include the additional shares issued upon the assumedconversion of the convertible securities along with the additional shareequivalents from the assumed conversion of stock options and warrantscalculated using the treasury stock method, again subject to the antidilutionprovisions of SFAS No. 128. Prior period earnings per share amounts havebeen presented to comply with the provisions of EITF Issue No. 03-6.

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THE THREEAND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

The following table presents the computationof earnings per share:

 
| ** **                                                                       | ** ** | **Three Months Ended  September 30,**               | ** ** | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|------------|-----------------------------------------------------|------------|------------|
| ** **                                                                       | ** ** | **2008**                                                           | ** ** | ** ** | ** **                                          | **2007**   | ** ** | ** ** | **2008** | ** ** | ** ** | ** ** | **2007** | ** ** | ** ** |
| ** **                                                                       | ** ** | **(in thousands, except per share data)** | ** ** | ** ** |
| **Basic and Diluted Earnings per Share**                | ** ** | ** **                                                         | ** ** | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Two-class Method)**                                                           | ** ** | ** **                                                         | ** ** | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                       |       | $                                                                  | 3,564      |       |                                                |       | $          | 548 |   |   | $ | 7,564 |   |   |   | $ | 2,166 |   |   |
| Less:                                                                            |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| Series A Cumulative Redeemable  Convertible Preferred Stock accretion       |       | —                                                             |       |       |                                                | (4,950     | )          |   | — |   |   |   | (25,068 | ) |   |
| Cash dividends paid:                                                             |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| Preferred                                                                        |       | —                                                             |       |       |                                                | (13,596    | )          |   | — |   |   |   | (13,596 | ) |   |
| Undistributed income (loss)                                                      |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
|                                                                             |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| **Distributed Earnings per Share**                                               |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| Cash dividends paid to preferred  stockholders                                   |       | $                                                                  | —     |       |                                                |       | $          | 13,596 |   |   | $ | — |   |   |   | $ | 13,596 |   |   |
| Weighted average preferred shares  outstanding                                   |       | —                                                             |       |       |                                                | 3,627      |       |   | — |   |   |   | 3,627 |   |   |
| Distributed earnings per share - Preferred                                       |       | $                                                                  | —     |       |                                                |       | $          | 3.75 |   |   | $ | — |   |   |   | $ | 3.75 |   |   |
| Cash dividends paid to common stockholders                                       |       | $                                                                  | —     |       |                                                |       | $          | 26,313 |   |   | $ | — |   |   |   | $ | 26,313 |   |   |
| Weighted average common shares outstanding                                       |       | —                                                             |       |       |                                                | 8,122      |       |   | — |   |   |   | 7,436 |   |   |
| Distributed earnings per share - Common                                          |       | $                                                                  | —     |       |                                                |       | $          | 3.24 |   |   | $ | — |   |   |   | $ | 3.54 |   |   |
|                                                                             |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| **Undistributed Earnings per Share**                                             |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| **  Basic**                                                                 |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| Undistributed income (loss)                                                      |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
| Series A Preferred ownership on a  converted basis                          |       | 0                                                                  | %          |       |                                                | 29         | %          |   | 0 | % |   |   | 29 | % |   |
| Series A Preferred stockholders  interest in undistributed income           |       | $                                                                  | —     |       |                                                |       | $          | — |   |   | $ | — |   |   |   | $ | — | (a) |
| Weighted average Series A Preferred  shares                                 |       | —                                                             |       |       |                                                | 3,627      |       |   | — |   |   |   | 3,627 |   |   |
| Undistributed earnings per share -  Series A Preferred Stock                |       | $                                                                  | —     |       |                                                |       | $          | — |   |   | $ | — |   |   |   | $ | — |   |   |
| Undistributed income (loss)                                                      |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
| Common ownership                                                                 |       | 100                                                                | %          |       |                                                | 71         | %(a)       | 100 | % |   |   | 71 | %(a) |
| Common stockholders interest in  undistributed income (loss)                     |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
| Weighted average common shares outstanding  - Basic                              |       | 16,733                                                             |       |       |                                                | 8,122      |       |   | 16,689 |   |   |   | 7,436 |   |   |
| Total basic earnings (loss) per share -  Common                                  |       | $                                                                  | 0.21       |       |                                                |       | $          | (2.22 | ) |   | $ | 0.45 |   |   |   | $ | (4.91 | ) |   |
|                                                                             |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| **Diluted Earnings per Share**                                                   |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| **(If-converted Method)**                                                        |       |                                                               |       |       |                                                |       |       |   |   |   |   |   |   |   |   |
| Net income (loss) available to common  stockholders                              |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
| Less: Series A Cumulative Redeemable  Convertible Preferred Stock accretion |       | —                                                             |       |       |                                                | —     | (b)        | — |   |   |   | — | (b) |
| Net income (loss) used in diluted earnings  per share                            |       | $                                                                  | 3,564      |       |                                                |       | $          | (17,998 | ) |   | $ | 7,564 |   |   |   | $ | (36,498 | ) |   |
| Weighted average common shares outstanding  - Basic                              |       | 16,733                                                             |       |       |                                                | 8,122      |       |   | 16,689 |   |   |   | 7,436 |   |   |
| Convertible preferred stock                                                      |       | —                                                             |       |       |                                                | —     | (b)        | — |   |   |   | — | (b) |
| Common share equivalents                                                         |       | 453                                                                | (d)        | —     | (c)(d)                                              | 529        | (d)        | — | (c)(d) |
| Shares used to compute earnings per common  share - Diluted                      |       | 17,186                                                             |       |       |                                                | 8,122      |       |   | 17,218 |   |   |   | 7,436 |   |   |
| Total diluted earnings (loss) per share                                          |       | $                                                                  | 0.21       |       |                                                |       | $          | (2.22 | ) |   | $ | 0.44 |   |   |   | $ | (4.91 | ) |

 

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**VIRTUALRADIOLOGIC CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS – (CONTINUED)**

**FOR THETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

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

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

(c)                                         Common share equivalents are not included in thediluted earnings per common share calculation for these periods as they areanti-dilutive. Potential common shares totaled approximately 2.0 millionand 2.2 million for the three and nine months ended September 30,2007, respectively.

(d)                                        The calculation of common stock equivalents excludesoptions to purchase approximately 1.4 million and 1.1 million shares of commonstock for the three and nine months ended September 30, 2008,respectively, and approximately 72,000 and 108,000 shares of common stock forthe three and nine months ended September 30, 2007, respectively, as aresult of their anti-dilutive effect on diluted earnings per share.

 

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**ITEM 2.****                             Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Special Note Regarding ForwardLooking Statements**

 

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

 

Factors that could cause ouractual results to differ materially from those expressed or implied in suchforward-looking statements include, but are not limited to the following:

 

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

 

·                  our ability to effectively manage ourgrowth and development;

 

·                  our ability to recruit and retainqualified radiologists;

 

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

 

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

 

·                  the regulation of the corporatepractice of medicine;

 

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

 

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

 

·                  the loss of key members of managementand personnel;

 

·                  new technologies;

 

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

 

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

 

·                  our ability to comply with governmentregulations;

 

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

 

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

 

Given these uncertainties, youshould not place undue reliance on these forward-looking statements.

 

In this report, VirtualRadiologic Corporation is sometimes referred to as “VRC.” Virtual RadiologicProfessionals of California, P.A., Virtual Radiologic Professionals ofIllinois, 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.” Virtual RadiologicProfessionals, LLC, or VRP, and the Professional Corporations are collectivelyreferred to as the “Affiliated Medical Practices.” VRC has a wholly owned andconsolidated subsidiary, Virtual Radiologic Limited, or VRL, formed under thelaws of 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 MedicalPractices and VRL.

 

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**Overview**

 

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

 

We continued to focus our growth initiativeson supplementing our core teleradiology business through the expansion of ourunique distributed operating model and enhancements to our proprietary workflowmanagement software through the third quarter of 2008. We have also continuedto focus on acquiring new customers, attracting and retaining additionalradiologists, generating additional sales from existing customers and furtherpenetration into the final read market.

 

We contracted with 26 net new customersduring the three months ended September 30, 2008, which resulted in anadditional 39 hospitals and other medical facilities to whom we provideservice.  For the nine months ended September 30,2008, we contracted with 132 net new customers, which resulted in an additional174 hospitals and other medical facilities. Included in the new customer andfacility numbers as of September 30, 2008 are the 42 customers and 54hospitals and other medical facilities that were added from the acquisition ofDiagna Radiology, LLC, or Diagna, on April 15, 2008.  This 32% year-over-year growth in customersbrought the total number of customers that we serve to 601 as of September 30,2008. In addition, we ended the quarter providing service to 978 medicalfacilities including 915 hospitals, which represents approximately 15% of all hospitalsin the United States and results in a 24% year-over-year growth in the numberof facilities that we serve.

