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Vital Images, Inc. (NASDAQ:VTAL)

Q3 2010 Earnings Call

November 04, 2010 11:30 am ET

Executives

Mike Carrel - President & CEO

Peter Goepfrich - CFO

Analysts

Steven Crowley - Craig-Hallum Capital Group

Sean Wieland - Piper Jaffray

Richard Close - Jefferies & Company

Charles Rhyee - Oppenheimer

Ernie Andberg - Feltl & Company

Steven Crowley - Craig-Hallum Capital Group

Operator

Good day, everyone, and welcome to the Vital Images third quarter earnings conference call. Today's call is being recorded. At this time, I would like to turn the call over to Mike Carrel, President and CEO. Please go ahead, sir.

Mike Carrel

Thank you, Marvin, good morning and welcome to our 2010 third quarter conference call. With me today is Peter Goepfrich, our Chief Financial Officer. I must preface all comments with the Safe Harbor statements. Some of the comments made today will be forward looking and are made under the Private Securities Litigation Reform Act of 1995. Actual results may differ and factors that may cause such results to differ are identified on page seven of the Form 10-K for the year ending December 31, 2009.

We are starting to see growth and improving trends with our technology and strategy these past couple of quarters as we extend our reach to the entire enterprise and expand our clinical footprint to directly improve the care of more patients. Our actions and investments over the past several years have enabled Vital to continue to be the market leader. Our most significant move was to attack the enterprise segment with Vitrea enterprise suite. This business model is geared to accelerate enterprise deployments of our solution, leverage our industry leading clinical solutions and meet and exceed our customers’ expectations.

With this strategy we continue to gain market share. That said we know we must stay on the cutting edge and I am confident of the progress we’ve made investing in key partnerships, technology, our service organization and our sales approach providing the right foundation for growth and creates shareholder value for the long term. We intend to build on our strong brand and expand in a new market including EMR, international and enterprise imaging.

Now on to our quarterly results which demonstrate some of this progress. We are pleased to announce that in a tough market we grew 2010 third quarter revenue to $14.9 million, up sequentially from 14 million in the second quarter and up from 14.3 million in the year-ago period. Some of the highlights include our second straight quarter of direct license growth, our strong gross margins of 75%, up sequentially from 69% and a profitable quarter as measured by both positive adjusted EBITDA and GAAP earnings per share.

While our sales growth rate has not reached its potential yet, the trends are looking positive and we remain confident that our enterprise solution is the right strategy; for the company, our customers and our shareholders. We have stood firm in controlling our operating expenses. Vital’s third quarter adjusted EBITDA of 1.9 million shows a sizable sequential improvement over negative 212,000 in the second quarter as well as a nice gain over 1.2 million in the prior year period.

Importantly we continue to generate cash from operating activities and our balance sheet remains solid with over $137 million in both cash and investments. For more financial details on the quarter I will turn the call over to Peter now.

Peter Goepfrich

Thank you, Mike, I will begin with a few comments regarding revenue. License revenue decreased $194,000 or 3% compared to the third quarter last year. The change consisted of an increase in direct and other distributor license revenue of $669,000 or 72%.

This was offset by decrease in Toshiba license revenue of $863,000 or 18%. License revenue increased $268,000 or 5% compared to the second quarter of 2010. The change consisted primarily of an increase in Toshiba license revenue of $244,000 or 7%. Maintenance and service revenue increased $487,000 from the third quarter last year primarily due to increase in professional services of $343,000 which included a $191,000 relating to development services provided to Medtronic during the third quarter. Maintenance and service revenue increased $596,000 from the second quarter of 2010 primarily due to an increase in professional services of $248,000 which included a previously mentioned $191,000 relating to development services provided to Medtronic and an increase in education revenue of $239,000 driven by an increase in direct sales the past several quarters.

McKesson represented $1.4 million in total revenue. This consisted of license revenue of $249,000, maintenance and service revenue of $1.1 million and hardware revenue of $74,000.

Next I would like to discuss gross margin. Licensee gross margin was 88.6% up slightly from the third quarter last year and up significantly from the second quarter of 2010 primarily due to improved pricing, a decrease in royalty expense and a decrease in third-party software sales. Licensee gross margin will continue to fluctuate based on the mix between installed base customer conversions to Vitrea Enterprise Suite and net new sales, the mix between Vitrea sales and Vitrea Enterprise Suite sales and the volume of third-party software sales.

Maintenance insurance gross margin was 72.4%, up from the third quarter last year and from the second quarter of 2010 due to an increase in maintenance and service revenue and a reduction in consulting expense. Maintenance and service gross margin will continue to fluctuate primarily based on fluctuations in maintenance and service revenue.

