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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended January 2, 2000
Commission file number: 0-26137
drugstore.com, inc.
(Exact Name of Registrant as Specified in its Charter)
Delaware 13920 Southeast Eastgate Way, Suite 300 04-3416255
(State or Other Bellevue, Washington 98005 (I.R.S. Employer
Jurisdiction of (425) 372-3200 Identification No.)
Incorporation or (Address, including zip code, and telephone number, including
Organization) area code, of Registrant's Principal Executive Offices)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.0001 per share
(Title of Class)
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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of Common Stock held by non-affiliates of the
Registrant was approximately $343,174,572 as of February 3, 2000, based upon
the closing price of $29.250 on the Nasdaq National Market reported on such
date. Shares of Common Stock held by each executive officer and director and
by each person who beneficially owns more than 5% of the outstanding Common
Stock have been excluded in that such persons may under certain circumstances
be deemed to be affiliates. This determination of executive officer and
affiliate status is not necessarily a conclusive determination for other
purposes.
As of February 3, 2000, the number of shares of Common Stock outstanding
was 46,022,560.
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drugstore.com, inc.
FORM 10-K
For the Fiscal Year Ended January 2, 2000
Index
Page
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Part I
Item 1. Business..................................................... 1
Item 2. Properties................................................... 16
Item 3. Legal Proceedings............................................ 16
Item 4. Submission of Matters to a Vote of Security Holders.......... 16
Part II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters.......................................... 17
Item 6. Selected Consolidated Financial Data......................... 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk... 43
Item 8. Financial Statements and Supplementary Data.................. 43
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 43
Part III
Item 10. Directors and Executive Officers of the Registrant........... 44
Item 11. Executive Compensation....................................... 47
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 51
Item 13. Certain Relationships and Related Transactions............... 52
Part IV
Item 14. Exhibits, Financial Statements Schedules and Reports on Form
8-K.......................................................... 56
PART I
Item 1. Business
Overview
drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products. As of
January 2, 2000, we have sold our products to approximately 695,000 customers.
We were incorporated in April 1998 and commercially launched our Web site on
February 24, 1999. We designed our store to provide a convenient, private and
informative shopping experience that encourages consumers to purchase products
essential to healthy, everyday living. Our Web site can be accessed 24 hours a
day, seven days a week from anywhere that a consumer has Internet access. We
believe we offer a larger selection of products than typical store-based
retailers, along with a wealth of health-related information, buying guides
and other tools designed to help consumers make more educated purchasing
decisions. Our shopping lists and e-mail reminders are designed to make it
easier for our customers to regularly purchase their preferred products. We
believe that our online store provides a customer with a superior shopping
experience, making buying What Every Body Needs(TM) less of a chore.
Industry Background
The Growth of the Internet and Electronic Commerce
The Internet has become an important medium for communicating, finding
information and purchasing products and services. We believe that the number
of Web users in the United States will increase as a result of a number of
factors including:
. The large installed base of personal computers in the workplace and
home;
. Advances in the performance and reductions in the cost of personal
computers and modems;
. Improvements in the ease of use and security of the Internet;
. The availability of a broader range of online products, information and
services; and
. Growing awareness among consumers and businesses of the benefits of
online shopping.
The Internet has unique and powerful characteristics that differentiate it
from traditional distribution channels and have facilitated its use as a
purchasing medium. We believe consumers using the Internet to purchase goods
expect a more information-intensive experience than when they shop at a
traditional retail store. We believe the ability to obtain relevant, up-to-
date information makes the consumer better prepared to make a purchase.
Accessing the Internet from a computer in the home or office allows a consumer
to easily scroll through and search articles, pages of product data and
related topics. This allows consumers to research and then purchase products
at their convenience.
Healthcare Trends on the Internet
Healthcare is one of the largest segments of the U.S. economy, representing
an annual expenditure of roughly $1 trillion, and health and medical
information is one of the fastest growing areas of interest on the Internet.
We believe that a large number of consumers shop for healthcare products
online and that the number of adults in the United States searching online for
health and medical information has grown and will continue to grow.
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The drugstore.com Market
The market we address can be divided into five primary categories: health,
beauty, wellness, personal care and pharmacy. Many products in this market are
personal (being used on a person's skin or in a person's body) and essential,
and often are purchased repeatedly. In this market, vendors frequently
introduce new products, and consumers seek comprehensive product information.
Consumers currently shop for these products primarily in chain drugstores,
mass market retailers, supermarkets, warehouse clubs and independent
drugstores. However, category-specific retailers and catalogs also serve each
of these categories. Overall, distribution of products in our primary market
categories is fragmented.
Key aspects of the primary categories of the drugstore.com market are as
follows:
Health. The health category includes over-the-counter remedies (such as
cough, cold, allergy and pain relief medications), first aid, medical devices
for home healthcare, contraceptives and other products related to the body's
health needs. We believe that the aging U.S. population, along with a greater
portion of prescription drugs becoming available as over-the-counter
medications, will contribute to growth in this market category. Consumers in
the health category often seek significant amounts of product information to
determine which products will meet their health needs. Consumers generally buy
health products from chain drugstores, mass market retailers, supermarkets,
and warehouse clubs as well as from locally-owned, independent drugstores and
convenience stores. Representative brands carried in our health product
category include Advil, Tylenol, Pepcid, Bausch & Lomb and Metamucil.
