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Article by DailyStocks_admin    (03-04-08 03:11 AM)

Discovery Group I reported ownership of about 5,175,394 shares (5.4%), after buying 733,849 from Jan. 4 to Feb. 15 at $2.65 to $3.05 each.

BUSINESS OVERVIEW

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision, and pharmacy products. We offer health, beauty, sexual well-being, household and other non-prescription products and prescription medications through our website at www.drugstore.com. We also offer prestige beauty products through our website located at www.beauty.com (which is also accessible through the drugstore.com website); contact lenses through our wholly owned subsidiary International Vision Direct Corp. and its subsidiaries, collectively referred to as Vision Direct, through websites located at www.visiondirect.com , www.lensmart.com and www.lensquest.com (which are also accessible through the drugstore.com website); and customized nutritional supplement programs through our wholly owned subsidiary, Custom Nutrition Services, Inc., or CNS. Our products are also available toll-free by telephone at 1-800-DRUGSTORE and 1-800-VISIONDIRECT. Under the terms of an agreement with Rite Aid Corporation, or Rite Aid, customers are also able to order refill prescriptions for pickup at any Rite Aid store. As of December 31, 2006, our lifetime customer base was approximately 8.5 million customers worldwide.

We operate our business in four segments: over-the-counter, or OTC; mail-order pharmacy; local pick-up pharmacy; and vision. Additional information regarding our business segments can be found in the section entitled “ Management’s Discussion and Analysis of Financial Condition and Results of Operations ” in Part II, Item 7 of this annual report and in Note 13 of our consolidated financial statements included in Part IV, Item 15 of this annual report. In 2006, 2005 and 2004, approximately 99% of our net sales were made, and over 99% of our assets were located, in the United States.

drugstore.com, inc. was incorporated in April 1998 in the state of Delaware. We launched our web store at www.drugstore.com in February 1999 and completed our initial public offering in July 1999. Our common stock is listed on the NASDAQ Global Market under the symbol “DSCM.” Our principal corporate offices are located in Bellevue, Washington. As used in this annual report, “drugstore.com,” “we,” “our” and similar terms refer to drugstore.com, inc. and its subsidiaries, unless the context indicates otherwise.

Business Strategy

Our business strategy is to offer our customers a wide selection of products at competitive prices and a superior online shopping experience.

Convenience . Our online stores are available to consumers 24 hours a day, seven days a week through the Internet. All of our products are also available for purchase by phone. We offer additional convenience to our customers through easy-to-use websites, robust search technology and a variety of features such as: Your List , a personal shopping list of the customer’s previous purchases that allows for quick and easy re-ordering, even without browsing the site; Auto Delivery , which enables customers to set up automatic shipments of frequently ordered products; the ability to schedule e-mail reminders about previously purchased products that are scheduled to run out or are on sale; and an automated flexible spending account, or FSA, manager that keeps track of FSA-eligible purchases and provides customers with downloadable receipts to submit to their FSA administrator.

Selection. We are able to offer a significantly broader assortment of products, with greater depth in each product category, because we do not have the shelf display space limitations of brick-and-mortar drugstores. With a single check-out, our customers are able to buy health, beauty and personal care products, prestige beauty brands, salon hair care, natural products, and other specialty items. In addition, we offer contact lenses and customized nutritional supplement programs through our subsidiary websites.

Information . We provide a broad array of interactive tools and information on our websites to help consumers make informed purchasing decisions. Our information services include detailed product information pages; personalized product recommendations; customer reviews and other editorial content; the eMedAlert program, which alerts customers to safety issues such as FDA and product manufacturer recalls; and extensive health- and pharmacy-related information, including a drug information database, a drug price index, information on generic drug alternatives, a drug interaction checker; and Ask Your Pharmacist , which is a database of our pharmacists’ responses to over 800 frequently-asked questions. Our customer care representatives and in-house pharmacists are available by phone or e-mail to provide personal guidance and answer customers’ questions.

Privacy . When shopping at a brick-and-mortar drugstore, many consumers may feel embarrassed or uncomfortable about buying items or asking questions that may reveal personally sensitive aspects of their health or lifestyle to pharmacists, store personnel or other shoppers. Our customers avoid these problems by shopping from the privacy of their home or office.

Value. Our goal is to offer shoppers a broad assortment of health, beauty, vision, and pharmacy products with competitive pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can pass along the savings to our customers in the form of lower prices and exclusive deals. We also seek to inform customers of additional cost savings opportunities when they become available. For example, in our pharmacy, we inform our customers of quantity price breaks for buying 90-day supplies of medication rather than 30-day supplies.

Business Segments

In 2006, our OTC segment accounted for 48% of our net sales, our local pick-up pharmacy segment accounted for 24%, our mail-order pharmacy segment accounted for 16%, and our vision segment accounted for 12%. See Note 13 of our consolidated financial statements included in Part IV, Item 15 of this annual report.

OTC

We stock approximately 30,000 non-prescription health, beauty, personal care, household and other products. We offer OTC products in a variety of categories, including:




• Personal Care


• Diet and Fitness


• Beauty & Jewelry


• Household & Pets


• Hair


• Baby


• Skin Care


• Food


• Men’s


• FSA Store


• Health


• Sexual Well-Being


• Vitamins


• Natural Store


• GNC


• Beauty.com (prestige beauty products, also accessible through www.beauty.com )

In addition, through our subsidiary CNS, we also provide personalized nutrition services to consumers in the form of an online assessment of an individual’s specific nutritional supplement needs, and deliver the personalized vitamins, minerals, herbs, and supplements in pharmaceutical-grade, daily dose packages. We are the exclusive online distributor of nutritional supplement programs for Dr. Barry Sears at www.ZoneDiet.com and The Pritikin Longevity Center & Spa at www.Pritikin.com . In addition, we act as the exclusive fulfillment provider for customized nutritional supplements sold through www.DrWeilVitaminAdvisor.com , www.DrWeil.com and other Dr. Weil-related websites.

Mail-Order Pharmacy and Local Pick-Up Pharmacy

Our pharmacy product category is divided into two business segments: mail-order pharmacy and local pick-up pharmacy. Our mail-order pharmacy segment covers the prescription drugs and supplies delivered to customers through our mail-order facility, and our local pick-up pharmacy business segment covers the prescriptions picked up by customers at Rite Aid stores. New prescriptions may be ordered on the drugstore.com website for mail-order delivery. Refill prescriptions that have previously been filled through our mail-order facility or at a Rite Aid store may be delivered by mail or picked up by the customer at any Rite Aid store.

We are a full-service pharmacy stocking over 5,000 prescription drugs. We employ licensed pharmacists and are licensed to ship prescriptions to all 50 states in the United States. We have received Verified Internet Pharmacy Practices Sites, or VIPPS, certification from the National Association of Boards of Pharmacy, or NABP. The voluntary VIPPS program sets standards for Internet pharmacies and certifies those online pharmacies that are licensed and in compliance with state pharmacy laws and the NABP’s stringent pharmacy practice standards.

We serve both cash-paying pharmacy customers and customers with insurance coverage. In addition, we act as an outsourced mail-order pharmacy service provider for pharmacy benefit managers, or PBMs.

Vision

Through our subsidiary Vision Direct, we offer a broad assortment of contact lenses, in addition to reading glasses, contact lens cases and other contact lens supplies. We believe that we offer these products at a substantial price savings over eye care practitioners, national optical chains and many online competitors.