Due to these factors as well as the mix between revenue categories, total gross margin was 75.4% compared to 75.8% the third quarter last year and 69.4% the second quarter of 2010. Total gross margin will continue to fluctuate between the low to mid 70s in the near term based on the factors previously noted as well as the mix between revenue categories.

Moving on to operating expenses, operating expenses decreased $1 million compared to the third quarter last year primarily due to decreases and headcount related costs. Operating expenses decreased $655,000 compared to the second quarter of 2010 primarily due to a lower number of trade shows in the third quarter and decreased consulting services and certain headcount related cost.

Total employee count was 237 as of September 30, 2010 compared to 241 as of June 30, 2010 and 253 as of September 30, 2009. It is important to note that the fourth quarter is always our highest sales and market expense quarter by significant amount because the fourth quarter is our busiest trade show quarter including RSNA, the major US Radiology Conference every year. Fourth quarter sales and market expense is typically 1.2 to $1.5 million greater than the third quarter.

As noted in our second quarter earnings release, our Board of Directors approved an additional stock buyback of $20 million, on top of 115,000 shares remain to be purchased under our previously approved plan. During the third quarter we repurchased 451,000 shares for $5.7 million. As of the end of third quarter, we had re-purchased $3.8 million shares for $50.3 million since 2008. Yesterday we also recorded and Vital Images has been awarded 9 qualifying therapeutic discovery project grants from the US government in the amount of $1.5 million based on Vital Images research expenditures for certain products.

The QTDP program provides one-time awards for projects that are determined by the US Department of Health and Human services to achieve reasonable potential to result in new therapy, reduce healthcare costs or significantly advanced for curing cancer. The grants will be recognized as an offset to research and development expense in the fourth quarter of 2010.

These grants are a reflection of Vital Images commitment to innovation, patient care and improved user productivity and communication. Next Mike will provide an update on our corporate priorities.

Mike Carrel

Thanks Peter, we continue to drive enterprise advanced visualization and have laid a foundation around technical solutions, delivery and sales resources focused on true enterprise imaging with no limit. As a reminder Vital key strategies in 2010 are to diversify our revenue, grow our direct enterprise sales channel, expand our product platform and drive customer satisfaction. Let’s take these one by one.

First, diversifying the revenue channels. Over the last several months, we’ve announced key partnerships and expanded agreements with leading healthcare IT companies Cerner and McKesson. We are beginning to see traction from these partnerships and they offer robust growth prospects in new markets in the coming years.

Our distribution agreement with McKesson which we enhanced and extended last year is gaining momentum. We are converting key sites to our enterprise platform and taking share from our competition. Specifically we closed seven deals during the third quarter and total revenue from McKesson was $1.4 million. McKesson recognizes Vital Images as a preferred provider of advanced visualization products and our new enterprise product release has been well received by McKesson’s customers.

Examples of recent new McKesson customers include Continuum Healthcare partners and Nyack hospital in New York City, Waukesha Memorial in Wisconsin, Natividad Medical Center in California and (inaudible) General Hospital in Indiana to name a few. Additionally we now have our first VES McKesson show site at Gwinnett Medical Center in Georgia and the University of Wisconsin. Moreover in preparation for RSNA, McKesson after Vital as it’s only advanced visualization partner to be part of their virtual boot with other leading technology vendors including Nuance, Barco and Cisco another demonstration of McKesson’s commitment to Vital Images.

Turning now to Medtronic. Through this agreement launched in late 2009, Vital Images is providing Medtronic with our Endovascular Stent Planning application for specialists using Medtronic stents to treat aortic aneurysms. In the third quarter we completed the work on the new Thoracic Aortic Aneurysm or TAA application. The majority of the revenue from Medtronic in the third quarter was related to professional services to build this application. Medtronic is excited but the sophistication and automation of the new application in industry first. Our [US role] is unplanned and we are introducing our application in other parts of the world through Medtronic’s regional offices.

Additionally, we are evaluating opportunities to leverage our technologies into other areas of Medtronic in the coming years as well as partnerships from other device manufacturers. Next I am going to provide an update on Toshiba. Our partnership with Toshiba remains strong and we have developed a good relationship with the new management team. Third quarter revenue grew (inaudible) was $7 million, an improvement sequentially from $6.6 million in the second quarter. But down from 8 million a year ago quarter.

More and more of our Toshiba orders in the US are now enterprise deals, an effective validation of our enterprise strategy. The seeking market is facing difficulties due to limited hospital CapEx spending and that is impacting revenue in this category.

Regarding Cerner, on April 30, we announced our relationship with this industry leader to deliver advanced imaging though the EMR. We continue to see positive trending with new opportunities. Due to the life of the sales cycle we do not see any current opportunities contribute to revenue in the third quarter.