 

During the three months ended September 30,2008, we added 4 radiologists under contract and 10 radiologists providingservice.  During the nine months ended September 30,2008, we added 19 radiologists under contract and 22 radiologists providingservice, resulting in 147 radiologists under contract and 134 radiologistsproviding service as of September 30, 2008.  Included in the new radiologist numbers as ofSeptember 30, 2008 are 7 radiologists providing service that came from theDiagna acquisition. We believe that the benefits of our distributed operatingmodel, such as flexible choice of location, predictable schedules andcompetitive compensation, have allowed us to successfully recruit and retainradiologists.

 

In addition to our customer and radiologistgrowth, our read volume grew by 27% to 600,386 total reads during the threemonths ended September 30, 2008, compared to 473,263 total reads duringthe three months ended September 30, 2007. Our read volume grew by 30% to 1,609,274 total reads during the ninemonths ended September 30, 2008, compared to 1,238,579 total reads duringthe nine months ended September 30, 2007. Volume retention was 97% for boththe three and nine months ended September 30, 2008. The increase in readvolume was primarily due to the growth in our customer base along withincreased volumes from existing customers and customers acquired in the Diagnaacquisition. Approximately 24% and 23% of our revenue from reads for the threeand nine months ended September 30, 2008, respectively, was derived fromfinal reads.  The remaining 76% and 77%of our revenue from reads for the three and nine months ended September 30,2008, respectively, was derived from preliminary reads.

 

On July 8, 2008, we entered into amulti-year teleradiology services agreement with Lion City Radiology ofSingapore to provide preliminary interpretations of CT and MRI images forimaging centers affiliated with Lion City Radiology located in Singapore andthe United Arab Emirates.  The agreementalso contemplates the provision of final interpretations upon approval by theSingapore Ministry of Health.

 

The following discussion pertains to ourfinancial position as of September 30, 2008 and December 31, 2007,and our results of operations for the three and nine months ended September 30,2008 and 2007. Results of the periods are not necessarily indicative of theresults to be expected for the complete year.

 

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**Basis of Presentation**

 

We consolidate our financial results underthe principles of Financial Accounting Standards Board, or FASB, InterpretationNo. 46R, *Consolidation of VariableInterest Entities,* or FIN 46R, which requires a primarybeneficiary to consolidate entities determined to be variable interestentities, or VIEs. VIEs are those entities which an enterprise funds, and as aresult recognizes, a majority of the entity’s expected losses, receives amajority of the entity’s expected residual returns, or both, as a result ofownership, contractual or other financial interest in the entity. Our AffiliatedMedical Practices were formed as our business expanded to facilitate compliancewith the corporate practice of medicine laws in the various states in which VRCoperates. Although VRC holds no legal ownership in the Affiliated MedicalPractices, as a result of the pricing structure in the management agreementsthat exist between the entities, between January 1, 2005 and September 30,2008, VRC funded losses of certain Affiliated Medical Practices totaling$8.0 million. Prior to January 1, 2005, VRC funded no losses of theAffiliated Medical Practices. Further, VRC will only receive residual returnsup to the amount of previously recognized losses. In addition, the managementof VRC was involved significantly in the design and creation of the AffiliatedMedical Practices and, with the exception of rendering medical judgments, holdssignificant influence over their continuing operations. We have thereforedetermined that the Affiliated Medical Practices are VIEs and that VRC is theirprimary beneficiary as defined by FIN 46R. As a result, we have concludedthat VRC is required to consolidate the Affiliated Medical Practices. Throughconsolidation, we recognize all net losses of each Affiliated Medical Practicein excess of the equity of that Affiliated Medical Practice. We recognize netearnings of each Affiliated Medical Practice only to the extent we arerecovering losses previously recognized by us with respect to that AffiliatedMedical Practice. Earnings of each Affiliated Medical Practice in excess of lossespreviously recognized by us with respect to that Affiliated Medical Practiceare excluded from our earnings and are attributed to the respective equityowners of that Affiliated Medical Practice by recording such earnings asnon-controlling interest in our consolidated financial statements. For thethree and nine months ended September 30, 2008 certain of our AffiliatedMedical Practices experienced net income that resulted in a non-controllinginterest expense of approximately $2,000 and $10,000, respectively.

 

VRL was formed on November 23, 2007 andis located in London, England. VRL is a wholly owned and consolidatedsubsidiary of VRC and was established to facilitate international expansion ofour 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.

 

**Stock Repurchase Program**

 

In August 2008,our Board of Directors authorized the repurchase of up to $8.0 million of ouroutstanding common stock. During the three months ended September 30,2008, we repurchased 197,423 shares of our common stock at an average price of$9.49 per share. Total cash consideration for the repurchased stock wasapproximately $1.9 million. As of September 30, 2008 the remainingauthorization under our stock repurchase program was approximately $6.1million.

 

On October 24,2008 we completed our stock repurchase program. We repurchased an aggregate of 944,760shares at an average purchase price of $8.44 per share. Repurchases took placein the open market and pursuant to trading plans meeting the requirements of Rule 10b5-1of the Securities Exchange Act of 1934.

 

**Critical Accounting Policies**

 

The discussion and analysis of our financialcondition and results of operations are based on our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States of America, or GAAP. The preparation ofthese financial statements in accordance with GAAP requires us to utilizeaccounting policies and make certain estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingencies asof the date 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 

 

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presentationof our financial condition and results of operations, and require criticalmanagement judgment and estimates about matters that are uncertain:

 

·                  principles of consolidation;

 

·                  revenue recognition and allowance fordoubtful accounts;

 

·                  accounting for stock-based compensation; and

 

·                  income taxes.

 

Further information regarding our criticalaccounting policies is included in Management’s Discussion and Analysis in ourAnnual Report on Form 10-K for the year ended December 31, 2007. If actualresults or events differ materially from those contemplated by us in makingthese estimates, our reported financial condition and results of operations forfuture periods could be materially affected.

 

***Principles of Consolidation***

 

VRL was formed on November 23,2007 and is located in London, England. VRL is a wholly owned and consolidatedsubsidiary of VRC and is included with VRC in the following condensed consolidatingbalance sheets as of September 30, 2008 and December 31, 2007, andstatements of operations for the three and nine months ended September 30,2008.

 

As described above, weconsolidate our financial results in accordance with FIN 46R, which requires aprimary beneficiary to consolidate entities determined to be VIEs.  We have determined that VRC is the primarybeneficiary of the Affiliated Medical Practices, as defined by FIN 46R, and asa result is required to consolidate the Affiliated Medical Practices.

 

The following tables show theunaudited condensed consolidating balance sheets as of September 30, 2008and December 31, 2007, and the unaudited condensed consolidatingstatements of operations for the three and nine months ended September 30,2008 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.

 

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**CondensedConsolidating Balance Sheets**

**(unaudited)**

 
| ** **                                      | ** ** | **As of September 30, 2008** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                      | ** ** | ** **                                       | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                       | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | **VRC**                                          | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                      | ** ** | **(in thousands)**                          | ** ** |
| Cash and cash equivalents                       |       | $                                                | 26,464     |   | $ | 1,291 |   | $ | — |   | $ | 27,755 |   |
| Short-term investments                          |       | 7,000                                            |       | — |   | — |   | 7,000 |   |
| Other current assets                            |       | 22,412                                           |       | 11,956 |   | (14,555 | ) | 19,813 |   |
| Non-current assets                              |       | 17,394                                           |       | 19 |   | (19 | ) | 17,394 |   |
| Total assets                                    |       | $                                                | 73,270     |   | $ | 13,266 |   | $ | (14,574 | ) | $ | 71,962 |   |
|                                            |       |                                             |       |   |   |   |   |   |   |
| Current liabilities                             |       | $                                                | 3,502      |   | $ | 21,216 |   | $ | (14,555 | ) | $ | 10,163 |   |
| Other non-current liabilities                   |       | 1,711                                            |       | — |   | (19 | ) | 1,692 |   |
| Total liabilities                               |       | 5,213                                            |       | 21,216 |   | (14,574 | ) | 11,855 |   |
| Non-controlling interest                        |       | —                                           |       | — |   | 18 |   | 18 |   |
| Total stockholders’ equity (deficiency)    |       | 68,057                                           |       | (7,950 | ) | (18 | ) | 60,089 |   |
| Total liabilities and stockholders’ equity |       | $                                                | 73,270     |   | $ | 13,266 |   | $ | (14,574 | ) | $ | 71,962 |   |