Our contact lens business is subject to the U.S. Fairness to Contact Lens Consumers Act, or FTCLCA, and the related regulations of the Federal Trade Commission, or FTC, which establish a national uniform standard for eye care practitioners and direct marketers with respect to the sale of contact lenses, including verification of contact lens prescriptions. In accordance with these guidelines, we ask the patient’s eye care professional to verify the prescription before we ship an order, and allow eight business hours for the eye care professional to reply to our verification request. If the eye care professional approves the prescription, or does not respond to our verification request within eight business hours, we ship the order to the customer as expressly permitted by the FTCLCA and FTC.

Marketing and Promotions

Our marketing and promotion strategy is designed to build brand recognition, increase customer traffic to our store, add new customers, build strong customer loyalty, maximize repeat purchases and develop incremental revenue opportunities. Our online advertising campaigns are focused on search engines, frequently visited Internet portals, health- and beauty-related websites, and direct-to-consumer e-mail marketing programs. We further extend our online market presence through our affiliate program, through which we permit associated websites to make our products and services available to their audiences through links to our websites. We also advertise from time to time in offline marketing channels, including direct mail, catalogs and brochures included with our shipped orders, magazines and newspapers (including freestanding inserts), and out-of-home advertising channels, such as transportation billboards.

We also employ a variety of marketing programs and promotions, such as discounted and free shipping promotions, dollar off and percentage discounts, free gifts with purchase, and the drugstore.com Dollars program, a loyalty program in which customers automatically earn a five percent rebate to be used for future non-prescription purchases.

Fulfillment and Customer Care

Order Fulfillment

We process all OTC orders and mail-order pharmacy orders from our primary distribution center in Swedesboro, New Jersey, and all vision orders from our distribution center in Ferndale, Washington. When a customer orders a refill prescription to be picked up at a local Rite Aid store, we use Rite Aid as a fulfillment partner. Due to the relatively short lead time required to fill orders for our products, usually 24 to 48 hours, order backlog is not material to our business.

We ship OTC and pharmacy products to U.S., U.S. Territory and APO/FPO military addresses. In addition, through an agreement with Access USA, Inc., we offer international shipment of select OTC health, beauty, and wellness products to over 160 countries. Vision Direct ships contact lenses and other vision products worldwide, primarily to the United States and Canada.

Customer Care

Our customer care representatives operate from our call center in Halifax, Nova Scotia, Canada and from our Bellevue, Washington headquarters. Our customer care specialists are available 24 hours a day, seven days a week via e-mail or telephone to handle customer inquiries and assist customers in finding desired products. The Help section of our website outlines store policies and provides answers to customers’ frequently asked questions. In addition, our pharmacists provide advice to customers about medications and other health-related issues.

Technology

We have implemented a broad array of services and systems for site management, product searching, customer interaction, transaction processing and order fulfillment functions. These services and systems use a combination of our own proprietary technologies and commercially available, licensed technologies. We focus our internal development efforts on creating and enhancing the specialized, proprietary software that is unique to our business. For example, our core merchandise catalog, customer interaction, order collection, fulfillment and back-end systems are proprietary to drugstore.com. Our systems are designed to provide real-time connectivity to the distribution center systems for both pharmacy and OTC products. They include an inventory-tracking system, a real-time order tracking system, an executive information system and an inventory replenishment system.

To enhance the online and offline experience for our pharmacy customers, we have integrated some of our information and pharmacy systems with Rite Aid’s systems. Rite Aid has granted us a nonexclusive, fully paid license to the Rite Aid systems that are integrated with our systems, subject to third-party rights to such technology. We license database, operating system and hardware components from third parties.

In August 1998, we entered into a ten-year technology license and advertising agreement with Amazon.com, under which we have the right to license substantially all of Amazon.com’s technology for use in our business and to receive certain technological and advertising support from Amazon.com, and Amazon.com has the right to license substantially all of our technology for use in its business. Neither party may use the other’s technology to compete against the other. Currently, neither party has licensed any technology from the other under this agreement. If we were to be acquired by a competitor of Amazon.com and Amazon.com did not vote its shares of drugstore.com in favor of the transaction, we would lose our rights to use Amazon.com’s technology, if we are using any at that time. This agreement also restricts us from promoting on our website any company, other than drugstore.com, that sells products or services competitive with those that Amazon.com offers or is preparing to produce or market.

Relationship with Rite Aid

In June 1999, we entered into a strategic relationship with Rite Aid. Through our agreements with Rite Aid, which expire in 2009, we have access to Rite Aid customers through the RiteAid.com website, which is powered by the drugstore.com website. All pharmacy orders processed through the drugstore.com website or the RiteAid.com website can either be shipped to the customer from our distribution center or, in the case of refills of existing drugstore.com or Rite Aid prescriptions, picked up by the customer at any Rite Aid store. Rite Aid adjudicates and collects insurance reimbursement payments for prescription medications on our behalf.

In addition to providing for multi-channel delivery options, we and Rite Aid agreed to promote each other’s services both online and offline. For example, Rite Aid includes the drugstore.com pharmacy logo in Rite Aid’s own weekly circular advertisements, as well as on Rite Aid shopping bags, prescription vial caps, receipts, in-store signs and links from the Rite Aid website to the drugstore.com website. As part of our relationship with Rite Aid, we agreed to certain exclusivity provisions that limit our ability to promote, or affiliate with, any other brick-and-mortar retail drugstore within a five-mile radius of a Rite Aid store or to operate as a traditional brick-and-mortar drugstore, and Rite Aid agreed not to offer or sell products or services on the Internet other than through our website.

We are required to purchase our pharmaceutical inventory through Rite Aid, unless we are able to obtain better overall terms from another vendor. This arrangement enables us to take advantage of Rite Aid’s volume discounts and favorable credit terms. To date, we have not been able to obtain more favorable overall terms from any other supplier, and we currently expect that we will continue to purchase our pharmaceutical products inventory through Rite Aid. As a result of this agreement, Rite Aid is one of our largest suppliers. We also benefit from access to many of Rite Aid’s relationships with insurance companies and PBMs, which enables us to meet the needs of more customers because of the availability of insurance coverage to those customers.

We license certain Rite Aid information technology and pharmacy systems, which we currently use to adjudicate and process local pharmacy orders.

Competition

The market for health, beauty, wellness, vision, and pharmacy products is intensely competitive and highly fragmented. Our competitors in the OTC segment include chain drugstores, mass market retailers, warehouse clubs, supermarkets and, with respect to prestige beauty, health, and spa products, specialty retailers and major department stores. In our mail-order pharmacy and local pick-up pharmacy segments, we compete with chain drugstores, PBMs, insurers and other health care providers, mail-order prescription drug providers and other online pharmacies, both domestic and foreign. Foreign online pharmacies and “rogue” online pharmacies can often sell drugs to American residents at a lower price because they do not comply with U.S. pharmacy regulations, are not subject to U.S. regulatory oversight, or both. Our competitors in the vision segment include other online providers of contact lenses, national optical chains, eye care professionals, and mass-market retailers and warehouse clubs that provide prescription vision services. In addition, we compete with Internet portals and online service providers that feature shopping services, and with other online or mail-order retailers that offer products within one or more of our business segments.

We believe that the principal competitive factors in our market segments include brand awareness and preference, company credibility, product selection and availability, convenience, price, actual or perceived value, website features, functionality and performance, ease of purchasing, customer service, privacy, quality and quantity of information supporting purchase decisions (such as product information and reviews), and reliability and speed of order shipment.

Intellectual Property

We regard our intellectual property as critical to our future success, and we rely on a combination of patent, copyright, trademark, service mark, and trade secret laws, as well as contractual restrictions to establish and protect our proprietary rights in products and services. We own a number of domain names, hold three patents and have applied for seven others, have registered several trademarks, and have filed applications for the registration of a number of our other trademarks and service marks in the United States as well as several other countries. We have licensed in the past, and expect to license in the future, some of our proprietary rights to third parties. For example, Amazon.com has the right to license our technology, and we have granted nonexclusive rights to our trademarks and copyrighted material in connection with advertising and affiliate relationships.