However, we remain confident this channel will produce strong results in the coming years. The pipeline in relationship are both excellent and we have done extensive training with our sales and support team over the past month. Brining our technologies to new position demographics through EMR offers opportunity in at a key strategic [trust] for Vital Images.

Our second priority is growing our direct enterprise channel. Vital’s direct business had a very good quarter, direct and total distributor revenue rose at the 7.9 million up sequentially from 7.4 million in the second quarter and 6.3 million in the year ago period, our second straight quarter of growth.

Most direct sales are now enterprise transactions that build the number of physician users while leading to substantial recurring revenue from long-term maintenance in services contracts. Further, we continue to win deals against the competition in some of their key reference sites. Since the beginning of 2009, we have landed or converted more than 150 direct Vitrea Enterprise suite customers and our average deal size in the US direct enterprise transactions is improving.

Over this year, we established a strategic accounting focused on large healthcare systems and we are seeing progress in those high level relationships. Some recent wins include Carolina Medical Center in North Carolina, Banner Sterling Regional Medical Center in Colorado, Rapid Sea Regional Hospital in South Dakota, St. Louis University Hospital in Missouri and in Europe OLV, Ziekenhuis in Antwerp, just to name a few.

Our European team completed five enterprise transactions in third quarter and in China we are pleased to have our first direct deal with our distributed partner, Chindex.

Third quarter international revenue was 4.3 million compared to 4.8 million in the year ago period. Much of the show flow related to the timing of some key deals that we have in Europe. We continue to see excellent long-term growth prospects in China, Europe and Australia.

Our third priority is expanding our product offerings for enterprise growth with platform and clinical applications. We launched Vitrea Enterprise Suite 1.3 in May as planned and has rapidly become both our new standard and a driver behind our direct sales. VES, as we call 1.3 offers new clinical capabilities within enriched set of work flow tools in a true in-client solution.

Cardiac applications include multi-chamber analysis with adult and pediatric options to automate the analysis of atrial and ventricular chambers. Additionally, VES 1.3 enables web based access to MeVis CT1 CAD products, the first and only clinically validated CAD system for chest CT outside of the US (inaudible) and a new myocardial perfusion application are also available.

Just last week we announced that our Vitrea Enterprise Suite has achieved VMware ready status. VMware status means VES has an extensive testing to enable virtualization using VMware technology. This is a major milestone in our strategy. Virtualization especially YF such a close collaboration with VMware the industry leader in virtualization tools is extremely important to our current and future customers.

It is a direct indication of our understanding and responsiveness to the markets needs. The ability to virtualize our products enabled our partners and customers to consolidate their hard work foot print and save on both capital and operational expenses.

These savings can be re-allocated to patient care as well as improving quality of care where needed. It did a very exciting trend in our market and Vital Images in the first advanced visualization provider to achieve this thus reforcing our technology leadership. Additionally, as Peter mentioned in his comment in recognition of our commitment to innovation and patient care at the research and development over the past 18 months, on Monday we are notified that we have been awarded the Qualifying Therapeutic Discovery Project Grant from the US government for approximately $1.5 million. We were the top grant recipient in the state of Minnesota, a state known for medical innovation and this honor reflects the talent of our entire product, research and development teams.

Our fourth priority is aligning with our customer success. In August Vital was re-certified by TSIA, the Technology Services Industry Association for providing superior technical support and services to our customers in North America. Currently, Vital is the only medical imaging software company to earn this certification which we first received in 2009. Earlier this year, we also became the only medical imaging provider to receive J.D. Power and Associates certification for service excellence following a rigorous audit of our service practice and an extensive customer survey.

Service excellence has been and will continue to be a well established priority of Vital Images. We believe it is an essential factor in attracting and retaining customers and growing shareholder value.

I want to share a conversation I had with one of our new customers who recently deployed our VES system. It is a large healthcare system in itself and a Chief Medical Office had the final say about our commitment to customers. "Vital Images is the best vendor we have ever worked with. We love your technology and your people. They are responsive, smart, honest, humble, and care about their customers. I know we made the right decision to go with Vital Images and look forward to being great partners for many years to come. Staying focused on our customer success is not only the right thing to do but also has financial benefits."

Additionally, I’m assuring that we continue to closely monitor the healthcare IT spending environment including CMS actions regarding stage 1 of the final meaningful use rule. That is standards for electronic health records for hospitals participating in Medicare and Medicaid programs.

Incentive payment to hospitals under the American Recovery and Reinvestment Act hinge on meeting these stringent requirements. Understandably, IT administrators are focused on the implications of these requirements. Stage 2 is scheduled to release in 2013 and will address images and imaging reports among other factors and we continue to stay on top of this trend as we move towards the enterprise.