 
| ** **                                      | ** ** | **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 September 30, 2008** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                         | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                         | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                            | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                            | ** ** |
| Revenue                                                       |       | $                                                                  | 22,285     |   | $ | 26,291 |   | $ | (19,551 | ) | $ | 29,025 |   |
| Operating costs and expenses                                  |       | 16,761                                                             |       | 26,575 |   | (19,551 | ) | 23,785 |   |
| Operating income (loss)                                       |       | 5,524                                                              |       | (284 | ) | — |   | 5,240 |   |
| Other income                                                  |       | 185                                                                |       | — |   | — |   | 185 |   |
| Income (loss) before non-controlling  interest and income tax |       | 5,709                                                              |       | (284 | ) | — |   | 5,425 |   |
| Non-controlling interest expense                              |       | —                                                             |       | — |   | 2 |   | 2 |   |
| Income tax expense                                            |       | 1,858                                                              |       | 1 |   | — |   | 1,859 |   |
| Net income (loss)                                             |       | $                                                                  | 3,851      |   | $ | (285 | ) | $ | (2 | ) | $ | 3,564 |   |

 
| ** **                                             | ** ** | **Three Months Ended September 30, 2007** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                             | ** ** | ** **                                                         | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | ** **                                                         | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **VRC**                                                            | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                                            | ** ** |
| Revenue                                                |       | $                                                                  | 18,320     |   | $ | 24,490 |   | $ | (18,777 | ) | $ | 24,033 |   |
| Operating costs and expenses                           |       | 15,198                                                             |       | 23,823 |   | (18,777 | ) | 20,244 |   |
| Operating income                                       |       | 3,122                                                              |       | 667 |   | — |   | 3,789 |   |
| Other expense                                          |       | (297                                                               | )          | — |   | — |   | (297 | ) |
| Income before non-controlling interest and  income tax |       | 2,825                                                              |       | 667 |   | — |   | 3,492 |   |
| Non-controlling interest expense                       |       | —                                                             |       | — |   | 1,752 |   | 1,752 |   |
| Income tax expense                                     |       | 1,192                                                              |       | — |   | — |   | 1,192 |   |
| Net income                                             |       | $                                                                  | 1,633      |   | $ | 667 |   | $ | (1,752 | ) | $ | 548 |   |

 
| ** **                                                    | ** ** | **Nine Months Ended September 30, 2008** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                        | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | ** **                                                        | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                    | ** ** | **VRC**                                                           | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | **(in thousands)**                                           | ** ** |
| Revenue                                                       |       | $                                                                 | 60,429     |   | $ | 70,138 |   | $ | (52,301 | ) | $ | 78,266 |   |
| Operating costs and expenses                                  |       | 47,518                                                            |       | 70,983 |   | (52,301 | ) | 66,200 |   |
| Operating income (loss)                                       |       | 12,911                                                            |       | (845 | ) | — |   | 12,066 |   |
| Other income                                                  |       | 450                                                               |       | — |   | — |   | 450 |   |
| Income (loss) before non-controlling  interest and income tax |       | 13,361                                                            |       | (845 | ) | — |   | 12,516 |   |
| Non-controlling interest expense                              |       | —                                                            |       | — |   | 10 |   | 10 |   |
| Income tax expense                                            |       | 4,936                                                             |       | 6 |   | — |   | 4,942 |   |
| Net income (loss)                                             |       | $                                                                 | 8,425      |   | $ | (851 | ) | $ | (10 | ) | $ | 7,564 |   |

 

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| ** **                                             | ** ** | **Nine Months Ended September 30, 2007** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                             | ** ** | ** **                                                        | ** ** | **Affiliated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | ** **                                                        | ** ** | **Medical** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                             | ** ** | **VRC**                                                           | ** ** | **Practices** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                                           | ** ** |
| Revenue                                                |       | $                                                                 | 48,071     |   | $ | 65,440 |   | $ | (50,213 | ) | $ | 63,298 |   |
| Operating costs and expenses                           |       | 41,524                                                            |       | 64,961 |   | (50,213 | ) | 56,272 |   |
| Operating income                                       |       | 6,547                                                             |       | 479 |   | — |   | 7,026 |   |
| Other expense                                          |       | (190                                                              | )          | — |   | — |   | (190 | ) |
| Income before non-controlling interest and  income tax |       | 6,357                                                             |       | 479 |   | — |   | 6,836 |   |
| Non-controlling interest expense                       |       | —                                                            |       | — |   | 2,091 |   | 2,091 |   |
| Income tax expense                                     |       | 2,579                                                             |       | — |   | — |   | 2,579 |   |
| Net income                                             |       | $                                                                 | 3,778      |   | $ | 479 |   | $ | (2,091 | ) | $ | 2,166 |   |

 

***Revenue Recognition and 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 doubtfulaccounts at a level that our management estimates to be sufficient to absorbfuture losses due to accounts that are potentially uncollectible. The allowanceis based on the current aging of past due accounts, our historical experience,the financial condition of the customer and the general economic conditions ofeach customer’s market place. Management uses all information available to themin establishing what we believe is an adequate allowance to absorb futurelosses. While our historical credit losses have not differed materially fromour estimates, and we do not currently believe any material changes inestimates are likely in the near future, actual future results could differmaterially from current estimates resulting in an increase or decrease in cashflows from receivable collections and/or in the allowance for doubtful accountsand the corresponding provision for bad debt expense. Any such changes inestimates could have a material impact on our consolidated balance sheets,statements of operations and/or cash flows in subsequent periods. We maintainedan allowance for doubtful accounts of approximately $422,000 and $328,000 as ofSeptember 30, 2008 and December 31, 2007, respectively.

 

We record an allowance for sales credits thatour management estimates to be adequate to cover future sales credits grantedwhich relate primarily to maintaining customer satisfaction with our services.The allowance 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 materiallyfrom these estimates resulting in an increase in the allowance for salescredits and the corresponding provision for sales credits. We maintained anallowance for sales credits of approximately $2,000 and $15,000 as of September 30,2008 and December 31, 2007, respectively.

 

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

 

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

 

***Employee Stock-Based Compensation.***  Wealso record stock-based compensation expense in connection with any award ofstock options to employees and directors. We calculate the stock-basedcompensation expense associated with such awards to our employees and directorsgranted prior to January 1, 

 

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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 with Statementof Financial Accounting Standards No. 123R, *Accounting for Stock Based Compensation*, or SFAS No. 123R,for awards granted on or after January 1, 2006, by determining the fairvalue using a Black-Scholes model. We calculate the stock-based compensationexpense related to awards to our employees and directors based on the fairvalue of awards on the date granted. Employee stock-based compensation expenseis included in sales, general and administrative expense.

 

***Determination of Fair Value of Our Stock Options.***  Asdiscussed above, we record stock-based compensation expense associated with ourawards of stock options in accordance with SFAS No. 123R and EITF Issue No. 96-18,as applicable, which require us to calculate the expense associated with such awardsby 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 NASDAQGlobal Market, which commenced on November 15, 2007, our Board ofDirectors considered 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. As of November 15, 2007, we use the closing price of our commonstock on the NASDAQ Global Market on the date of grant to determine theexercise price of such options.

 

The following table shows the fair value ofone share of our common stock and the exercise price of one option granted onall of the stock option grant dates during the nine months ended September 30,2008 and 2007.

 
| **Grant Date**    | ** ** | **Fair Value of One  Share of  Common Stock** | ** ** | **Exercise Price  of One Option  Granted** | ** ** |
|------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| April 1, 2007     |       | $                                                                      | 12.00      |                                                      | $          | 12.00 |   |
| April 2, 2007     |       | 12.00                                                                  |       | 12.00                                                     |       |
| May 9, 2007       |       | 12.00                                                                  |       | 12.00                                                     |       |
| May 29, 2007      |       | 12.00                                                                  |       | 12.00                                                     |       |
| June 20, 2007     |       | 19.23                                                                  |       | 19.23                                                     |       |
| January 28, 2008  |       | 17.55                                                                  |       | 17.55                                                     |       |
| February 4, 2008  |       | 16.46                                                                  |       | 16.46                                                     |       |
| February 27, 2008 |       | 17.75                                                                  |       | 17.75                                                     |       |
| February 29, 2008 |       | 17.38                                                                  |       | 17.38                                                     |       |
| April 14, 2008    |       | 16.54                                                                  |       | 16.54                                                     |       |
| May 7, 2008       |       | 14.52                                                                  |       | 14.52                                                     |       |
| May 12, 2008      |       | 13.40                                                                  |       | 13.40                                                     |       |
| May 19, 2008      |       | 11.75                                                                  |       | 11.75                                                     |       |
| May 30, 2008      |       | 10.20                                                                  |       | 10.20                                                     |       |
| June 5, 2008      |       | 12.49                                                                  |       | 12.49                                                     |       |
| June 30, 2008     |       | 13.25                                                                  |       | 13.25                                                     |       |
| September 4, 2008 |       | 12.17                                                                  |       | 12.17                                                     |       |
| September 8, 2008 |       | 12.86                                                                  |       | 12.86                                                     |       |
|                        |            |                                                                        |            |                                                           |            |  |  |

 

***Income Taxes***

 

VRC recognizes income taxes under the assetand liability 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.