Seasonality

Our OTC business is subject to seasonal variations in demand. Historically, the fourth quarter of each year has been our strongest sales quarter, primarily because of increased online shopping and our greater marketing efforts during the holiday season as well as increased purchases by customers using funds from flexible spending accounts. We do not believe that our mail-order pharmacy, local pick-up pharmacy or vision business segments are substantially affected by seasonality.

Employees

As of December 31, 2006, we had 732 full-time employees . However, employment levels fluctuate due to seasonal variations in our OTC business, and we hire independent contractors and temporary employees as needed to address demand. None of our employees is represented by a labor union, and we consider our employee relations to be good.

CEO BACKGROUND

President, Chief Executive Officer and Chairman of the Board, drugstore.com, inc.
Ms. Lepore has served as president, chief executive officer and chairman of the board of drugstore.com, inc. since October 2004. Ms. Lepore served as vice chairman—Active Trader, technology, operations, administration and business strategy of The Charles Schwab Corporation (“ CSC ”) from August 2003 to October 2004. CSC, through Charles Schwab & Co., Inc. (“ Schwab ”) and its other operating subsidiaries, is a financial services firm. Ms. Lepore served as vice chairman—technology, Active Trader, operations, and administration of CSC and Schwab from May 2003 until August 2003, as vice chairman—technology, operations and administration of CSC and Schwab from July 2002 until May 2003, as vice chairman—technology and administration of CSC and Schwab from 2001 to 2002, as vice chairman and chief information officer of CSC and Schwab from 1999 to 2001, and as executive vice president and chief information officer of CSC and Schwab from 1993 to 1999. She joined Schwab in 1983. She serves as a director of eBay Inc. Ms. Lepore received a B.A. from Smith College.

President and Chief Executive Officer, Direct Holdings Worldwide.
Mr. Bennet is the President and Chief Executive Officer of Direct Holdings Worldwide, a book, music, and video retailer under the Time-Life brand. Bennet has more than 30 years of leadership and management experience in the retail industry. He served in various management positions including President and CEO of Famous Barr and Kaufmanns, both retail department stores. In 2000, he was appointed Vice Chairman of May Department Stores, a $14 billion retail enterprise. Mr. Bennet received his undergraduate degree from Central Missouri State University and an MBA from Washington University.


Principal, Madrona Venture Group.
Mr. Entress is a principal with the Madrona Venture Group, a Seattle-based venture capital firm. Prior to joining Madrona, he was a founder and the Chief Financial Officer of UrbanEarth.com, a Seattle-based Internet start-up. He has been a securities lawyer with Perkins Coie, a Seattle law firm, and has managed financial analysis and reporting groups at Salomon Brothers in New York and The Prudential Home Mortgage Company in New Jersey. He has also held positions at Mellon Bank, Priority Investment Management, and Duquesne Capital Management. Mr. Entress received his bachelor’s degree in English and Economics from the University of Notre Dame, an MS in Industrial Administration from Carnegie Mellon University, and a law degree from the University of Michigan Law School.

Chairman and CEO, Global Spec Inc.
Mr. Killeen is the chairman and CEO of Global Spec Inc., a vertical search, information services, and e-publishing company, a position he has held since January, 2002. Mr. Killeen has more than 25 years of executive management experience in the media, information services, and Internet industries. Prior to joining Global Spec, he was CEO of Forbes.com from 1999-2001. Mr. Killeen has also held positions as the Chief Operating Officer of barnesandnoble.com, as CEO of Pacific Bell Interactive Media, as CEO of ESS Ventures (a joint venture of Pacific Bell and the Los Angeles Times) and as President of American Insurance Services Group. Mr. Killeen began his career with The Dun & Bradstreet Corporation, holding a number of executive positions at several D&B subsidiary companies. Mr. Killeen also serves on the boards of SkyTerra Corporation, The Center For Disability Services and The Lake George Opera Company. Mr. Killeen received his B.A. degree in Political Science from St. Lawrence University.

Consultant.
Mr. Savoy has served as a consultant for the Muckleshoot Indian Tribe, in the areas of strategic planning, economic development, and portfolio management, since May 2005. Mr. Savoy served as a consultant for Vulcan Inc., an investment entity managing the personal financial activities of Paul Allen, from September 2003 to December 2005. Vulcan Inc. resulted from the consolidation in 2000 of Vulcan Ventures Inc., a venture capital fund, and Vulcan Northwest, an investment entity managing Paul Allen’s personal financial activities. Mr. Savoy served in various capacities at Vulcan Inc. and its predecessors from 1988 to September 2003, most recently as the president of the portfolio and asset management division of Vulcan Inc., managing Vulcan’s commercial real estate, hedge fund, treasury, and other financial activities, and as the president of both Vulcan Northwest and Vulcan Ventures. Mr. Savoy served as the president and chief executive officer of Layered, Inc., a software company, from June 1989 until its sale in June 1990, and as its chief financial officer from August 1988 to June 1989. He serves as a director of Charter Communications, Inc. and previously served on the advisory board of DreamWorks SKG and as a director of RCN Corporation. Mr. Savoy received a B.S. in computer science, accounting, and finance from Atlantic Union College.

Venture Partner, Technology Crossover Ventures.
Mr. Stanger has served as Venture Partner of Technology Crossover Ventures (“ TCV ”), a venture capital firm investing in technology companies, since June 2005. From December 2003 until June 2005, Mr. Stanger served as Executive in Residence of TCV. He served as senior vice president, chief financial officer, and director of Expedia Inc., an online travel company, from February 2002 to December 2003 and as its chief financial officer from October 1999 to December 2003. Before joining Expedia, he served as senior director, corporate development of Microsoft Corporation from 1998 to 1999 and held various positions within Microsoft’s corporate development department from 1993 to 1998. Mr. Stanger received a B.A. from Williams College and an M.B.A. from the University of California at Berkeley.

COMPENSATION

(1) Represents the dollar amount recognized for financial statement reporting purposes with respect to the 2006 fiscal year for the fair value of stock options granted to each of the directors, in accordance with SFAS 123(R). Pursuant to SEC rules, the amounts shown exclude the impact of estimated forfeitures related to service-based vesting conditions. For additional information on the valuation assumptions with respect to the 2006 grants, refer to note 11 of our consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2006, as filed with the SEC. These amounts reflect our accounting expense for these awards, and do not correspond to the actual value that will be recognized by the directors.
(2) Unless otherwise indicated, all options included in the table were granted in June 2006 and vest in full on the date of the Annual Meeting.
(3) Represents amounts paid in 2007 for services rendered in 2006.
(4) Represents an option to purchase 100,000 shares of our common stock, which option was granted at the time of the director’s appointment to our board of directors and will vest over four years, with 20% vesting six months after the date of his appointment and the remaining 80% vesting in equal increments at the end of each quarterly period thereafter.
(5)

Includes $3,750 paid to Mrs. Gates in 2006 for services rendered in 2005.

(6) Represents an option to purchase 25,000 shares of our common stock, which option was granted in June 2007, but canceled for failure to vest at the time of Mrs. Gates’ resignation from our board of directors in August 2006.
(7) Includes $2,500 paid to Mr. Killeen in 2007 for services rendered in 2006.
(8) Includes $5,000 paid to Mr. Levitan in 2006 for services rendered during 2005 and $3,333 paid to him in 2007 for services rendered during 2006.
(9) Represents an option to purchase 25,000 shares of our common stock, which option was granted in June 2007, but canceled for failure to vest at the time of Mr. Levitan’s resignation from our board of directors in November 2006.
(10) Includes $3,750 paid to Mr. Savoy in 2006 for services rendered during 2005 and $5,000 paid to him in 2007 for services rendered during 2006.
(11) Includes $3,750 paid to Mr. Stanger in 2006 for services rendered during 2005 and $3,750 paid to him in 2007 for services rendered during 2006.