Additionally in august, I joined the Board of MITA or the Medical Industry Technology Alliance, the collective voice of medical imaging technology industry. I am honored to have the opportunity contributing to MITA. Through my Board position Vital will now be an active participant in discussions in positioning and reimbursement in technology assessment practices.

In summary, while the CT market continues to struggle we are pleased with the momentum we are seeing and have seen in the third quarter on both the top and the bottom-line because of our enterprise approach, diversification of revenue and customer focus strategies. We look forward to a great RSNA and a strong end of the year.

With that, we'll open up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Steven Crowley with Craig-Hallum Capital Group.

Steven Crowley - Craig-Hallum Capital Group

Couple of questions for you. In terms of the expansion of the products that you are working with at Medtronic, Medtronic had some news earlier in the week about the talent through our sustained graph in the delivery system. Did the timing of that approval dealt nicely with where you sit in terms of being able to work with that product line or is this just part of a bigger puzzle there and not that significant a timing element?

Mike Carrel

From a timing element, it is significant in the sense that we'll actually be at the one of major shows for that in two weeks for this conference which is in New York City and they really actually did. We accelerated our roadmap to get that done for them by October 1 so they could actually be ready to deliver and have it on their sales reps, laptops and available on the webform. So, there was clearly a push from them onto us to make sure that happened.

Steven Crowley - Craig-Hallum Capital Group

Great, and then in terms of future potential with Medtronic, should we view your comments or digest your comments earlier that you kind of made some headway, there is a pause here, you're going to develop some things for the long term, but the flurry of activity was Medtronic is behind us for a little bit or how should we think about that equation?

Mike Carrel

I wouldn’t say that the flurry of activity, it’s not going to be consistent necessarily quarter-over-quarter. This past quarter, very strong as you saw on the services front to make sure we were developing this application for them or continuing to develop the automation on it. What we really was develop automation in the application form. But it was still rolling out globally, they've primarily rolled out in the US, we still have Europe and Asia and other areas to go where there is going to be continued licenses that will ordered, number one. Number two, now they've got and they are ready to kind of accept the products in a web-based platform and that’s actually happening this quarter and into early part of next year. So we continue to see activity coming from them. It won’t be as big as it was last fourth quarter but we do continue to see them ordering licenses as well.

Steven Crowley - Craig-Hallum Capital Group

Now in terms of Toshiba, there have obviously been some challenges there. It looks like and sounds like you’ve engaged them to get more enterprise-centric with their efforts, and that seems to be paying off just qualitatively if we listen to your discussion. But what can you do with Toshiba? Is it about just better equipping them be an enterprise seller of your product in CT or are there other modalities? What can you make happen there?

Mike Carrel

I think that we're working on all of the above. Toshiba is the industry leader in CT. Unfortunately the CT market happens to have been hit very hard both in Europe and in the US primarily. A lot of the down turn that we've seeing actually on the Toshiba numbers have been in the European market over the last, kind of when you look at the quarter-over-quarter numbers. But we're working very much with them in terms of how to go into the markets like China and other areas with a product demand a little bit de-featured set. In addition to that, we are working to look at how we can go multi-modality with them as well. So we are in constant communication and working with them. The relationship is very good and fortunately for us they’ve got great technology. They just happen to be in a market that is a very tight market at this point.

Steven Crowley - Craig-Hallum Capital Group

Great, last question for me. I'll hop back in the queue. On Cerner it sounds like the pipeline continues to build. It didn’t payoff explicitly in Q3 but what are the prospects as we go forward here?

Mike Carrel

As I mentioned in my comments I feel very strongly that long-term Cerner is going to be a great relationship. Getting access to imaging data through the EMR and having to be able to enterprise enable their platform from an imaging standpoint is a big deal and they are very excited about it. We were at their customer user conference in early October and there was a lot of buzz created around that in the profit creating and support and service personnel, in addition to their sales team and feel like that not only the pipeline building but the relationship is building there. It takes time for the pipeline to begin to build and so we are fortunate that one deal in the second quarter but we do anticipate that we’ll see growth next year.

Operator

Thank you. And our next question comes from Sean Wieland with Piper Jaffray.

Sean Wieland - Piper Jaffray

In the 1.6 million in licenses that were non-Toshiba, can you comment on how of this was direct versus other channels?

Mike Carrel

All of it was direct. So, okay when we are selling as you all know, when we are selling with McKesson we are driving those transactions in the installed base and then it goes under their paper just based on the way we do the relationship and so, pretty much a 100% direct.

Sean Wieland - Piper Jaffray

Okay so what does your direct sales force looks like now and of the deals that you mentioned how do we think about average deal size in the direct channel?