 

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Developing a provision forincome taxes, including the effective tax rate and the analysis of potentialtax exposure items, if any, requires significant judgment and expertise infederal, state and foreign income tax laws, regulations and strategies,including the determination of deferred tax assets. Our judgment and taxstrategies are subject to audit by various taxing authorities. While we believewe have provided adequately for our income tax liabilities in the consolidatedfinancial statements, adverse determinations by these taxing authorities couldhave a material adverse effect on our consolidated financial condition, resultsof operations, and/or cash flows.

 

As previously noted, weconsolidate our financial results under the provisions of FIN 46R. Forincome tax purposes, however, we are not considered a consolidated entity. As aresult, income generated by the Affiliated Medical Practices, as well as any lossesthey are able to fund, are excluded from VRC’s calculation of income taxliability. In addition, losses generated by the Affiliated Medical Practicesthat are funded by VRC result in temporary differences between VRC’s book andtax bases of accounting. These temporary differences will reverse in futureperiods to the extent those losses are able to be recovered by VRC.

 

**FactorsAffecting Our Results of Operations**

 

***Revenue***

 

We generate substantiallyall of our revenue from the radiology services that we provide to ourcustomers. We provide these services pursuant to contracts that typically havea one-year term and automatically renew for successive one-year terms unlessterminated by the customer or by us. The amount that we charge for ourradiology services varies by customer and is based upon a number of factors,including the hours of coverage, the number of reads, whether the reads arepreliminary reads or final reads, and the technical and administrative servicesprovided. We recognize revenue when a read has been completed and we determinethat payment for the read is reasonably assured. We typically bill ourcustomers at the beginning of the month following the month in which theservices were provided. Because we primarily contract directly with ourcustomers and are paid directly by our customers, we do not currentlymaterially depend upon payment by third party payers such as Medicare,Medicaid, private insurance or patients.

 

We have experiencedsignificant revenue growth from $27.0 million in 2005, to$54.1 million in 2006 and $86.2 million for the year ended December 31,2007. In addition, our revenue grew from $63.3 million for the nine monthsended September 30, 2007 to $78.3 million for the nine months ended September 30,2008. This growth in revenue resulted from:

 

·                  an increase in our customer base;

 

·                  an increase in utilization of our services byour customers;

 

·                  an increase in provision of higher-pricedfinal reads;

 

·                  high customer retention rates; and

 

·                  our acquisition of Diagna.

 

The above factors were partially offset by a decline in our averageprice per study and a decline in some site volume during the three and ninemonths ended September 30, 2008.

 

As of September 30,2008, our affiliated radiologists provided services to 601 customers serving978 medical facilities, which included 915 hospitals representing approximately15% of hospitals in the United States.

 

***Operating Expenses***

 

Our operating expensesconsist of professional services expense, sales, general and administrativeexpense and depreciation and amortization.

 

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

 

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

 

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

 

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

 

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

 

***Other  Income (Expense)***

 

Other income (expense)consists primarily of non-operating interest income earned on cash balances,investments held in demand deposit accounts and short-term investments, offsetfrom time to time by interest expense on debt that may be outstanding.

 

***Redeemable Preferred Stock Accretion***

 

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

 

**Trends inOur Business and Results of Operations**

 

***Revenue***

 

Our business has grownrapidly since inception. Recently this growth has been driven by an increase inthe demand for our services and a corresponding increase in our customer base.We have historically experienced an increase in the utilization of our servicesby our existing customers, the provision of final reads, a high customerretention rate and the growth in the use of diagnostic imaging technologies andprocedures in the healthcare market. Our revenue growth has resulted primarilyfrom increased 

 

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

 

Thetotal number of reads we performed has increased on a quarter-over-quarterbasis for the past eight quarters as follows:

 
| ** **                                 | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| ** **                                 | ** ** | **September 30,**           | ** ** | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** | **June 30,** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                                 | ** ** | **2008**                         | ** ** | **2008** | ** ** | **2008** | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2007** | ** ** | **2006** | ** ** |
| Total reads                                |       | 600,386                          |       | 538,194 |   | 470,694 |   | 453,280 |   | 473,263 |   | 413,167 |   | 352,149 |   | 309,151 |   |
| Percentage growth  over prior year quarter |       | 26.9                             | %          | 30.3 | % | 33.7 | % | 46.6 | % | 56.5 | % | 74.1 | % | 90.8 | % | 99.8 | % |

 

Our volumes are affected byseasonality. While our volumes have continued to grow each year, we typicallyexperience increased demand for our services and higher volume growth duringthe third quarter of the year. We believe that during that time there are anincreased amount of outdoor and transportation activities, which leads to morehospital visits, as well as there being more frequent vacation time taken byour customers’ radiologists. During the first quarter of each year, whenweather conditions are colder for a large portion of the United States, we havehistorically experienced lower volume growth than that experienced during thelater half of the year. We expect this seasonality with respect to our volumesto continue. We have also recently seen a lower demand for additional servicesfrom our current customers which we attribute to a corresponding decrease inthe numbers of hospital admissions, and to two of our large customers’ decisionto in source some of the reads they would otherwise send to us. As a result,our operating results may be subject to seasonal fluctuations, which makes ourresults difficult to predict and could cause our performance to fall short ofquarterly expectations. We also expect to derive revenue in the future fromcontracts we have recently entered into for the licensing of our technologyinfrastructure and the provision of management and support services, and fromthe deployment of our services in overseas markets.

 

In addition, our revenuesare affected by fluctuations in the price per study charged to the customers towhom we provide service. We have historically seen the greatest amount of pricevolatility in plain film reads.  In thenine months ended September 30, 2008 we began to see additional pricedeclines on our preliminary reads and most notably in the CT modality. Weexpect recent pricing trends to continue, however we anticipate there will becontinued quarterly variations and that any negative price trends will belargely offset by continuing improvements in operating efficiencies. The tablebelow illustrates the year over year percentage change in the average revenueper read for lower price plain film reads and all other modalities for thethree and nine months ended September 30, 2008 and 2007:

 
| ** **              | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **              | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
| Plain film(1)           |       | (7.6                                                     | )%         | (7.0                                                    | )%         | (7.7 | )% | (7.1 | )% |
| All other modalities(2) |       | (4.3                                                     | )%         | (1.2                                                    | )%         | (3.9 | )% | (0.1 | )% |
| Total                   |       | (5.0                                                     | )%         | (3.3                                                    | )%         | (4.8 | )% | (2.4 | )% |

 

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

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

 

***Physician Cash Compensation Expense***

 

Since our inception, ourphysician cash compensation expense has increased each year as we have addedmore affiliated radiologists to fulfill the increased demand for our servicesas our business and customer base have grown. However, physician cashcompensation expense as a percentage of revenue has generally decreased due tothe increased productivity of our affiliated radiologists. During the threemonths ended September 30, 2008, we saw an increase in physiciancompensation as a percentage of revenue caused by excess capacity related tolower than anticipated volumes. Also, the increases in productivity by theexisting affiliated radiologists have been, and may continue to be, offset, inpart, by significant increases in newly engaged affiliated radiologists and thecosts associated with the typical 90- to 180-day period during which newlyengaged affiliated radiologists obtain necessary state licenses and hospitalcredentials, and thereafter become accustomed to our workflow technology. Weexpect that our physician cash compensation expense will continue to increase,but will decrease as a percentage of revenue over time as our expanding base ofindependent radiologists continues to grow.

 

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***Physician Stock-Based CompensationExpense***

 

Physician stock-basedcompensation expense is a non-cash expense that fluctuates based upon the fairvalue of our common stock underlying the awards at the close of each reportingperiod as required by EITF Issue No. 96-18. As the value of an award isbased on the underlying value of our common stock, we may record additionalexpense or income based on fluctuations in that value. Our physicianstock-based compensation expense may increase or decrease in future periods ifwe issue additional options and other stock-based awards to our affiliatedradiologists and/or if the value of our common stock increases or decreases.However, the amount of expense or income for any period attributable tophysician stock-based compensation fluctuates and is difficult to predict.

 

***Medical Liability Expense***

 

Our medical liability expensehas increased each year since inception due to increases in our medicalliability insurance premiums primarily associated with the increased volume ofreads our affiliated radiologists have performed, but has decreased as apercentage of revenue. We expect this trend will continue.

 

***Sales, General and AdministrativeExpense***

 

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

 

**Results ofOperations**

 

Thefollowing table sets forth selected consolidated statements of operations datafor each of the periods indicated as a percentage of revenue.

