UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004

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 0-22229

VITAL IMAGES, INC.

(Exact name of registrant as specified in its charter)

(763) 852-4100

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   o   No  ý

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).Yes   ý   No   o

On November 8, 2004, there were 11,775,529 shares of the Registrant’s common stock, par value $.01 per share, outstanding.

VITAL IMAGES, INC.

Quarterly Report on Form 10-Q

For the Quarter Ended September 30, 2004

Table of Contents

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PART I.  FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

VITAL IMAGES, INC.
CONSOLIDATED BALANCE SHEETS

(The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.)

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VITAL IMAGES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

(The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.)

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VITAL IMAGES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

(The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.)

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VITAL IMAGES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(1) BASIS OF PRESENTATION:

The accompanying unaudited consolidated financial statements of Vital Images, Inc. (“Vital Images” or the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America.  In the opinion of management, all adjustments, consisting only of normal recurring adjustments, for a fair presentation have been included. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2003.

(2) MAJOR CUSTOMER AND GEOGRAPHIC DATA:

The following customer accounted for more than 10% of the Company’s total revenue for the periods indicated:

The Company’s accounts receivable are generally concentrated with a small base of customers.  As of September 30, 2004, Toshiba Medical Systems Corporation accounted for 33% of accounts receivable, and as of December 31, 2003, no single customer accounted for more than 10% of accounts receivable.

Export revenue amounted to 20% and 16% of total revenue for the three months ended September 30, 2004 and 2003, respectively.  Export revenue amounted to 17% and 12% of total revenue for the nine months ended September 30, 2004 and 2003, respectively.  Substantially all of the Company’s export revenue is negotiated, invoiced and paid in U.S. dollars.  Gross export revenue by geographic area is summarized as follows:

(3) NET INCOME (LOSS) PER SHARE:

Net income (loss) per share - basic is computed using the weighted average common shares outstanding during the period.  Net income (loss) per share — diluted is computed using the weighted average common shares outstanding and common share equivalents shares outstanding during the period.  Common share equivalents consist of common stock warrants and options to purchase common stock.  Certain potential dilutive shares of common stock were excluded from the diluted earnings per share computation because their exercise prices were greater than the average market price of the common shares during the period and were therefore not dilutive. In addition, potential dilutive shares of common stock were excluded from periods with a net loss because they were anti-dilutive.

The computations for basic and diluted net income (loss) per share for each period are as follows:

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For the three months ended September 30, 2004 and 2003, options and warrants to purchase 556,100 and 0 shares of common stock, respectively, were excluded from the diluted earnings per share computation because they were anti-dilutive.  For the nine months ended September 30, 2004 and 2003, options and warrants to purchase 2,588,423 and 110,500 shares of common stock, respectively, were excluded from the diluted earnings per share computation because they were anti-dilutive.

(4) COMPREHENSIVE INCOME (LOSS):

The components of comprehensive income (loss) were as follows:

Accumulated other comprehensive loss at September 30, 2004 and December 31, 2003 was $28,442 and $0, respectively.

(5) STOCK-BASED COMPENSATION:

The Company has stock-based employee and director compensation plans, which the Company accounts for under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. The Company has adopted the disclosure requirements of Statement of Financial Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation —Transition and Disclosure — an amendment of SFAS No. 123.” The Company continues to apply the recognition and measurement principles as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees.” No stock-based employee and director compensation cost is reflected in net income (loss), as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income (loss) and net income (loss) per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee and director compensation.

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The pro forma effects on the net income (loss) for the nine months ended September 30, 2004 and 2003 may not be indicative of the future results for the full fiscal year due to continuing option activity and other factors.

(6) HINNOVATION, INC. ACQUISITION:

On February 18, 2004, the Company completed the acquisition of HInnovation, Inc. (“HInnovation”) in accordance with the terms and conditions of an Acquisition Agreement and Plan of Reorganization (the “Acquisition Agreement”) dated as of January 8, 2004.  HInnovation is a provider of software solutions that allow physicians to use PCs or notebook computers to access 2D, 3D and 4D medical imaging applications securely over the Internet.  The acquisition of HInnovation was made to acquire products and technology that will enable the Company to more effectively compete in the distributed computing market for 2D/3D/4D visualization and analysis software.