Peter Goepfrich

The sales force is of roughly the same size as it's been this year, it’s about 50 total direct presence in the field of direct sales up to about 20 but globally with a support team and management team of 30. Size of deals we are seeing, we saw that obviously come down slightly last year as the market entrenched a bit. We are seeing that start to come back. You are seeing some of it in margins. We are beginning to see larger transactions in this quarter that converted licenses but also add on licenses which is some of the improved margins again. So holistically, it's driving the broader strategy of increased field size.

Mike Carrel

You should know, as part of the sales team we also have three dedicated people that are focused on renewals, on service contracts. We've also got three that are focused on inside sales and selling additional options and kind of lead generation for us as well. So, its more than just that and now the direct sales team has got about 18 or so in the US and then the make up of the rest is international at about 25 a bit in the field doing the selling and we call enterprise sales managers.

Sean Wieland - Piper Jaffray

Okay. So a macro question, what do you think the catalyst is for growth in the license fee line? Do we need to see a recovery in the CT market?

Mike Carrel

We don’t believe we need them and obviously recovering the CT market will definitely help. As you can see on our numbers what you're seeing are now is that there has definitely been pressure on there because a lot that goes through the Toshiba channel is through the CT side. We have been working towards larger transactions, the products that we have been introducing over the last year are now getting a lot of buzz in the market place and we anticipate that catalysts are going to be quite frankly more macro oriented. When are people ready to release the funds, when do they have time to do the larger projects as they are dealing with meaningful use etcetera and we're trying to attach ourselves to the EMR into those other areas so that we can accelerate that number. There is no like definitive time, it's as of x. Some of that is definitely macro as you mentioned.

Operator

Our next question comes from Richard Close with Jefferies & Company.

Richard Close - Jefferies & Company

I just want to be clear. The McKesson revenue was that 1.4 million in the quarter?

Peter Goepfrich

It was 1.4 total.

Richard Close - Jefferies & Company

And that was 1.6 in the second quarter, was that correct?

Peter Goepfrich

Yes

Richard Close - Jefferies & Company

Okay, any thoughts there with that slight sequential decline. I know it's not huge but anything to comment on that?

Mike Carrel

Nothing meaningful and we continue to feel good about our conversion ratio. A lot of the deals that we are doing there are taking an install base and converting that already has our licenses and converting them to the DES solutions. So there is a big conversion play that goes on there and each feels a little bit different in terms of size of them and how many they bought originally and what that conversion looks like. So nothing meaningful from that standpoint.

Richard Close - Jefferies & Company

And so is all that 1.4 million in the license. Are those all license sales or how does that break down?

Mike Carrel

It's about half and half percent.

Peter Goepfrich

249,000 in license revenue which is a slight drop-off from last quarter and that’s because the number of deals converting. The deal size is about the same and then 1.1 million in maintenance and service revenue.

Richard Close - Jefferies & Company

Okay, so roughly 200-250 in license and then so McKesson revenues included in your direct channel, correct is that what you said earlier?

Mike Carrel

Yes, because our team is driving those transactions.

Richard Close - Jefferies & Company

Okay, so you still had like $1.4 million or so of direct sales through your own, excluding McKesson on the license side?

Mike Carrel

Yes.

Richard Close - Jefferies & Company

Okay. And then with Cerner, is there any thoughts in terms of quantifying the pipeline, or what does pipeline mean to you guys, what is considered the pipeline?

Mike Carrel

I am not going to be giving out any kind of pipeline data in terms of how many dollars are filling into that, we are very happy with the number of transactions, they have over 600 installed base customers that really want to be imaging enabled through and using our products, we are building relationships, actually finding budgets, having conversations with those end user customers if they have, talking about those budgets, the size of the transactions et cetera.

So, the number of transactions are increasing, the number of leads that are coming through our pipeline and then now there is actually dollars of tax to it, that’s when we say is that increasing the top of the funnel is increasing substantially as it relates to that. So quite sales funnel from that standpoint, but giving dollars, I'm comfortable with giving those dollars.

Richard Close - Jefferies & Company

And then you would say McKesson's is increasing, is that progressively increased throughout this year?

Mike Carrel

Well McKesson is different, I mean McKesson as I mentioned it’s in the pack space that has, also had some suffering in terms of just dollars and so there are a lot of net new packs deals going down, most of what we are doing within the McKesson space is we’ve a great install base that we are converting and we are converting to them to the VES solution, that’s where the revenue, we may have a lot of transactions, but the upfront revenue may be very low because we are banking on the longer-term maintenance contracts going forward and then getting on the newer technology. So that actually, it is a different dynamic and that is not the necessarily the pipelines increasing, that’s a matter of bringing all those conversions and bringing them to beyond VES.