Ms. Lepore, our president, chief executive officer and chairman of the board, receives compensation as an employee of drugstore.com but receives no additional compensation for her service as director. For details of our arrangements with Ms. Lepore, see the section entitled “ Executive Compensation .” In addition, we have traditionally not paid any cash or equity compensation for service as members of our board of directors to directors who serve on behalf of an entity with a contractual right to a board seat, including Mr. Roy who formerly served on behalf of Amazon.com. However, the board of directors has determined that in light of the unique insight he offers the board, Mr. Entress, who is the current appointee of Amazon.com, but is not employed by Amazon.com, will be eligible to receive the same cash and equity compensation as our other non-employee directors. We also reimburse all directors for certain expenses they incur in connection with attendance at board and committee meetings.

Our non-employee directors receive annual cash compensation in the amount of $5,000 for their service as members of the board of directors. Non-employee directors who are members of the audit committee receive an additional $10,000 in annual compensation, and non-employee directors who are members of any other committee receive an additional $5,000 per committee in annual compensation.

Non-employee directors are also eligible to receive stock option grants under our 1998 Stock Plan, as amended in June 2000 (the “ 1998 Stock Plan ”). Each of our non-employee directors receives an annual grant of an option to purchase 25,000 shares of our common stock under the 1998 Stock Plan, for his or her service on the board of directors during the one-year term following his or her election (or re-election) at our annual stockholders meeting. The exercise price of the option is the market price per share on the date of grant. These options vest in full on the first anniversary of the date of grant. In June 2006, for their service during the 2006-2007 term, each of Mrs. Gates and Messrs. Levitan, Savoy, and Stanger received an option to purchase 25,000 shares of our common stock at an exercise price of $3.85 per share, which was the market price on the date of grant. The options we granted to Mrs. Gates and Mr. Levitan were canceled for failure to vest at the time of each director’s respective resignation. After his or her election as a director at the Annual Meeting, each of our non-employee directors will receive an option to purchase an additional 25,000 shares of our common stock, at an exercise price equal to the market price on the date of grant, for service during the 2007-2008 term. In addition, we generally grant options under the 1998 Stock Plan to new non-employee directors at the time they first join our board of directors. In August 2006, we granted Mr. Killeen an option to purchase 100,000 shares of our common stock at an exercise price of $3.00 per share, which was the market price on the date of grant. In November 2006, we granted each of Messrs. Bennet and Entress an option to purchase 100,000 shares of our common stock at an exercise price of $3.49, which was the market price on the date of grant. These options vest over four years, with 20% vesting six months after the date of the director’s appointment and the remaining 80% vesting in equal increments at the end of each quarterly period thereafter.

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision and pharmacy products. We believe that we offer a better way for consumers to shop for these products through our web stores, including those located on the Internet at www.drugstore.com, www.beauty.com, www.visiondirect.com, www.lensmart.com and www.lensquest.com .

We operate on a 52/53-week retail calendar, with each quarter in a 52-week fiscal year representing a 13-week period. Fiscal years 2006 and 2005 were 52-week fiscal years and fiscal year 2004 was a 53-week fiscal year, with the fourth quarter representing a 14-week period. References in the following discussion to yearly periods are to fiscal years, unless the context indicates otherwise. The year “2006” refers to the fiscal year ended December 31, 2006, “2005” refers to the fiscal year ended January 1, 2006, and “2004” refers to the fiscal year ended January 2, 2005.

2006 Highlights . During the latter half of fiscal year 2005 and the first half of fiscal year 2006, we performed a comprehensive strategic review of each of our business segments to evaluate the profitability of each customer order and partnership. As a result of our analyses, we eliminated or adjusted the price on several thousand over-the-counter, or OTC, SKUs and reduced our net shipping costs by revising our shipping policies, introducing weight- and location-based surcharges for certain customer orders, and negotiated lower shipping rates from our primary shipping carrier. In addition, we terminated our low-margin wholesale OTC fulfillment agreement with Amazon.com, renegotiated the terms of our agreement with Weil Lifestyle, LLC, or Weil, terminated several unprofitable agreements with third-party prescription benefit providers, and decided not to participate in the low-margin Medicare Part D prescription drug program. We also exited an unprofitable relationship with a pharmacy benefits management company, or PBM, in the second half of 2006. These profitability initiatives resulted in improved OTC gross margins, which increased by 160 basis points, to 29.4%, and total gross margins, which increased by 110 basis points, to 21.6%, for the year ended December 31, 2006 as compared to the year ended January 1, 2006. These initiatives also positively affected our contribution margin dollars, which increased year-over-year to $59.0 million, or 20%, primarily as a result of improved OTC contribution margin dollars, which increased year-over-year by $8.5 million, or 27%. Although these profitability initiatives resulted in loss of revenue (albeit revenue from unprofitable business), we achieved year-over-year revenue growth of 4%. This growth occurred primarily in our OTC segment, with OTC net sales increasing by $17.4 million, or 9.6%, and core OTC net sales (a non-GAAP measure defined below) increasing by $29.3 million, or 17.7%, for fiscal year 2006 compared to fiscal year 2005.

Business Segments; Growth Strategies. We operate our business in four business segments: OTC; mail-order pharmacy; local pick-up pharmacy; and vision.


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Over-the-counter (OTC) . Our OTC segment includes all non-prescription products sold online through our web stores at www.drugstore.com and www.beauty.com or over the telephone, including customized nutritional supplements sold through our subsidiary CNS. Before December 31, 2005, we recognized all sales of customized vitamins through CNS on a gross basis, net of promotional discounts, cancellations, rebates and returns allowances. On December 31, 2005, we entered into a fulfillment agreement with Weil. Under the terms of the new agreement, which replaced our previous agreement with Weil, we recognize the revenue associated with the fulfillment of customized vitamins sold through Weil on a net basis. Until November 9, 2005, our OTC segment also included product revenues and fulfillment fees received under our wholesale OTC fulfillment agreement with Amazon.com, Inc., under which we acted as a nonexclusive wholesaler and fulfillment provider for certain OTC products sold through the Health & Personal Care store on the Amazon.com website. Effective November 9, 2005, we terminated this agreement. The change in the terms of our agreement with Weil, which led us to recognize revenue on a net basis for the substantial majority of our 2006 CNS revenue, and the termination of the Amazon.com wholesale OTC agreement make it more difficult to provide a meaningful year-over-year comparison. Accordingly, in this annual report we refer to our “core OTC” net sales, which is a non-GAAP measure that excludes from OTC net sales wholesale OTC net sales of $6.3 million for the year ended January 1, 2006 and CNS net sales of $2.4 million and $8.0 million for the years ended December 31, 2006 and January 1, 2006. Our management believes that the presentation of core OTC net sales and related information provides useful information to the company and its investors, because it excludes specific items that are no longer indicative of our core operating results and facilitates a more meaningful comparison of year-over-year results of our OTC segment. We source our OTC products from various manufacturers and distributors. We believe that continued growth in this segment will depend on our ability to offer customers a superior shopping experience and service, including providing a broad selection of basic necessity items and hard-to-find specialty items, which encourages customers to return to our websites and make repeat, replenishment, and impulse purchases. In 2007, we will continue to focus on improving our customers’ shopping experience by enhancing our internal search technology and website conversion, expanding our category offerings through the introduction of our drop ship program and making key investments in our prestige Beauty.com website.