The acquisition was accounted for under the purchase method of accounting and, accordingly, the assets and liabilities acquired were recorded at their estimated fair values at the effective date of the acquisition, and the results of operations have been included in the unaudited consolidated statements of operations since the acquisition date. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill recorded as a result of the acquisition will be subject to an annual impairment test and will not be amortized.

The total purchase price of the HInnovation acquisition was approximately $13.0 million and has been accounted for as the purchase of a business under SFAS No. 141, “Business Combinations.”  The Company acquired all of the outstanding common stock of HInnovation in exchange for $6.0 million in cash paid and 376,262 newly issued shares of common stock issued to the shareholders of HInnovation. The common stock was valued at $6.1 million for accounting purposes.  Vital Images’ stock was valued at $16.2375 per share, which was equal to the average of the closing sale prices of one share of Vital Images’ stock as reported on the NASDAQ National Market for the two consecutive trading days occurring before the first public announcement of the signing of the Acquisition Agreement and the two consecutive trading days occurring immediately after such public announcement date. The Company incurred approximately $0.5 million in direct costs of the acquisition and assumed $0.4 million of liabilities.  In addition, the transaction includes a maximum of $6.0 million of contingent milestone payments comprised of $3.0 million in common stock and $3.0 million in cash.  The contingent milestone payments are based on the achievement of certain revenue targets resulting from the sale of products containing HInnovation technology during the period following the closing date and ending March 25, 2005 - the porting of Vital Images’ product to HInnovation’s product platform and the commercial launch thereof and licensing the HInnovation patented technology within 24 months after the closing date.  The number of shares issued under the contingent milestone payments will be determined based on the average closing price of the Company’s common stock during the 10 trading days before completion of the milestone objective.  However, the Acquisition Agreement provides that the number of shares of Vital Images common stock comprising the contingent consideration cannot exceed 300,000 shares.  If, at the time of its issuance, the value of such stock is less than $3 million due to this limitation on the number of shares, Vital Images will pay the shortfall in cash.  Any contingent payments made by the Company will result in an increase in goodwill. The Company did not assume any stock options or warrants.  As of September 30, 2004, no contingent payments had been earned, and the Company does not expect that any such payments will be earned in 2004.

The purchase price was allocated to the identified assets of HInnovation.  A third-party appraisal firm assisted the Company with the valuation of the identified intangible assets.  The valuation resulted in the allocation of $6.9 million to identifiable intangibles, which

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will be amortized over periods ranging from three to seven years.  The valuation also resulted in the identification of $1.0 million of in-process research and development costs (“R&D”), which were immediately expensed on the closing date as a non-deductible charge for income tax purposes.  In addition, the Company is finalizing the tax attributes acquired from HInnovation.  If successful, there could be a reduction in Vital Images’ net deferred tax liability and a reduction of goodwill of up to approximately $1.1 million.  The final purchase price allocation is also subject to adjustment for payments of contingent consideration in future periods.  There is also the possibility that a contractual service obligation of $0.3 million may be reduced.  This obligation is reflected at its present fair value in deferred revenue.  If the maximum amount of reduction occurs, it will not have a material impact on goodwill, but any reduction of the obligation will be reflected as a reduction of goodwill and deferred revenue.  Until these matters are completed, the purchase price is preliminary and subject to adjustment.

At the time of acquisition, HInnovation had development projects in process, including the collaboration module of its Web-based product (the “Collaboration Module Project”). The Collaboration Module Project involves the design and development of innovative features for Web-based consultation meetings with interactive and synchronized viewing of full-quality images, annotation and mouse movement.  The Collaboration Module Project includes significant and innovative advancements to the HInnovation software platform in the areas of network synchronization of high quality images and user privilege management for online collaboration. The design, verification and other processes involved in the Collaboration Module Project require tools and skills that are new to HInnovation.  The appraisal referenced to above estimated that $1.0 million of the purchase price represents the fair value of purchased in-process R&D related to the Collaboration Module Project, that it has not yet reached technological feasibility and that it has no alternative future uses. This amount was expensed as a non-recurring, non-tax-deductible charge upon consummation of the acquisition.

The appraisal firm applied the income valuation approach to assist the Company in determining the estimated fair value of the purchased in-process R&D.  These estimates were based on the following assumptions:

•       The estimated revenue was based upon HInnovation’s estimate of revenue growth over the next seven years from the revenue growth of primarily the Collaboration Module.