And we have converted about 25 or so of the installed base of McKesson. So there is a still a long way to go relative to where we are and we’ve got 200 plus customers in that installed base that we are converting. There is a couple of deals in McKesson where they are unhappy with the competition and therefore they are coming to us, that’s happened on several occasions.

And those are a little bit larger transactions, that was one of the reasons why Q2 was a little higher in revenue because we had two of those deals in that quarter that were conversions from the competition, we get more revenue up front on those transactions. So McKesson is a little bit different.

Richard Close - Jefferies & Company

Okay and then on the Medtronic revenue I think you said it was. Was it all professional services or were there any license revenue in there?

Mike Carrel

There was small amount of license revenue about 100,000 of license revenue.

Richard Close - Jefferies & Company

So 910,00 of 191 is development services?

Mike Carrel

191 was the development services, (inaudible) was the licenses, 290.

Richard Close - Jefferies & Company

On the grants, just to be clear, so that’s a fourth quarter offset, we should take 1.5 million out of our R&D expense.

Mike Carrel

Yes.

Richard Close - Jefferies & Company

And is pretty much a wash because you are saying that sales and marketing usually call it 1.2 to 1.5 higher because of our SNA.

Mike Carrel

Correct.

Operator

Our next question comes from Charles Rhyee with Oppenheimer.

Charles Rhyee - Oppenheimer

Maybe if I could Mike, ask you sort of question in response to the earlier question you are talking about. You can’t pinpoint the recovery to x date and it’s not necessarily tied to CT itself. But as we think about maybe health reform in general and a general trend towards reimbursement for primary care as an example and away from specialties. It continues to see that diagnostic imaging gets lumped into the specialty side and so reimbursement looks to continue to the space pressure and how much of that potentially continue to impact a rebound in sort of the imaging market and do you think that presents maybe a longer-term headwind as we go forward?

Mike Carrel

It’s a great question because there is no question that there is pressure on the reimbursement side as you mentioned on the core imaging area. But if you actually look at our strategy and you look at we are getting out to the full enterprise and actually leveraging the imaging data that is already out there is really where we are going. And actually less reimbursement driven and much more driven by improving both safety and care of the patients through the EMR and actually combining the information with all the other information in the EMR which is why we are really attaching ourselves so much to whether it is Cerner on a direct basis meaning through them and with them in partnership or in the other EMRs that are out there like Allscripts, Epic, iSOFT over in the UK where we got the integrations complete, we worked on those and is not as much driven by kind of the imaging dollars.

This is actually more driven by what they want to access to that they already have from an imaging standpoint in their facilities and that’s why we are pushing towards that. So I think you are right on some of the headwinds that are there in some of the imaging area, but that’s why we also get very excited about the enterprise that we have because the technology we have is available anywhere and there really are no limits and then when we talk about the relationship we have with VMware, we are talking more to CIOs now then we are to anybody else and they want to basically save cost on the hardware and their infrastructure and that’s being able to virtualize our product as an example to something that resonates very well with them and they find dollars for that. And so that’s why we are beginning to build those types of budgets

Charles Rhyee - Oppenheimer

How much you think you might benefit as we move into our replacement cycle for enterprise pacts as well and when do you think that cycle really gets started and I know you had announced that you and McKesson couple of quarters ago (Inaudible) I think it was. And if you think back in the last pact replacement cycle sort of completed, call it 2006 or so. Do you think we’re getting ready for that next replacement cycle and so does it start relatively sooner because of maybe stimulus here on EMRs pushing down the [personal] cycle out a little bit but either ways is that a potential catalyst for enterprise solution?

Mike Carrel

I would say that’s not much of a potential catalyst but I really do see that the enterprise play through the EMR but also now-a-days about 65% of all hospitals are part of large IDN systems and so what we are really seeing as much, we are also seeing a lot of traction around systems that have multiple pact systems they don’t want to replace the whole thing and they want unified imaging throughout various aspects of that and so how do we actually plan that through the EMR connecting to the risk system naturally where there is a lot of excitement quite frankly out in the market place today.

Charles Rhyee - Oppenheimer

Could you give us just in Medtronic real quickly just, I know we are talking about here rolling it out to their sales force and so we are getting from the licensees. So if I remembering correctly, a part of idea with the Medtronic deal was really just to show, hold new groups of doctors that the value of the Vital software and maybe help spur them to go back to their hospitals engage their facilities to bring on the enterprise solutions.

And I remember them correctly and we start to see maybe some of that trailing effect, maybe on the enterprise side?