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Mail-Order Pharmacy . Our mail-order pharmacy segment includes prescription drugs and supplies, other than prescription contact lenses, sold online through the pharmacy section of the www.drugstore.com web store or over the telephone and delivered to customers through our mail-order facility. We procure our prescription inventory through Rite Aid Corporation as part of our ongoing relationship. We market to both cash-paying and insurance-covered individuals, and we also serve as a third-party provider of mail-order prescription fulfillment services for PBMs. We sell over 5,000 prescription drugs, including many specialty drugs for the treatment of chronic conditions such as cancer, HIV and multiple sclerosis, which are not carried by brick-and-mortar pharmacies, and require special handling or service. In this segment, we focus our marketing efforts directly to consumers online and through doctors to maximize growth in our cash prescription and specialty pharmacy business. In

addition to the sale of prescription drugs, we sell advertising on our website, to monetize the more than one million unique visitors per month researching drugs and other healthcare content provided on the site. We anticipate that continued growth in this segment in 2007 will substantially depend on our ability to grow prescription volumes through these efforts. We anticipate that our decision not to participate in the low-margin Medicare Part D prescription drug benefit program offered by the U.S. government will continue to have a negative impact on our growth but a favorable impact on our gross margin.


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Local Pick-Up Pharmacy . Our local pick-up pharmacy business segment includes prescription refills sold online through the www.drugstore.com web store or the www.RiteAid.com web store (which is powered by the www.drugstore.com web store) or over the telephone and picked up by customers at Rite Aid stores. In this segment, Rite Aid acts as our fulfillment partner. Our success in this segment depends on our ability to leverage our relationship with Rite Aid through its marketing media, including Rite Aid store receipts, weekly Rite Aid advertising circulars and e-mail refill reminders. In 2007, we anticipate that net sales in the local pick-up pharmacy segment will not be a significant source of growth, as we continue to focus the majority of our marketing efforts on our OTC segment.


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Vision . The vision segment includes contact lenses sold through our wholly owned subsidiary International Vision Direct Corp. and its subsidiaries, collectively referred to as Vision Direct, through websites located at www.visiondirect.com, www.lensmart.com and www.lensquest.com , or over the telephone at 1-800-VISIONDIRECT. We purchase our contact lens inventory directly from various manufacturers and other distributors. In 2007, we are focusing on a strategy of balancing customer acquisition with net margin in order to maximize our profits, rather than focusing exclusively on revenue growth.

Revenues . We generate revenue primarily from product sales and shipping fees. In 2006, we reported consolidated total net sales of $415.8 million, which reflected a $16.3 million, or 4%, increase over 2005. Our net sales growth was driven by a 6% increase in our total order volume to 5.4 million orders, partially offset by a 2% decline in our average net sales per order to $77. Our net sales benefited from strong year-over-year growth in our OTC segment, which grew by 10% over 2005, and specifically core OTC net sales (which excludes wholesale and CNS net sales), which increased by 18% over 2005. In addition, net sales in our local pick-up pharmacy and vision segments increased 5% and 6%, respectively, year-over-year, while net sales in our mail order pharmacy segment decreased by 11% year-over-year.

Expenses . Our operating expenses, including cost of goods sold, decreased as a percentage of net sales to 104% in 2006 compared to 106% in 2005. The decrease reflects both a favorable shift in our product mix and significant improvement in OTC margins due to the success of the profitability initiatives described above. Our marketing expenses decreased as a percentage of net sales as a result of the conclusion of our brand campaign in the first quarter of 2006. Our general and administrative expenses also decreased year-over-year as a percentage of net sales in 2006. These declines were partially offset by an increase in technology and content expenses as a percentage of net sales, as a result of ongoing enhancements to our IT infrastructure. During the first quarter of 2006, we adopted the provisions of Financial Accounting Standards Board Statement No. 123 (revised 2004), Share-Based Payment , or FAS 123(R), which requires the recognition of the fair value of stock-based compensation. As a result, stock-based compensation expense increased $4.7 million, or 1% of net sales, during 2006, compared to 2005.

Net Loss; Cash Position . Our net loss for the year ended December 31, 2006 decreased by 38%, or $7.9 million, to $13.0 million, compared to $20.9 million for the year ended January 1, 2006. We ended 2006 with $40.6 million in cash, cash equivalents and marketable securities, compared to $46.5 million at the end of 2005. This balance reflects the use in 2006 of $1.1 million to fund operating activities, $7.6 million for capital expenditures, and $2.2 million to repay debt obligations, offset by proceeds of $2.7 million from the exercise of employee stock options and purchases under our employee stock purchase plan, and proceeds from debt borrowings of $2.3 million. Significant Accounting Judgments

The preparation of financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC defines a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and that require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the significant accounting policies and judgments addressed below. We also have other key accounting policies that involve the use of estimates, judgments and assumptions that are significant to understanding our results. We have included additional information about our significant accounting policies in Note 1 of our consolidated financial statements included in Part IV, Item 15 of this annual report. Although we believe that our estimates, assumptions and judgments are reasonable, they are based on information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. In addition, any significant unanticipated changes in any of our assumptions could have a material adverse effect on our business, financial condition, and results of operations.

Revenue Recognition

We recognize revenues in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition.

Revenues from sales of OTC (other than Weil-related CNS sales, as described below), mail-order pharmacy, and vision products are recorded net of promotional discounts, cancellations, rebates, and returns allowances. Revenue is recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the selling price or fee earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. We generally require payment by credit card at the point of sale. Return allowances, which reduce product sales by our estimate of expected product returns, are estimated using historical experience. Historically, product returns and differences between our estimates and actual returns have not been significant.

Revenues from sales of customized vitamins sold through our fulfillment agreement with Weil are recognized when products are shipped and title passes to the customer. In accordance with Emerging Issues Task Force Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, or EITF 99-19, we record revenues generated by the Weil agreement in our OTC segment on a net basis, because we act as an agent, based on the fact that we earn a fixed dollar amount per customer transaction regardless of the amount billed to the customer and we do not bear general inventory risk associated with these sales. Non-Weil customized vitamin sales are recognized on a gross basis, net of promotional discounts, cancellations, rebates, and returns allowances. (Before we entered into the new fulfillment agreement with Weil on December 31, 2005, we also recognized Weil customized vitamin sales on a gross basis, net of promotional discounts, cancellations, rebates, and returns allowances.) Net sales in our OTC segment also include consignment service fees earned under our agreement with General Nutrition Corporation, or GNC, and agreements with other consignment vendors, which are also recorded on a net basis, because we do not take title to the inventory and do not establish pricing.

Effective November 9, 2005, we terminated our agreement with Amazon.com. Prior to the termination, we recognized revenues from sales of OTC products ordered through the Amazon.com website and fulfilled by drugstore.com when we shipped the products from our distribution center. In accordance with EITF 99-19, we recorded fulfillment fees and revenues generated by the Amazon.com agreement in our OTC segment on a gross basis, because we acted as a principal, based on the fact that we bore general inventory risk associated with these sales. Neither party had any material obligations following termination.

Revenues from sales of prescription products ordered online or by telephone through the drugstore.com web store or the RiteAid.com web store (which is powered by the drugstore.com web store) for pick-up at a Rite Aid store, including co-payments received and collected on our behalf by Rite Aid, are recognized when the customer picks up the product. In these circumstances, we use Rite Aid as our fulfillment partner. In accordance with EITF 99-19, we record revenues in our local pick-up pharmacy segment on a gross basis, because we act as a principal, based on the fact that, among other things, we bear both inventory risk and credit and collection risk associated with these sales.