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenue                                             |       | 100.0                                                | %          | 100.0                                               | %          | 100.0 | % | 100.0 | % |
| Operating costs and expenses:                       |       |                                                 |       |                                                |       |   |   |   |   |
| Professional services                               |       | 44.4                                                 |       | 48.9                                                |       | 44.9 |   | 51.2 |   |
| Physician cash compensation                         |       | 44.5                                                 |       | 43.7                                                |       | 44.6 |   | 44.8 |   |
| Physician stock-based compensation                  |       | (1.5                                                 | )          | 3.6                                                 |       | (1.3 | ) | 4.6 |   |
| Medical liability expenses                          |       | 1.4                                                  |       | 1.6                                                 |       | 1.6 |   | 1.8 |   |
| Sales, general and administrative                   |       | 33.1                                                 |       | 32.6                                                |       | 35.4 |   | 35.0 |   |
| Depreciation and amortization                       |       | 4.4                                                  |       | 2.7                                                 |       | 4.3 |   | 2.7 |   |
| Total operating costs and expenses                  |       | 81.9                                                 |       | 84.2                                                |       | 84.6 |   | 88.9 |   |
| Operating income                                    |       | 18.1                                                 |       | 15.8                                                |       | 15.4 |   | 11.1 |   |
| Interest income (expense), net                      |       | 0.6                                                  |       | (1.2                                                | )          | 0.6 |   | (0.3 | ) |
| Non-controlling interest expense(1)                 |       | —                                               | (1)        | 7.3                                                 |       | — | (1) | 3.3 |   |
| Income tax expense                                  |       | 6.4                                                  |       | 5.0                                                 |       | 6.3 |   | 4.1 |   |
| Net income                                          |       | 12.3                                                 |       | 2.3                                                 |       | 9.7 |   | 3.4 |   |
| Cash dividends paid on preferred stock              |       | —                                               |       | (56.6                                               | )          | — |   | (21.5 | ) |
| Series A Cumulative Redeemable  Convertible    |       |                                                 |       |                                                |       |   |   |   |   |
| Preferred Stock accretion                           |       | —                                               |       | (20.6                                               | )          | — |   | (39.6 | ) |
| Net income (loss) available to common  stockholders |       | 12.3                                                 | %          | (74.9                                               | )%         | 9.7 | % | (57.7 | )% |

 

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(1) Non-controllinginterest for the three and nine months ended September 30, 2008 representsless than 0.1% as a percentage of revenue.

 

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

 

***Revenue***

 
| ** **         | ** ** | **Three Months Ended**     | ** ** | ** ** | ** ** | ** **          | ** ** |
|--------------------|------------|--------------------------------------|------------|------------|------------|---------------------|------------|
| ** **         | ** ** | **September 30,**               | ** ** | **Change** | ** ** |
| ** **         | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **         | ** ** | **(dollars in thousands)** | ** ** |
| Revenue from reads |       | $                                    | 28,653     |       | $          | 23,809              |       | $ | 4,844 |   | 20.3 | % |
| Other revenue      |       | 372                                  |       | 224        |       | 148                 |       | 66.1 |   |
| Total revenue      |       | $                                    | 29,025     |       | $          | 24,033              |       | $ | 4,992 |   | 20.8 | % |

 

The 20.8% increase inrevenue for the three months ended September 30, 2008, as compared to thethree months ended September 30, 2007, resulted primarily from an increasein the number of customers to whom we provided services and increased volumefrom existing customers, which was partially offset by a 5.0% decline in ouraverage price per read. The number of customers to whom we provide servicesincreased to 601 as of September 30, 2008, from 457 as of September 30,2007. The number of medical facilities to whom we provide services increased to978 as of September 30, 2008, from 787 as of September 30, 2007. Samesite volume growth increased approximately 1% for the three months ended September 30,2008, as compared to the three months ended September 30, 2007. Same sitevolume growth measures the percentage increase in the number of reads over thecomparable prior year period generated by a facility that has been undercontract for at least three months at the beginning of the measurement periodand remains a customer throughout that period.

 

***Operating Costs and Expenses***

 

***Professional Services***

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** | **Percentage**      | ** ** | **Three Months Ended**     | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                           | ** ** | **September 30, 2008** | ** ** | **of Revenue** | ** ** | **September 30, 2007**     | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                                           | ** ** | ** **                       | ** ** | ** **          | ** ** | **(dollars in thousands)** | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Physician cash compensation expense                  |       | $                                | 12,908     |                | 44.5       | %                                    | $          | 10,498              |       | 43.7                | %          | $ | 2,410 |   | 23.0 | % |
| Physician stock-based compensation (income)  expense |       | (419                             | )          | (1.5                | )          | 875                                  |       | 3.6                 |       | (1,294              | )          | (147.9 | ) |
| Medical liability expense                            |       | 410                              |       | 1.4                 |       | 375                                  |       | 1.6                 |       | 35                  |       | 9.3 |   |
| Professional services                                |       | $                                | 12,899     |                | 44.4       | %                                    | $          | 11,748              |       | 48.9                | %          | $ | 1,151 |   | 9.8 | % |

 

The 9.8% increase inprofessional services expense for the three months ended September 30,2008, compared to the three months ended September 30, 2007, resultedprimarily from an increase in physician cash compensation expense associatedwith our increased number of affiliated radiologists and an increase in thetotal number of reads performed by our radiologists together with additionalmedical liability insurance premiums. This increase was partially offset by a decrease in non-cash physicianstock-based compensation which resulted from the declining price of our stockduring the quarter ended September 30, 2008. For the three months ended September 30,2008, the number of physicians performing reads increased 26.4%, from 106 as ofSeptember 30, 2007 to 134 as of September 30, 2008. The increase inphysician cash compensation expense as a percentage of revenue from 43.7% forthe three months ended September 30, 2007 to 44.5% for the three monthsended September 30, 2008 resulted primarily from excess capacity caused bylower than expected volumes during the three months ended September 30,2008 from the factors described in “Trends in Our Business and Results ofOperations - Revenue” above. We believe that this is a short term trend andthat while physician cash compensation expense will continue to increase as wecontinue to grow, it will decrease as a percentage of revenue over time.

 

***Sales, General and Administrative***

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Percentage**      | ** ** | **Three Months Ended**     | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | **September 30, 2008** | ** ** | **of Revenue** | ** ** | **September 30, 2007**     | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                        | ** ** | ** **                       | ** ** | ** **          | ** ** | **(dollars in thousands)** | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Sales, general and administrative |       | $                                | 9,600      |                | 33.1       | %                                    | $          | 7,842               |       | 32.6                | %          | $ | 1,758 |   | 22.4 | % |
|                                   |            |                                  |            |                     |            |                                      |            |                     |            |                     |            |  |  |  |  |  |

 

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The 22.4% increase in sales,general and administrative expense for the three months ended September 30,2008, compared to the three months ended September 30, 2007, resulted fromincreased expenses for employee compensation, sales and marketing, informationtechnology, licensing and credentialing and other general and administrativeexpense.

 

·                  ***EmployeeCompensation.***  Our employee compensation expense increasedfrom $4.6 million for the three months ended September 30, 2007 to$4.7 million for the three months ended September 30, 2008. Thisresulted primarily from an increase in non-cash employee stock basedcompensation expense and the hiring of additional administrative and operationspersonnel to manage, operate and maintain our business.  The increase in non-cash employee stock-basedcompensation expense relates primarily to an increase in the number of optionsoutstanding as of September 30, 2008 and the increase in the fair value ofthose options when they were granted. These increases were partially offset by a decrease in performance-basedbonus compensation. As of September 30, 2008, the number of non-sales andmarketing employees increased 7.6% over September 30, 2007. Employeecompensation expense as a percentage of revenue was 16.3% and 19.0% for thethree months ended September 30, 2008 and 2007, respectively.

 

·                  ***Sales andMarketing.***  Our sales and marketing expenses increasedfrom $627,000 for the three months ended September 30, 2007 to $1.2million for the three months ended September 30, 2008. The 91.4% increaseresulted primarily from additional compensation expense related to an increasednumber of sales and marketing personnel. As of September 30, 2008, thenumber of sales and marketing personnel increased 52.2% over September 30,2007. Sales and marketing expenses as a percentage of revenue were 4.0% and2.6% for the three months ended September 30, 2008 and 2007, respectively.

 

·                  ***InformationTechnology.***  Our information technology expense increasedfrom $492,000 for the three months ended September 30, 2007 to $861,000for the three months ended September 30, 2008. The 75.0% increase resultedfrom additional provisioning and maintenance costs for communications bandwidthand additional software transactional costs associated with increased studyvolumes. Information technology expense as a percentage of revenue was 3.0% and2.0% for the three months ended September 30, 2008 and 2007, respectively.

 

·                  ***Licensingand Credentialing.***  Our licensing and credentialing relatedexpenses increased from $229,000 for the three months ended September 30,2007 to $346,000 for the three months ended September 30, 2008. The 51.1%increase relates primarily to the amount and timing of initial and renewallicense applications for our affiliated radiologists. This increase waspartially offset by the comparatively lower costs of renewal applications.Licensing and credentialing related expenses as a percentage of revenue were1.2% and 1.0% for the three months ended September 30, 2008 and 2007,respectively.