Mike Carrel

You are definitely remembering it correctly. I think the trailing effect that you are seeing is in a lot of the relationships that we are in today, whether it’s in a competitor’s install base or our own. There seemed to be much more brand awareness outside of radiology which is actually helping us get the clinical work to those transactions and so we are seeing a lot of that today.

I wouldn’t say that we can tie that directly related to (Inaudible) revenue in this quarter but our ability to basically becoming innovative leader in the space, the vascular surgeons talking about our products like they never have from before, its definitely having that type of impact which is very positive in terms of influencing a lot of the buyers and decision makers that we are going after.

Charles Rhyee - Oppenheimer

Is there any other sort of area of medicine that you are looking into I mean orthopedics or any other outsider radiology, cardiology, lets say that’s just more actively developing in yet?

Mike Carrel

Oncology is one of our biggest pushes both from US, we are very involved from an Oncological standpoint. We have got the surgical planning, that is a big play for us much from an application standpoint or some of the areas that we are focused on.

Charles Rhyee - Oppenheimer

I think a last question for peter here, we looked at the margins, obviously gross margins. We are pretty good this quarter, much better than last quarter and you give some sort of caveats on what are the variations going forward here. Can you just remind us again sort of the difference in profitability right now between the licensed product and an enterprise product, I usually think about that?

Peter Goepfrich

It comes down between the Vitrea Enterprise Suite conversions of our installed base result and slightly lower upfront revenue, licensed revenue because we allow them, we provide them a discount for the previous purchases but it does lead to a longer term larger maintenance contracts. So in the end, a sure Vitrea sale of our workstation is generating larger, higher profit margin on the upfront transaction but long-term is lower profit and the enterprise transaction drives the higher profit.

Charles Rhyee - Oppenheimer

So if we were modeling sort of implying that over time our enterprise sales are getting a bigger share then we will directly have our revenue growth may be have slowed a little bit our license margin tick down but our maintenance margins go up I mean does the revenue go up.

Peter Goepfrich

Yes, over the near term, yes.

Operator

Thank you. Our next question comes from Ernie Andberg with Feltl & Company.

Ernie Andberg - Feltl & Company

We colored a lot of space here but just a couple of questions, first on Toshiba, Mike you had talked about two things affecting Toshiba revenue one is just the state of the CT market and two more of Toshiba's business looking are coming through the enterprise side. Is it Toshiba's volume or the switch to enterprise which is driving the lower revenue there?

Mike Carrel

I guess I am not the, with the lower revenue with Toshiba is a 100% based on the CT market, I mean there is not -- that’s not based on them buying the VES or distributing VES. VES is enabling them to compete in the marketplace against products that are in the market for example Siemens has a product called Single Via which is approved in Europe, which is putting a lot of pressure on them. In the US, there's Philips which has their portal technology and GE has their own accessible platform that they basically use.

And so what they are seeing is competitive pressure to make sure that they are actually distributing that. What's good about that from our standpoint is with Toshiba on that front we wind up taking over the maintenance contract. The maintenance contracts are higher when we get that and then we have that relationship with that customer to be able sell them more product longer terms. But it is actually very good for us.

On a long term, you're not seeing revenue, but Toshiba's number through us is primarily driven by just a CT market and there's two aspects of it, one is the CT market has been flatter down and most markets around the world expect for over in Asia, and especially over in Europe; and then number two is that there is also lot of margin pressure that they feel and they have margin pressure where they are not necessarily including us in everyone of the transactions they do and so those cause our numbers to come down when it comes to Toshiba from that standpoint.

Ernie Andberg - Feltl & Company

Peter, going into the third quarter after you reported Q2 I had the feeling that your total operating expenses might be relatively flat sequentially but they showed a nice drop but they are only four, I think the number was four less people actually on the payroll. What else is going to drive that improvement in operating expenses?

Peter Goepfrich

Two primary things, one is third quarter tends to be our lowest trade show and advertising cost quarter. If you look historically you will see a dip in sales marketing in the third quarter is pretty typical. That's a driver. And then there is an increased effort to migrate away from certain consultant projects that were going on in transition them in-house as they were completed. Those include the drivers.

Ernie Andberg - Feltl & Company

Are you focusing more on trying to drive positive to bottom-line rather than maintaining your expense levels?

Mike Carrel

As we’ve talked about on this call, we are driving for growth on our top-line and making sure that we not only maintain but we've also talked having improved the bottom-line number for the year. And the guidance that we gave at the beginning of the year was that we're going to grow both top-line and bottom-line. I think that we’ve proven so far. So just part of the other we've actually done that. And so that’s kind of where we are right now, but we're really focused on growth in the top-line. So we got to create the catalyst for growth as some of the questions have come out as we need growth on that top-line to really drive the leverage in this business. We don’t have to add a lot of cost on certain aspects of our business for that. And so we are really focused on making so we can drive that top-line.