For insured prescriptions in both our local pick-up and mail-order segments, the co-payment and the insurance reimbursement (which together make up the amount due to drugstore.com) constitute the full value of the prescription drug sale, and we receive this entire amount as cash. We therefore recognize the entire amount as revenue when the order is shipped to the customer (for mail order prescriptions) or picked up by the customer (for local pick-up prescriptions).

From time to time, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, or future rebates based on a percentage of the current purchase, as well as other offers. Discounts, when accepted by our customers, are treated as a reduction to the sales price of the related transaction and are presented as a net amount in net sales. Rebates are treated as a reduction to the sales price based on estimated redemption rates. Redemption rates are estimated using our historical experience for similar offers. Historically, our redemption rates have not differed materially from our estimates, which we adjust quarterly.

Inventories

We value our inventories at the lower of cost (using the weighted-average cost method) or the current estimated market value. We regularly review inventory quantities on hand and adjust our inventories for shrinkage and slow-moving, damaged, and expired inventory, which is recorded as the difference between the cost of the inventory and the estimated market value based on management’s assumptions about future demand for the products we offer and market conditions. We use a variety of methods to reduce the quantity of slow-moving inventory, including reducing sales prices on our websites, negotiating returns to vendors, and liquidating inventory through third parties. If our estimates of future product demand or our assumptions about market conditions are inaccurate, we could understate or overstate the provision required for excess and obsolete inventory. Historically, inventory reserves have not differed materially from our estimates.

Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 142, Accounting for Goodwill and Other Intangibles , or FAS 142, we test for impairment of goodwill at the beginning of the fourth quarter and whenever indicators of impairment occur. The first phase of the test screens for impairment. If impairment is determined, the second phase measures the amount of impairment by comparing the fair value of the applicable reporting unit to its carrying value. Fair value is determined using either a discounted cash flow methodology or methodology based on comparable market prices.

We review our indefinite-lived intangible assets for impairment when indicators of impairment occur and annually at the beginning of the fourth quarter. We compare the carrying value of the asset to its estimated fair value and record an impairment charge when the carrying value of the asset exceeds the estimated fair value.

In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets , or FAS 144, we review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment occurs. When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. The determination of whether impairment exists is based on any excess of the carrying value over the expected future cash flows, as estimated through undiscounted cash flows, excluding interest charges. We measure any resulting impairment charge based on the difference between the carrying value of the asset and its fair value, as estimated through expected future discounted cash flows, discounted at a rate of return for an alternate investment.

Results of Operations

Net sales include gross revenues from sales of product and related shipping fees, net of discounts and provision for sales returns, and other allowances. Net sales also include consignment service fees earned from our arrangement with GNC and other consignment vendors, under which we do not take title to the inventory and cannot establish pricing. Consignment service fees are recorded on a net basis and constitute approximately 1% of total net sales in each period presented. Net sales in 2005 and 2004 included fulfillment fees and product revenue from our wholesale OTC fulfillment agreement with Amazon.com, which we terminated in November 2005. Also included in net sales in 2005 and 2004, recorded on a gross basis, are sales of customized nutritional supplements sold through CNS, which, effective December 31, 2005, are now primarily recorded on a net basis under our fulfillment agreement with Weil. Orders are billed to the customer’s credit card or, in the case of prescriptions covered by insurance, the co-payment is billed to the customer’s credit card and the remainder of he prescription price is billed to insurance. Sales of pharmaceutical products covered by insurance are recorded as the sum of the amounts received from the customer and the third party. Sales made to Amazon.com under our terminated wholesale OTC fulfillment agreement were billed directly to Amazon.com and recorded at the gross amount received from Amazon.com.

Total net sales increased in 2006 compared to the prior year, primarily as a result of a 6% increase in order volume, to 5.4 million orders from 5.1 million in 2005, and were partially offset with a 2% decrease in the average net revenue per order, to $77. The order growth was primarily driven by growth in our OTC segment, and to a lesser extent, in our local-pick up segment. Our average net revenue per order decreased in our OTC segment and local-pick up segments in 2006, offset by growth in our average net revenue per order in our mail-order pharmacy and vision segments. Total net sales increased in 2005, compared to the prior year, primarily as a result of an 8% increase in order volume (11% on a comparative 52-week basis), to 5.1 million from 4.7 million in 2004, and, to a lesser extent, a 2% increase in average net revenue per order, to $78. Order volume increased from 2004 primarily as a result of strong growth in our OTC and mail-order pharmacy segments. Average net revenue per order increased in 2005 compared to 2004 as a result of growth in net sales per order in each of our segments, particularly within our mail-order pharmacy segment. Revenues from repeat customers increased year-over-year to 81% of total net sales in 2006 compared to 79% in 2005 and 74% in 2004.

Net sales in our OTC segment increased in 2006 compared to the prior year, as a result of an increase in order volume. The number of orders in our OTC segment grew year-over-year by 12% to 3.5 million in 2006, compared to 3.2 million in 2005. Our core OTC net sales, which excludes CNS net sales of $2.4 million in 2006 and $8.0 million in 2005, and wholesale OTC net sales and fulfillment fees of $6.3 million in 2005, increased by 18% to $195.6 million in 2006 compared to $166.2 million in 2005. The number of orders in our core OTC segment grew by 21% to just under 3.5 million in 2006 compared to 2.8 million in 2005. Average net sales per order for our OTC segment decreased to $56 in 2006 compared to $57 in 2005 and average net sales per order for our core OTC segment decreased to $57 in 2006 compared to $58 in 2005, as a result of our profitability initiatives related to shipping and our efforts to maintain competitive pricing, which reduced our average number of units per order.

Net sales in our OTC segment increased in 2005 compared to the prior year, primarily as a result of an increase in order volume. Our core OTC net sales, which exclude CNS net sales of $8.0 million in 2005 and $8.3 million in 2004, and wholesale OTC net sales and fulfillment fees of $6.3 million in 2005 and $14.1 million in 2004, increased by 25% to $166.2 million in 2005 compared to $132.9 million in 2004. On a comparative 52-week basis, OTC net sales increased 19% and, excluding CNS and wholesale OTC, increased 27%. The number of orders in this segment grew by 15% to 3.2 million in 2005, compared to 2.7 million in 2004, reflecting increases in the numbers of both repeat orders from existing customers and orders from new customers, offset by a decline in wholesale OTC orders. Average net sales per order for our OTC segment remained flat at $57 for both 2005 and 2004 and average net sales per order for our core OTC segment remained flat at $58 in 2005 and 2004. During 2006, 2005 and 2004, we generally did not implement material price changes in our OTC products.

The number of customer orders includes new and repeat orders made through the drugstore.com website and the websites of our subsidiaries, orders generated through our fulfillment agreement with Weil, and orders generated through our wholesale OTC fulfillment agreement with Amazon.com. The increase in OTC order volume was driven by increased orders from both new and repeat customers as a result of the 8% increase in our active customer base to approximately 2.2 million and our continued efforts to improve customer retention and conversion. OTC wholesale orders and Weil-related orders (after December 31, 2005) are included in the number of total orders but are considered neither repeat nor new orders for calculating repeat orders as a percentage of total orders.