 

·                  ***OtherGeneral and Administrative.***  Our other general and administrative expensesincreased from $1.9 million for the three months ended September 30,2007 to $2.5 million for the three months ended September 30, 2008.The 31.6% increase resulted primarily from a charge for our deductible due toadverse developments on a medical malpractice claim and an increase in travelexpenses.  These increases were partiallyoffset by reduction in legal expenses and shipping costs for the three monthsended September 30, 2008 when compared to the three months ended September 30,2007.  Additionally, we experiencedincreases in outside accounting expenses and filing fees related to the costsof being a public company, as well as increases in corporate insurance expense,repairs and maintenance expense and other facilities related expenses resultingfrom the growth in our business. Other general and administrative expenses as apercentage of revenue were 8.6% and 8.0% for the three months ended September 30,2008 and 2007, respectively.

 

The increase in sales,general and administrative expense as a percentage of revenue was due primarilyto the increase in sales and marketing expense, additional provisioning andmaintenance costs for communications bandwidth and the accrual for ourdeductible related to adverse developments on a medical malpractice claimduring the quarter ended September 30, 2008.  We believe that sales, general andadministrative expenses, including the costs related to being a public company,will increase as we continue to grow. We also anticipate that in the near termour sales, general and administrative expense as a percentage of 

 

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revenue will increase, however, we believethat this expense will decrease as a percentage of revenue over time.

 

***Depreciation and Amortization Expense.*** Depreciation and amortization expense increased from $654,000 for thethree months ended September 30, 2007 to $1.3 million for the three monthsended September 30, 2008. This 98.8% increase was due primarily to theadditional capital equipment purchased for our operations and the amortizationof customer relationship and non-compete intangible assets, which resulted fromour acquisition of Diagna. We believe that depreciation and amortizationexpense will increase in the future. Depreciation and amortization expense as apercentage of revenue was 4.4% and 2.7% for the three months ended September 30,2008 and 2007, respectively.

 

***Interest (Expense) Income, Net.*** Interest (expense) income, net, increased from expense of $297,000 forthe three months ended September 30, 2007 to income of $185,000 for thethree months ended September 30, 2008. This increase in interest incomerelates primarily to the interest earned on the proceeds from our initialpublic offering and the fact that we had no debt outstanding during the threemonths ended September 30, 2008.

 

***Non-Controlling Interest Expense.*** Through consolidation, we recognize all net losses of the AffiliatedMedical Practices in excess of the equity of the Affiliated Medical Practices.During the three months ended September 30, 2007, VRP experienced netincome that increased its positive equity position and, as a result, werecognized non-controlling interest expense of $1.8 million. During the threemonths ended September 30, 2008, one of the Affiliated Medical Practicesexperienced net income that increased its positive equity position. As aresult, for the three months ended September 30, 2008, we recognizednon-controlling interest expense of $2,000.

 

***Income Tax Expense.***  Income tax expense increasedfrom $1.2 million for the three months ended September 30, 2007 to$1.9 million for the three months ended September 30, 2008, whichresulted primarily from an increase in pre-tax net income for VRC ofapproximately $2.8 million for the three months ended September 30, 2007to approximately $5.7 million for the three months ended September 30,2008. The increase in income tax expense was partially offset by a $405,000research and development tax credit VRC was able to utilize during the threemonths ended September 30, 2008. As previously discussed, we consolidateour financial results in accordance with FIN 46R. However, for income taxpurposes, VRC is a single tax entity that is taxed as a corporation and is notincluded in a tax consolidated group with the Affiliated Medical Practices. Asa result, tax losses of the Affiliated Medical Practices are not available tooffset taxable income of VRC. The difference in the consolidated group forfinancial statement purposes and tax purposes, combined with the valuationallowances established for deferred tax assets related to net operating losscarryforwards of certain of the Affiliated Medical Practices, also contributedto the increase in income tax expense for the three months ended September 30,2008 compared to the three months ended September 30, 2007. The totalityof these factors resulted in an effective tax rate of 34.3% for the threemonths ended September 30, 2008 compared to a rate of 68.5% for the threemonths ended September 30, 2007.

 

***Preferred Stock Accretion.***  Preferred stock accretiondecreased from $5.0 million for the three months ended September 30,2007 to zero for the three months ended September 30, 2008. All shares ofour Series A Preferred Stock were converted to common stock upon closingof our initial public offering in November 2007, and as a result, therewas no further recognition of preferred stock accretion or decretion for thethree months ended September 30, 2008.

 

**Comparisonof the Nine Months Ended September 30, 2008 and September 30, 2007**

 

***Revenue***

 
| ** **         | ** ** | **Nine Months Ended**      | ** ** | ** ** | ** ** | ** **          | ** ** |
|--------------------|------------|--------------------------------------|------------|------------|------------|---------------------|------------|
| ** **         | ** ** | **September 30,**               | ** ** | **Change** | ** ** |
| ** **         | ** ** | **2008**                             | ** ** | **2007**   | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **         | ** ** | **(dollars in thousands)** | ** ** |
| Revenue from reads |       | $                                    | 77,215     |       | $          | 62,760              |       | $ | 14,455 |   | 23.0 | % |
| Other revenue      |       | 1,051                                |       | 538        |       | 513                 |       | 95.4 |   |
| Total revenue      |       | $                                    | 78,266     |       | $          | 63,298              |       | $ | 14,968 |   | 23.6 | % |

 

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The23.6% increase in revenue for the nine months ended September 30, 2008, ascompared to the nine months ended September 30, 2007, resulted primarilyfrom an increase in the number of customers to whom we provide services andincreased volume from existing customers, which was partially offset by a 4.8%decline in our average price per read. The number of customers to whom weprovided services increased to 601 as of September 30, 2008, from 457 asof September 30, 2007. The number of medical facilities to whom we provideservices increased to 978 as of September 30, 2008, from 787 as of September 30,2007. Same site volume growth increased approximately 7% for the nine monthsended September 30, 2008, as compared to the nine months ended September 30,2007.

 

***Operating Costs andExpenses***

 

***Professional Services***

 
| ** **                          | ** ** | **Nine Months Ended**  | ** ** | **Percentage**      | ** ** | **Nine Months Ended**      | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                          | ** ** | **September 30, 2008** | ** ** | **of Revenue** | ** ** | **September 30, 2007**     | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                          | ** ** | ** **                       | ** ** | ** **          | ** ** | **(dollars in thousands)** | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Physician cash compensation expense |       | $                                | 34,933     |                | 44.6       | %                                    | $          | 28,379              |       | 44.8                | %          | $ | 6,554 |   | 23.1 | % |
| Physician stock-based               |       |                             |       |                |       |                                 |       |                |       |                |       |   |   |
| compensation  (income) expense      |       | (978                             | )          | (1.3                | )          | 2,928                                |       | 4.6                 |       | (3,906              | )          | (133.4 | ) |
| Medical liability expense           |       | 1,221                            |       | 1.6                 |       | 1,127                                |       | 1.8                 |       | 94                  |       | 8.3 |   |
| Professional services               |       | $                                | 35,176     |                | 44.9       |                                 | $          | 32,434              |       | 51.2                |       | $ | 2,742 |   | 8.5 | % |

 

The 8.5% increase in professional services expense forthe nine months ended September 30, 2008, compared to the nine monthsended September 30, 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.These increases were partially offset by the decrease in non-cash physicianstock-based compensation expense. For the nine months ended September 30,2008, the number of physicians performing reads increased 26.4%, from 106 as ofSeptember 30, 2007 to 134 as of September 30, 2008. The decrease innon-cash physician stock-based compensation expense relates primarily to thedecreased fair value of our common stock during the first nine months of 2008.We believe that physician cash compensation expense will increase as wecontinue to grow, but will decrease as a percentage of revenue.

 

***Sales, General andAdministrative***

 
| ** **                        | ** ** | **Nine Months Ended**  | ** ** | **Percentage**      | ** ** | **Nine Months Ended**      | ** ** | **Percentage**      | ** ** | **Change**          | ** ** |
|-----------------------------------|------------|----------------------------------|------------|---------------------|------------|--------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                        | ** ** | **September 30, 2008** | ** ** | **of Revenue** | ** ** | **September 30, 2007**     | ** ** | **of Revenue** | ** ** | **In Dollars** | ** ** | **Percentage** | ** ** |
| ** **                        | ** ** | ** **                       | ** ** | ** **          | ** ** | **(dollars in thousands)** | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Sales, general and administrative |       | $                                | 27,667     |                | 35.4       | %                                    | $          | 22,137              |       | 35.0                | %          | $ | 5,530 |   | 25.0 | % |
|                                   |            |                                  |            |                     |            |                                      |            |                     |            |                     |            |  |  |  |  |  |

 

The 25.0% increase in sales, general andadministrative expense for the nine months ended September 30, 2008,compared to the nine months ended September 30, 2007, resulted fromincreased expenses for employee compensation, sales and marketing, informationtechnology and other general and administrative expense, partially offset by adecrease in licensing and credentialing costs.