Operator

Our next question comes from Steven Crowley with Craig-Hallum Capital Group.

Steven Crowley - Craig-Hallum Capital Group

Just a couple of follow-ups. In terms of the success you had with these qualifying therapeutic discovery project brands, you garnered a fair number of these. And I am wondering the underlying projects that they relate to are they more related to kind of a historical clinical applications that we've heard about from Vital or do they really represent the stuff you had going on under the hood there that we haven’t heard about yet.

Peter Goepfrich

It represents the innovations that we're doing around the clinical applications that we continue to do because we have always fashioned ourselves as being a leader on the clinical application side of the business, whether things such as low dose or other areas like that, that are may be important to the marketplace today but its an area that we're focused on from that standpoint. If we did not get any qualifying grants for the underlying infrastructure IT components of our technology that we talk about from an enterprise standpoint. So we still do stand as well know, a lot on R&D relative to not just the infrastructure but also maintaining our technology edge on the clinical side as well and that’s what this is for. So if you look at most of the grant winners, a lot of them were medical device companies, they weren’t meaning like pure device companies and not many software companies. In fact when we looked at the data for Minnesota, I believe we may have been the only software company included in that.

Steven Crowley - Craig-Hallum Capital Group

I agree with you. Well Pete, you seem to be a bird of a little different (Inaudible) here and kudos to you guys for going to find these [dollars] but it sounds like the size of the economic benefit of expense offset, it also has enabled you to move down the path of some new products downstream that we will hear about?

Peter Goepfrich

Yes, I mean its definitely supportive of the, its actually supportive of the effort and vision that we have in place today around making sure that we are maintaining that lead on the clinical side of our business. Just because we're going after the enterprise we believe that one of the big differentiators that we have from other players out there is that we have superior clinical capabilities. We can bring that to the enterprise, then that’s great. And so we're going to continue to invest in those areas.

Steven Crowley - Craig-Hallum Capital Group

Great and then final question from me relates to; the comments about better pricing in the quarter and the great progress with margin in the quarter, that pricing dynamic it seems like it’s a combination of at least a couple of factors that work. The dynamics of VES as that strategy and your efforts get more mature around pricing or maybe as you have more success across the broader list of customers seems to be helping pricing, but did you also do some things with how your approach pricing of hardware or service to try and drive that margin higher in all of the things might be a bit more sustainable or should we think about the better pricing and better margin in Q3 as more episodic in the good side of a coin after having the bad side of the coin in Q2?

Mike Carrel

Its more of the former which is the transactions that they come through are drawing, turning into larger transactions as well as even some of the larger transactions we did this quarter represented IV conversions. But they actually purchased more incremental licenses which improved that actual deal structure so led to more profit. But there hasn’t been a fundamental shift in any other service side element to it. What was the (Inaudible) question that I missed?

Steven Crowley - Craig-Hallum Capital Group

On pricing, you saw margin go up in even hardware. Is that sharpening the pencil a little more there and trying to make that more of a profit center or was this just fluky good after being fluky bad?

Mike Carrel

Not hardware, its minimal margin, sometimes a slight loss just depending on the specific deals we are doing. So I wouldn’t say there is any fundamental shift, the shift you are seeing is on the license side and the number we gave, I mean I gave a bit of guidance for go forward which is mid to low 70s for total margin, depending on product mix and this evolution of the enterprise strategy to license revenue.

Steven Crowley - Craig-Hallum Capital Group

And it sounds great. And then in terms of competitive dynamics, it seemed to be that there was enough qualitative stuff to infer that you're continuing to do well versus some of your smaller competitors Vitrea and the like. Can you tell us a little bit about what kind of successors you lack there or you have there in Q3?

Mike Carrel

As I mentioned on the call, we're continuing to see success against all of the competition and turning over many of their big reference sites to be some of our customers so we are definitely seeing that and we are very happy with that. Primarily we win a lot of these deals doing in larger institutions that have multi-site facilities because our products are truly enterprise enabled and other products are just not nearly as strong from that standpoint. And in the modality players continues to sort of bundle their workstations or their proceeds and client into their products and that continues to be a competitive threat for us that we're winning many deals on that front. I mean the biggest thing there is, one we don’t know about a deal and that I am more nervous more than anything else.

Operator

And with that we have no further questions in queue. I would like to turn the conference back over to Mike Carrel for any additional or closing remarks.

Mike Carrel

Thank you everyone and thank you for your questions. We continue to make great progress on many fronts and expect a strong end of 2010 with both and top and bottom line growth over last year. Again thank you for joining us today.

Operator

And that does conclude today's conference ladies and gentlemen. Again we appreciate everyone’s participation today.

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