•       The estimated gross margin of 65% to 78% was based upon gross margin for comparable products.

•       The estimated selling, general and administrative expenses were based on consideration of historical operating expenses as a percentage of revenue and HInnovation’s projected operating expenses.

•       The cost to complete each project was based on estimated remaining labor hours and a fully-burdened labor cost and other direct expenses.

•       The discount rate used in the alternative income valuation approach was based on the weighted average cost of capital (WACC). The WACC calculation produces the average required rate of return of an investment in an operating enterprise based on various required rates of return from investments in various areas of that enterprise. The discount rate used in the alternative valuation approach was 35%.  Premiums were added to the WACC to account for the inherent risks in the development of the products, the risks of the products being completed on schedule, and the risk of the eventual sales of the product meeting the expectations of HInnovation.

The first phase of the Collaboration Module was released in the third quarter of 2004.  The first phase provides basic collaboration between users allowing one user to present to another user.  The second, and more sophisticated, phase of the Collaboration Module will provide two-way collaboration between users allowing both users to interact with the data and is expected to be available for general market release in the first quarter of 2005.  Through September 30, 2004, the Company has incurred approximately $133,000 in costs to develop the Collaboration Module.  The Company estimates that it will incur another $167,000 to complete the development of the second phase of the Collaboration Module.  Given the uncertainties of the development process, these estimates are subject to change, and deviations from these estimates may occur.

The total purchase price is as follows:

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The allocation of the total purchase price, which has not been finalized, is as follows:

Identified Intangible Assets

Identified intangible assets subject to amortization are as follows:

The amortization periods of the intangible assets subject to amortization are all straight-line, and amortization expense was $312,000 and $802,000 for the three-and nine-month periods ended September 30, 2004.   The estimated future annual amortization expense for identified intangible assets is as follows:

The following factors contributed to a purchase price that resulted in the recognition of goodwill:

•       HInnovation had the first Web-based product in the Company’s market.

•       HInnovation had a patent and patent applications that cover certain important aspects of the underlying technology.

•       HInnovation also had unique technology under development that was included as part of the in-process R&D.

The following unaudited pro forma condensed consolidated results of operations have been prepared as if the acquisition of HInnovation had occurred as of the beginning of the periods presented.  Pro forma adjustments relate to amortization of identified intangible assets and acquired in-process R&D.  The unaudited pro forma condensed consolidated results of operations are not necessarily indicative of results that would have occurred had the acquisition occurred as of the beginning of the periods presented, nor are they necessarily indicative of future results.

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(7)  NEW ACCOUNTING PRONOUNCEMENT:

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition.” SAB 104 supercedes SAB 101, “Revenue Recognition in Financial Statements.” SAB 104’s primary purpose is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of Emerging Issues Task Force (“EITF 00-21”), “Accounting for Revenue Arrangements with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (“the FAQ”) issued with SAB 101 that had been codified in Securities and Exchange Commission SAB Topic 13, “Revenue Recognition.” Selected portions of the FAQ have been incorporated into SAB 104. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. Because the Company’s revenue recognition practices previously conformed to the interpretations codified by SAB No. 104, its adoption did not have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

(8) RESTATEMENTS:

The Company has restated its consolidated financial statements and related footnote disclosures for the three and nine months ended September 30, 2003 to correct the accounting for unrecognized deferred maintenance and service revenue from certain maintenance and service arrangements. The Company has made the appropriate modifications to the consolidated statements of operations and consolidated statement of cash flows to give effect to the adjustment.  The adjustment for the deferred maintenance and service revenue (a) increased maintenance and service revenue, total revenue, operating income, and net income, and (b) decreased the benefit for income taxes for both the three and nine month periods ended September 30, 2003.  There was no change to net income per diluted share for the three months ended September 30, 2003, but an increase to net income per diluted share for the nine months ended September 30, 2003.  As a result of the maintenance and service revenue restatement, the Company also restated the disclosures to the consolidated financial statements to increase revenue from Toshiba Medical Systems by $110,000 and $280,000 and increase revenue from export sales by $28,000 and $69,000 for the three and nine months ended September 30, 2003, respectively.  The Company also restated the disclosures to the consolidated financial statements to correct the computation of pro forma stock-based employee compensation expense for the three and nine months ended September 30, 2003.  The following statements present the effect of the adjustments for the three and nine months ended September 30, 2003:

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Statements of Operations:

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