Net sales in our mail-order pharmacy segment decreased in 2006 compared to the prior year as a result of decreases in order volume, partially offset by increases in average net sales per order. Included in net sales of our mail-order pharmacy segment in 2006 were wholesale orders to one party totaling $3.5 million, which increased our average net sales per order by $9 in 2006. In addition to the wholesale orders, average net sales per order increased $8 in this segment in 2006 compared to the prior year as a result of selling a larger proportion of higher-priced brand-name and specialty drugs, increases in prescription prices of approximately 5% resulting primarily from brand-name product inflation, and pricing adjustments to certain SKUs resulting from our review of the pricing and profitability of our pharmaceutical SKUs. The number of orders in this segment decreased 20% to 411,000 in 2006 compared to 515,000 in 2005. These decreases reflected a 23% decrease in orders from PBM partnerships primarily due to our decision to exit unprofitable PBM partnerships, and a 19% decrease in orders from customers, both new and repeat, primarily due to our decision not to participate in the low-margin Medicare Part D prescription drug benefit program offered by the U.S. government.

Net sales in our mail-order pharmacy segment increased in 2005 compared to the prior year, as a result of increases in order volume and average net sales per order. On a comparative 52-week basis, net sales in our mail-order pharmacy segment increased by 21% in 2005, compared to 2004. The number of orders in this segment grew by 10% to 515,000 in 2005, compared to 471,000 in 2004, reflecting year-over-year increases in the numbers of both repeat orders from existing customers and orders from new customers. The average net sales per order in this segment increased in 2005, compared to the prior year, as a result of a larger proportion of customers purchasing supply quantities of 90 days or more, as well as increases of approximately 6% in the average price per prescription resulting from higher pharmaceutical costs.

Net sales in our local pick-up pharmacy segment increased in 2006 compared to the prior year, as a result of an increase in order volume, partially offset by decreases in average net sales per order. The number of orders in this segment increased to 948,000 in 2006 compared to 880,000 in 2005, as a result of increased repeat customer orders. The decrease in average net sales per order resulted primarily from a 5% decline year-over-year in the average number of prescriptions filled per order and a lower number of higher-priced brand-name prescriptions filled compared to lower-priced generic prescriptions filled.

Net sales in our local pick-up pharmacy increased in 2005 compared to the prior year, as a result of an increase in average net sales per order. On a comparative 52-week basis, net sales in our local pick-up pharmacy segment increased by 6% in 2005, compared to the prior year. The number of orders in this segment remained relatively flat at 880,000 in 2005, compared to 892,000 in 2004. The average net sales per order in this segment increased in 2005, compared to the prior year, as a result of increases in the average price per prescription paid by the customer and the average number of prescriptions per order.

Rite Aid drives orders in this segment through its marketing media, including Rite Aid store receipts, weekly Rite Aid advertising circulars and e-mail refill reminders.

Net sales in our vision segment increased in 2006 compared to the prior year, as a result of an increase in average net sales per order, partially offset by a slight decrease in order volume. The increase in net sales per order was driven primarily by selling a greater proportion of higher-priced, newer-technology contact lenses, and to a lesser extent, price increases for certain SKUs (none of which were individually material) and an increase in the average number of items per order. These increases were partially offset by increased discount and promotional offers. The number of orders in this segment decreased to 551,000 in 2006 compared to 572,000 in 2005, as a result of decreased new customer orders.

Net sales in our vision segment decreased in 2005 compared the prior year, as a result of a decrease in order volume, partially offset by an increase in the average net sales per order. On a comparative 52-week basis, net sales in our vision segment remained flat. The number of orders in this segment decreased to 572,000 in 2005 compared to 615,000 in 2004, as a result of fewer orders from new customers. The average net sales per order increased primarily from an increase in the average number of items per order and increased purchases of higher-priced specialty contact lenses.

Customer Data

Approximately 1.3 million new customers placed orders during 2006, increasing our total customer base to approximately 8.5 million customers since inception. Orders from repeat customers as a percentage of total orders increased year-over-year to 75% for 2006 compared to 72% for 2005 and 67% for 2004, as a result of an increase in our trailing 12-month active customer base. The year-over-year increase in orders from repeat customers as a percentage of total orders in 2006 and 2005 primarily resulted from improved customer retention and increased order frequency. In addition, to a lesser extent, this increase reflects the inclusion of 225,000 and 352,000 wholesale OTC orders in total orders for 2005 and 2004, compared to no such orders in 2006. OTC wholesale orders and Weil-related orders (after December 31, 2005) are included in the number of total orders but are considered neither repeat nor new orders for calculating repeat orders as a percentage of total orders.

Cost of Sales

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving and expired inventory, outbound and inbound shipping costs, and expenses related to promotional inventory included in shipments to customers. Payments that we receive from vendors in connection with volume purchase or rebate allowances and payment discount terms are netted against cost of sales.

Total cost of sales increased in absolute dollars in 2006 and 2005, compared to the prior year, as a result of growth in order volume and net sales. Cost of sales as a percentage of net sales decreased in 2006, compared to the prior year, as a result of lower net shipping loss, a larger proportion of net sales in our OTC segment, which is our highest-margin segment, and improved margins resulting from our operational initiatives, including the review of pricing and profitability of our OTC SKUs. Cost of sales as a percentage of net sales decreased slightly in 2005, compared to 2004, primarily as a result of higher product margins in our OTC segment, partially offset by higher shipping costs.

Our revenues from shipping charges to customers are included in net sales and were $13.6 million in 2006, $11.1 million in 2005 and $10.2 million in 2004. Outbound shipping costs are included in cost of sales and were $21.9 million in 2006, $21.4 million in 2005 and $17.5 million in 2004. As part of our profitability initiatives, in 2006, we eliminated free 3-day shipping on orders of $99 or more, added shipping surcharges for shipments to Alaska, Hawaii, U.S. Territories, and APO/FPO military addresses, added a weight-based shipping surcharge for orders over 20 pounds, and secured a lower contractual rate from one of our shipping carriers. We expect to continue to subsidize a portion of customers’ shipping costs for the foreseeable future, through certain free shipping options, as a strategy to attract and retain customers.

Cost of sales in our OTC segment increased in absolute dollars in 2006 compared to the prior year, as a result of growth in order volume and net sales. Cost of sales as a percentage of net sales in this segment decreased in 2006 compared to the prior year, primarily as a result of improved margins resulting from our OTC SKU profitability initiatives, and lower per-order net shipping costs resulting from revisions to our shipping policies.

Cost of sales in this segment increased in absolute dollars in 2005 compared to the prior year, as a result of growth in order volume and net sales. Cost of sales as a percentage of net sales in this segment decreased in 2005 compared to 2004, as a result of higher product margins partially offset by higher shipping costs.

Cost of sales in our mail-order pharmacy segment decreased in absolute dollars in 2006 compared to the prior year, as a result of a decrease in order volume and net sales. Cost of sales as a percentage of net sales in this segment decreased slightly over 2005 as a result of improved margins from exiting unprofitable partnerships with certain PBMs and our review of pricing and profitability of pharmaceutical SKUs.

Cost of sales in our mail-order pharmacy segment increased in absolute dollars in 2005 compared to the prior year, as a result of increased order volume and net sales, and higher per-order product costs. Cost of sales as a percentage of net sales, and per-order product costs in this segment increased in 2005 compared to the prior year, as a result of our initiatives to grow this segment by providing third-party fulfillment services to PBMs. This strategy focuses on fulfilling 90-day-or-greater order quantities, which generates higher per-order revenue than 30-day quantity orders but also results in higher per-order product costs and lower product margins.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Results of Operations

Net sales include gross revenues from sales of product and related shipping fees, net of discounts and provision for sales returns, and other allowances. Net sales also include consignment service fees earned from our arrangement with GNC and other consignment vendors, under which we do not take title to the inventory and cannot establish pricing. We record on a net basis consignment service fees, which constitute approximately 1% of total net sales in each period presented. We bill orders to the customer’s credit card or, in the case of prescriptions covered by insurance, we bill the co-payment to the customer’s credit card and the remainder of the prescription price to insurance. We record sales of pharmaceutical products covered by insurance as the sum of the amounts received from the customer and the third party.