 

·                  ***EmployeeCompensation.***  Our employee compensation expense increasedfrom $12.6 million for the nine months ended September 30, 2007 to$14.2 million for the nine months ended September 30, 2008. The 12.7%increase resulted primarily from the hiring of additional administrative andoperations personnel to manage, operate and maintain our business, and anincrease in non-cash employee stock-based compensation expense.  These increases were partially offset by adecrease in performance-based bonus compensation. As of September 30,2008, the number of non-sales and marketing employees increased 7.6% over September 30,2007. The increase in non-cash employee stock-based compensation expenserelates primarily to an increase in the number of options outstanding as of September 30,2008 and the increase in the fair value of those options when they weregranted.  Employee compensation expenseas a percentage of revenue was 18.1% and 20.0% for the nine months ended September 30,2008 and 2007, respectively.

 

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·                  ***Salesand Marketing.***  Our sales and marketing expenses increasedfrom $2.1 million for the nine months ended September 30, 2007 to $3.0million for the nine months ended September 30, 2008. The 42.9% increaseresulted primarily from additional compensation expense related to an increasednumber of sales and marketing personnel. As of September 30, 2008, thenumber of sales and marketing personnel increased 52.2% over September 30,2007. Sales and marketing expenses as a percentage of revenue were 3.8% and3.4% for the nine months ended September 30, 2008 and 2007, respectively.

 

·                  ***InformationTechnology.***  Our information technology expense increasedfrom $1.4 million for the nine months ended September 30, 2007 to $2.1million for the nine months ended September 30, 2008. The 50.0% increaseresulted from additional provisioning costs for communications bandwidth andadditional software transactional costs associated with increased studyvolumes. Information technology expense as a percentage of revenue was 2.7% and2.2% for the nine months ended September 30, 2008 and 2007, respectively.

 

·                  ***Licensingand Credentialing.***  Our licensing and credentialingrelated expenses decreased from $1.2 million for the nine months ended September 30,2007 to $1.1 million for the nine months ended September 30, 2008. The8.3% 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 1.4% and 1.9% for the ninemonths ended September 30, 2008 and 2007, respectively.

 

·                  ***OtherGeneral and Administrative.***  Our othergeneral and administrative expenses increased from $4.8 million for thenine months ended September 30, 2007 to $7.3 million for the ninemonths ended September 30, 2008. The 52.1% increase resulted primarily from  the settlement of a medical malpractice claimand a charge for our deductible due to adverse developments on another medicalmalpractice claim, an increase in travel expense and a bad debt charge.  Additionally, we experienced increases inoutside accounting, legal and board of director fees relating to the costs ofbeing a public company, as well as increases in hiring expenses, corporateinsurance expense, repairs and maintenance expense and other facilities-relatedexpenses resulting from the growth in our business. Other general andadministrative expenses as a percentage of revenue were 9.4% and 7.5% for thenine months ended September 30, 2008 and 2007, respectively.

 

We believe that sales, general and administrativeexpenses, including the costs related to being a public company, will increaseas we continue to grow. We also anticipate that in the near term our sales,general and administrative expense as a percentage of revenue will increase,however, we believe that this expense will decrease as a percentage of revenueover time.

 

***Depreciation andAmortization Expense.***  Depreciation and amortizationexpense increased from $1.7 million for the nine months ended September 30,2007 to $3.4 million for the nine months ended September 30, 2008. This 100.0%increase was primarily due to the increase in depreciation expense related toadditional capital equipment purchased for our operations and the amortizationof customer relationship and non-compete intangible assets resulting from ouracquisition of Diagna. We believe that depreciation and amortization expensewill increase in the future. Depreciation and amortization expense as apercentage of revenue was 4.3% and 2.7% for the nine months ended September 30,2008 and 2007, respectively.

 

***Interest (Expense)Income, Net.***  Interest (expense) income, net, increasedfrom expense of $190,000 for the nine months ended September 30, 2007 toincome of $450,000 for the nine months ended September 30, 2008. Thisincrease in interest income relates primarily to the interest earned on theproceeds from our initial public offering and the fact that we had no debtoutstanding during the nine months ended September 30, 2008.

 

***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 nine months ended September 30,2007, VRP experienced net income that changed VRP’s equity position to apositive equity position and, as a result, we recognized non-controllinginterest expense of $2.1 million. During the nine months ended September 30,2008, one of the Affiliated Medical Practices experienced net income thatincreased its positive equity position. As a result, for the nine months ended September 30,2008, we recognized non-controlling interest expense of $10,000.

 

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***Income Tax Expense.*** Income tax expense increased from $2.6 million for the nine months endedSeptember 30, 2007 to $4.9 million for the nine months ended September 30,2008, which resulted primarily from an increase in pre-tax net income for VRCof approximately $6.4 million for the nine months ended September 30, 2007to approximately $13.4 million for the nine months ended September 30,2008. The increase in income tax expense was partially offset by a $405,000research and development tax credit VRC was able to utilize during the nine monthsended September 30, 2008. As previously discussed, we consolidate ourfinancial results in accordance with FIN 46R. However, for income taxpurposes, VRC is a single tax entity that is taxed as a corporation and is notincluded in a tax consolidated group with the Affiliated Medical Practices. Asa result, tax losses of the Affiliated Medical Practices are not available tooffset taxable income of VRC. The difference in the consolidated group forfinancial statement purposes and tax purposes, combined with the valuationallowances established for deferred tax assets related to net operating losscarryforwards of certain of the Affiliated Medical Practices, resulted in theincrease in income tax expense for the nine months ended September 30,2008 compared to the nine months ended September 30, 2007. The totality ofthese factors resulted in an effective tax rate of 39.5% for the nine monthsended September 30, 2008 compared to a rate of 54.4% for the nine monthsended September 30, 2007.

 

***Preferred StockAccretion.***  Preferred stock accretion decreased from$25.1 million for the nine months ended September 30, 2007 to zerofor the nine months ended September 30, 2008. All shares of our Series APreferred Stock were converted to common stock upon closing of our initialpublic offering in November 2007, and as a result, there was no furtherrecognition of preferred stock accretion or decretion for the nine months endedSeptember 30, 2008.

 

**Liquidity and Capital Resources**

 

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

 

Our financial position included cash and cashequivalents of $27.8 million and $11.5 million at September 30,2008 and 2007, respectively. We have historically funded our operations fromcash flows generated from our operating activities, by proceeds generated fromthe sale of our stock, and to a lesser extent from borrowings under ourrevolving credit facilities previously in place.

 

The reported changes incash and cash equivalents for the nine months ended September 30, 2008 and2007 are summarized below:

 
| ** **                                       | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                                 | ** ** |
| Net cash provided by operating activities        |       | $                                                       | 12,323     |   | $ | 5,194 |   |
| Net cash used in investing activities            |       | (19,793                                                 | )          | (3,574 | ) |
| Net cash provided by financing activities        |       | 1,738                                                   |       | 3,897 |   |
| (Decrease) increase in cash and cash equivalents |       | $                                                       | (5,732     | ) | $ | 5,517 |   |

 

***Cash Flows fromOperating Activities***

 

For the nine months endedSeptember 30, 2008, we generated $12.3 million of net cash fromoperating activities from net income of $7.6 million. Our net cashfrom operating activities during this period included cash inflows of $1.5million as a result of a decrease in prepaid expenses related to theamortization of prepaid medical liability insurance premiums, $920,000 as aresult of a decrease in current taxes receivable and $1.6 million as a resultof an increase in accrued expenses related primarily to an increase in accruedprofessional services expense.  Theseinflows were partially offset by cash outflows of $4.1 million related to anincrease in accounts receivable resulting primarily from the growth in ourbusiness. In addition, we had non-cash charges of $3.4 million for depreciationand amortization, $925,000 as a result of an increase in deferred income taxesand $143,000 for stock-based compensation.

 

For the nine months ended September 30, 2007, wegenerated $5.2 million of net cash from operating activities from net income of$2.2 million. Our net cash provided by operations during this period includedan increase in our accounts receivable of $5.2 million, which resultedprimarily from the growth in our business and a $1.9 million increase incurrent taxes receivable as a result of a projected taxable loss for the yearended December 31, 2007. In addition, the net cash provided by operatingactivities included an increase in accrued 

 

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expenses of $2.1 million resulting primarily from an increase inprofessional services compensation, and a decrease in prepaid expenses of $1.2million resulting primarily from the amortization of our prepaid medicalmalpractice insurance.

 

***Cash Flows fromInvesting Activities***

 

Net cash used in investing activities was$19.8 million for the nine months ended September 30, 2008, whichresulted primarily from outflows of $6.5 million for the acquisition of Diagna,$7.0 million for the purchase of a short-term investment and $6.2 million incapital expenditures associated with purchases of equipment and continuedinvestment in our information technology infrastructure.