Total net sales increased year-over-year primarily as a result of a 16% increase in order volume for the three-month period ended September 30, 2007, and a 17% increase in order volume for the nine-month period ended September 30, 2007, in our OTC segment. Revenues from repeat customers represented 82% of net sales in the three-and nine-month periods ended September 30, 2007, compared to 84% of net sales in the third quarter of 2006 and 83% of net sales in the nine-month period ended October 1, 2006. The year-over-year decrease in average net sales per order for the three- and nine-month periods ended September 30, 2007 resulted from a higher mix of OTC orders, which have lower average net sales per order. Compared to the third quarter and the nine-month period ended October 1, 2006, net sales in our OTC segment increased by $9.0 million and $26.5 million, net sales in our vision segment increased by $2.2 million and $4.5 million, and net sales in our local pick-up pharmacy segment increased by $1.2 million and $4.8 million, respectively, all of which were partially offset by a decrease in net sales in our mail-order pharmacy segment of $5.7 million and $15.5 million, respectively.

Net sales in our OTC segment increased year-over-year for the three-month period ended September 30, 2007, as a result of an increase in order volume. The number of orders in our OTC segment grew year-over-year by 16% to 966,000 for the third quarter of 2007, compared to 830,000 for the third quarter of 2006 with the average net sales per order for the third quarter of 2007 increasing year-over-year to $57 from $55. During the nine-month period ended September 30, 2007 the number of OTC orders grew year-over year by 15% to 3.0 million compared to 2.5 million in the same period of 2006, and the average net sales per order also increased to $57 from $56. The number of customer orders includes new and repeat orders made through the drugstore.com website and websites of our subsidiaries and orders generated through our fulfillment agreement with Weil. The increase in OTC order volumes in 2007 as compared to 2006 was driven by increased orders from both new and repeat customers as a result of our increasing active customer base and our continued efforts to improve customer retention and conversion resulting from our ongoing website enhancements. The slight year-over-year increase in average net sales per order for the three- and nine-month periods ended September 30, 2007 is primarily the result of increased sales of higher priced prestige beauty products.

Net sales in our vision segment increased year-over-year in the three- and nine-month periods ended September 30, 2007 as a result of an increase in average net sales per order driven primarily by selling a greater proportion of higher-priced, newer-technology contact lenses, and to a lesser extent, an increase in the average number of items per order and price increases for certain SKUs (none of which were individually material). Net sales per order increased to $101 for the three-month period ended September 30, 2007 compared to $92 for the three-month period ended October 1, 2006 and increased to $99 for the nine-month period ended September 30, 2007 compared to $90 for the nine-month period ended October 1, 2006. The number of orders in this segment increased to 146,000 for the three-month period ended September 30, 2007, compared to 138,000 for the three-month period ended October 1, 2006, and increased to 428,000 for the nine-month period ended September 30, 2007, compared to 421,000 for the nine-month period ended October 1, 2006 as a result of increases in orders from repeat customers.

Net sales in our mail-order pharmacy segment decreased year-over-year for the three- and nine-month periods ended September 30, 2007 as a result of decreases in order volume. Included in net sales of our mail-order pharmacy segment for the three- and nine-month periods ended September 30, 2007 were wholesale orders to one party of $71,000 and $1.0 million, respectively, and included in net sales for the three- and nine-month periods ended October 1, 2006 were wholesale orders to one party for $2.0 million. The wholesale orders increased our average net sales per order by $1 and $4 for the three- and nine-month periods ended September 30, 2007, respectively, and increased our net sales per order by $21 and $6 for the three- and nine-month periods ended October 1, 2006, respectively. The number of orders in this segment decreased 22% year-over-year to 76,000 for the three-month period ended September 30, 2007, compared to 98,000 for the same period in 2006, and decreased 27% year-over-year to 238,000 for the nine-month period ended September 30, 2007, compared to 324,000 for the same period in 2006, as a result of a year-over-year decrease of 49% and 53% in orders from PBMs, due to our decision to exit unprofitable partnerships, in the three- and nine-month periods ended September 30, 2007, respectively, and decreases in new and repeat orders.

The increase in net sales in our local pick-up pharmacy segment for the three-month period ended September 30, 2007 reflects a 3% year-over-year increase in the number of orders in this segment, to 249,000, compared to 241,000 for the third quarter of 2006, as a result of an increase in orders from repeat customers. In addition, the segment experienced a slight increase in the average net sales per order to $106 during the three-month period ended September 30, 2007 compared to $104 for the three-month period ended October 1, 2006, primarily due to increased prices of brand name drugs as a result of a 4% average increase in prescription costs, offset slightly by a greater number of prescriptions filled with lower priced generic drugs compared to higher priced brand name drugs. The increase in net sales for the nine-month period ended September 30, 2007 reflects a 7% year-over-year increase in the number of orders in this segment, to 753,000 for the nine-month period ended September 30, 2007 compared to 703,000 for the nine-month period ended October 1, 2006, as a result of increases in orders from repeat customers . The average net sales per order remained consistent at $106 for the nine-month period ended September 30, 2007 and October 1, 2006. Orders in this segment are driven by Rite Aid through its marketing media, including Rite Aid store receipts, weekly Rite Aid advertising circulars, and e-mail refill reminders.

Customer Data

Approximately 326,000 and 1.0 million new customers placed orders during the three-and nine-month periods ended September 30, 2007, increasing our total customer base to approximately 9.5 million customers since inception. Orders from repeat customers as a percentage of total orders decreased slightly to 76% for the third quarter of 2007, compared to 77% in the same period in 2006, and remained consistent at 76% year-over-year for the nine-month period ended September 30, 2007 and October 1, 2006. Our active customer based increased 12% to 2.4 million year-over-year for the nine-months ended September 30, 2007, compared to the same period in 2006, and the average annual spend per active customer was $180. Active customer base includes those customers who have purchased at least once within the last 12 months. Both the active customer base (a trailing 12-month number) and average annual spend per active customer exclude net sales and orders generated by our CNS fulfillment relationship with Weil, and reflect only the activity of customers making purchases through the web sites of drugstore.com and its subsidiaries.

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving, and expired inventory, outbound and inbound shipping costs, and expenses related to promotional inventory included in shipments to customers. Payments that we receive from vendors in connection with volume purchase or rebate allowances and payment discount terms are netted against cost of sales.

Total cost of sales increased in absolute dollars in the three- and nine-month periods ended September 30, 2007, compared to the three- and nine-month periods ended October 1, 2006, as a result of growth in order volume and net sales. Total gross margin percentage increased year-over-year for the three- and nine-month periods ended September 30, 2007, primarily as a result of a larger proportion of net sales in our OTC segment, which is our highest-margin segment, as well as improved gross margins in all of our other segments.

Our net shipping loss for the three- and nine-month periods ended September 30, 2007 increased in absolute dollars and as a percentage of net sales compared to the same periods ended October 1, 2006 due to a higher mix of OTC orders, which have a higher net shipping loss than orders in our other segments. We include in net sales our revenues from shipping charges to customers and we include in cost of sales outbound shipping costs. We expect to continue to subsidize a portion of customers’ shipping costs for the foreseeable future, through certain free shipping options, as a strategy to attract and retain customers.

The year-over-year increase in cost of sales in our OTC segment in absolute dollars for the three- and nine-month periods ended September 30, 2007 resulted from increased order volume and net sales. The year-over-year decrease in gross margin percentage for the three- and nine-month periods ended September 30, 2007 was primarily a result of higher per-order net shipping costs.

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