 

Net cash used in investing activities was$3.6 million for the nine months ended September 30, 2007. The cashused was primarily for capital expenditures associated with the purchase ofequipment and continued investment in our information technologyinfrastructure.

 

***Cash Flows fromFinancing Activities***

 

Net cash provided by financing activities was$1.7 million for the nine months ended September 30, 2008. Our netcash provided by financing activities included retained cash of $3.7 million asa result of tax benefits generated by the disqualified disposition of stockoptions during the period and $198,000 of net proceeds from the issuance ofcommon stock relating to the exercise of stock options. These inflows werepartially offset by $1.9 million paid for the repurchase of our common stockand $306,000 for payments of costs related to our initial public offering.

 

Net cash provided by financing activities was $3.9million for the nine months ended September 30, 2007. Our net cashprovided by financing activities included an increase of $3.6 million as aresult of tax benefits generated by the disqualified disposition of stockoptions during the period. In addition, cash flows from financing activitiesincluded net proceeds from the issuance of common stock of $1.2 million thatresulted from the exercise of stock options and warrants during the period, andpayments related to the costs associated with our anticipated initial publicoffering of $674,000. Our net cash provided by financing activities alsoincluded an increase of $41.0 million related to the incurrence of debt underthe term loan under our previous Senior Credit Facility, which was partiallyoffset by an approximately $1.2 million decrease in cash provided by financingactivities resulting from the payment of debt issuance costs and anapproximately $39.9 million decrease resulting from the payment of a dividenddeclared by our Board of Directors.

 

***Future LiquidityRequirements***

 

We believe that our cash balances, including theproceeds from our initial public offering and the expected cash flow fromoperations, 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.

 

**Contractual Obligations andCommitments**

 

On January 22, 2008, we entered into two newlicense agreements for the provision of network related services that allow usto utilize space in a building in Minnetonka, Minnesota, that houses one of ourdata centers. The license agreements commenced on February 15, 2008 and June 1,2008 and have 36 month terms, expiring in February 2011 and May 2011,respectively. Both license agreements have monthly minimum usage requirementsof $10,000 for which we are obligated to pay if actual services used do notexceed these minimums. These service minimums have been recorded as a liabilityas of September 30, 2008, in accordance with FASB Interpretation No. 45,*Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,and FASB Staff Position, or FSP, FIN 45-3, *Application of FASBInterpretation No. 45 to Minimum Revenue Guarantees Granted to a Businessor Its Owners*. The maximum 

 

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potential amount of future payments is $605,000 and the current portionof this obligation is $240,000, which is recorded in other current liabilitieson the consolidated balance sheet as of September 30, 2008.  The non-current portion is recorded in otherliabilities on the consolidated balance sheet as of September 30, 2008.This obligation will become due immediately if we prematurely terminate eitherof the license agreements.

 

We did not have any current or future capital leasecommitments as of September 30, 2008.

 

**Recent Accounting Pronouncements**

 

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 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 material impact to our financial assets and financial liabilities thatare 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 requirements for how an acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, any noncontrolling interests in the acquireeand the goodwill acquired. Some of the key changes under SFAS No. 141Rwill change the accounting treatment for certain specific acquisition relateditems including: (1) accounting for acquired in-process research anddevelopment as an indefinite-lived intangible asset until approved ordiscontinued rather than as an immediate expense; (2) expensingacquisition costs rather than adding them to the cost of an acquisition; (3) expensingrestructuring costs in connection with an acquisition rather than adding themto the cost of an acquisition; (4) including the fair value of contingentconsideration at the date of an acquisition in the cost of an acquisition; and (5) recordingat the date of an acquisition the fair value of contingent liabilities that aremore likely than not to occur. SFAS No. 141R also includes a substantialnumber of new disclosure requirements. SFAS No. 141R applies prospectivelyto business combinations for which the acquisition date is on or after thebeginning of the first annual reporting period beginning on or after December 15,2008, and interim periods within those fiscal years. Early application of thisstatement is prohibited. 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 being 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. We are currently evaluating the impact of thisstatement.

 

In April 2008, the FASB issued FSP No. FAS142-3, *Determination of the Useful Like of IntangibleAssets*,  this FASB StaffPosition amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset. This is effective for fiscal years beginning after December 15,2008. The Company is currently evaluating the impact of this statement.

 

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**ITEM3.****                            ****Quantitative andQualitative Disclosure About Market Risk**

 

***Foreign CurrencyExchange Risk***

 

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

 

***Interest RateMarket Risk***

 

Our cash is invested in bank deposits, demand depositaccounts and certificates of deposit denominated in U.S. dollars. The carryingvalue of our cash, restricted cash, accounts receivable, other current assets,trade accounts payable, accrued expenses and customer deposits approximate fairvalue because of 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 andprocedures were effective to ensure that information required to be disclosedin the reports that we file or submit under the Exchange Act is (i) recorded,processed, summarized and reported within the time periods specified in theapplicable rules and forms, and (ii) accumulated and communicated toour management, including our Chief Executive Officer and Chief FinancialOfficer, to allow timely decisions regarding required disclosure.

 

***Changes in Internal Controls***

 

During the most recent fiscal quarter, 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**

 

**ITEM1.****                            ****Legal Proceedings**

 

We have included information about legal proceedingsin Note 9 of our Notes to Consolidated Financial Statements, which isincorporated herein by reference.  On August 28,2008, the United States Patent and Trademark Office, or PTO, upon completion ofour requested re-examination ruled invalid all claims in both of the patentsupon which Merge eMed, Inc., or Merge, had sued us as described in “Item3. Legal Proceedings” of our Annual Report on Form 10-K for the year endedDecember 31, 2007.   Merge has notyet responded to the PTO action.  Thejudicial stay of proceedings in the lawsuit continues in effect at this time.

 

**ITEM2.****                            ****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, or Diagna, an Idaho-based teleradiologyprovider for total consideration of approximately $6.6 million, which includes$6.0 million of initial purchase price, $504,000 for estimated working capitaland $93,000 in initial direct acquisition costs.  Diagna’s owners may also receive additional cashconsideration of up to an aggregate of $2.2 million to be paid as earn-outpayments to be made over two years. We used cash proceeds from our initialpublic offering to finance this purchase.

 

**Issuer Purchases of Equity Securities**

 
| **Period**                              | ** ** | **Total Number   of Shares   Purchased** | ** ** | **Average Price   Paid per Share** | ** ** | **Total Number of   Shares Purchased   as Part of Publicly  Announced Plans** | ** ** | **Maximum Value that   May Yet Be Purchased   Under the Plan**

**(in  thousands)** | ** ** |
|-----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| August 7, 2008 - August 13, 2008        |       | 69,704                                   |       | $                                  | 10.61      |                                                                          | 69,704     |                                                                                | $          | 7,300 |   |
| September 15, 2008 - September 30, 2008 |       | 127,719                                  |       | 8.87                               |       | 197,423                                                                       |       | 6,100                                                                               |       |
| October 1, 2008 - October 24, 2008      |       | 747,337                                  |       | 8.16                               |       | 944,760                                                                       |       | —                                                                              |       |
| Total                                   |       | 944,760                                  |       | $                                  | 8.44       |                                                                          | 944,760    |                                                                                | $          | — |   |

 

InAugust 2008, our Board of Directors authorized the repurchase of up to$8.0 million of our outstanding common stock. On October 24, 2008 we completed ourstock repurchase program.  Repurchasestook place in the open market and pursuant to trading plans meeting therequirements of Rule 10b5-1 of the Securities Exchange Act of 1934.

 

**ITEM6.****                            ****Exhibits**

 

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

 

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                          |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                 |       | Certification by  Principal Executive Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*** |
| 31.2                 |       | Certification of  Principal Financial Officer pursuant to Rule 13a-14(a) or  15d-14(a) of the Securities Exchange Act of 1934, as amended, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*** |
| 32.1                 |       | Certification by  Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                        |
| 32.2                 |       | Certification by  Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                        |

 

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***                           Filed herewith.

 

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**SIGNATURES**

 

 

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

 
| **Signature**           | ** ** | **Title**                             | ** ** | **Date**              |
|-------------------------|------------|---------------------------------------|------------|-----------------------|
| ** **              | ** ** | ** **                            | ** ** | ** **            |
|                    |       |                                  |       |                  |
| /s/ Sean O. Casey, M.D. |       | Chief Executive  Officer and Chairman |       | November 3, 2008 |
| **Sean O. Casey, M.D.** |       | of the Board of Directors (Principal  |       |                  |
|                    |       | Executive Officer)                    |       |                  |
|                    |       |                                  |       |                  |
|                    |       |                                  |       |                  |
| /s/ Leonard C. Purkis   |       | Chief Financial  Officer (Principal   |       | November 3, 2008 |
| **Leonard C. Purkis**   |       | Financial and Accounting Officer)     |       |                  |

 

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