Beauty. The beauty category includes cosmetics, fragrances and a variety of
skin care products. Some of the factors driving consumer demand for beauty
products include regular and seasonal new product introductions, as well as
changing fashion trends. Consumers often seek advice regarding these trends or
the functionality of new products. The beauty category can be broadly
classified into two subcategories: mass market and prestige products.
Consumers for mass market beauty products typically purchase such products in
mass market retailers, drugstores and supermarkets. Consumers for prestige
products generally shop in department stores, beauty specialty stores, or spas
and salons. Representative brands carried in our beauty product category
include Revlon, L'Oreal, Cover Girl and Neutrogena.
Wellness. The wellness category includes vitamins, nutritional supplements,
herbs, homeopathy, and other natural products. We believe that increasing
consumer interest in nutritional and wellness products to improve physical and
mental well-being has contributed to growth in this category. We believe
supplemental product information is important to these consumers because they
are interested in the intended physiological effects of these products.
Consumers can obtain these products at chain drugstores, mass market
retailers, supermarkets, warehouse clubs, and specialty stores as well as
through catalogs or online vitamin and nutrition stores. Representative brands
carried in our wellness product category include Centrum, One-A-Day, Nature
Made, Twinlab, Natrol and Nature's Way. We are also the exclusive online
retailer of GNC wellness products.
Personal Care. The personal care market category includes products related
to hair, body and eye care, shaving, oral hygiene and feminine needs. The
personal care category is comprised of a number of different product groups
that consumers typically shop for at mass market retailers, chain drugstores,
supermarkets, warehouse clubs and specialty stores. Representative brands
carried in our personal care product category include Gillette, Colgate,
Johnson & Johnson, Rogaine and Pampers.
Pharmacy. This category consists primarily of prescription medication for
chronic illnesses, such as high blood pressure, osteoporosis and depression.
We believe that a significant percentage of prescription sales for chronic
illnesses are distributed through retail channels, and that the number of
prescriptions written for chronic illnesses will grow due to an aging
population and the increasing utilization of pharmaceuticals in medical
management. Over the past ten years, mail order pharmacies have become an
increasingly important source of pharmaceuticals for chronic illnesses.
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Limitations on Traditional Channels of Distribution
Traditional channels of retail distribution for health, beauty, wellness,
personal care and pharmacy products have many limitations, including:
Inconvenience. Consumers often view shopping for many of these products as
a chore. Shopping at a physical store can be highly inconvenient. It generally
involves time-consuming activities such as making a trip to the store, finding
a parking space, searching for the desired products, and waiting in line to
fill a prescription or make a purchase. This process can be especially
difficult for customers with disabilities or parents with young children. To
increase convenience for consumers, traditional store-based retailers often
need to open new stores, which is time-consuming and expensive. Each new store
results in significant investments in inventory, real estate, building
improvements and the hiring and training of store personnel. The required
investment may limit the ability of traditional store-based retailers to serve
geographic areas that are not densely populated. Also, an existing store may
face substantial added costs if it attempts to build more parking spaces or
hire more clerks in order to reduce parking and waiting inconveniences.
Narrow Selection. Consumers value the opportunity to select items from a
broad range of products that best fit their needs. However, consumers must
often choose from a narrow product selection at traditional store-based
retailers. Stores may not carry a full range of products, especially prestige,
specialty or regional products, or carry a full assortment of sizes. Desired
items may be out of stock. Overcoming these difficulties can be prohibitively
expensive for traditional retail stores, usually due to shelf space
limitations, the cost of carrying inventory and the resulting need to allocate
inventory dollars to popular products. To the extent that mass market
retailers allocate physical store space to items such as alcohol, lawn
furniture, motor oil and snack foods, they may have to reduce the number of
health, beauty, wellness and personal care products that they offer. Product
selection in traditional store-based retailers cannot be tailored to
individual needs because it is driven by aggregate demand.
Limited Information and Communication. Consumers buying health, beauty,
wellness, personal care and pharmacy products often seek information and
knowledgeable advice to assist them in making purchasing decisions. Many
traditional store-based retailers do not provide consumers with access to
useful product information or readily-available on-site experts who can
provide helpful advice. Employees at traditional store-based retailers,
especially supermarkets and mass market retailers, may have limited if any
interaction with their customers. Often there is no direct contact, except at
the check-out line. Customers may also face difficulties following up with
questions after a purchase. While traditional store-based retailers could take
steps to increase the availability of customized information and on-site
experts, such steps would involve substantial investments in printing and
training. In addition, it is difficult for a traditional retail store to use
information about a particular consumer to personalize that consumer's
shopping experience.
Lack of Privacy. Because many health, beauty, wellness, personal care and
pharmacy products are inherently personal, consumers often desire ways to
preserve the anonymity of their purchases and the confidentiality of the
information transferred in the buying process. Many consumers may feel
uncomfortable purchasing certain drugstore products, such as birth control
devices, feminine care products, and incontinence products, in a traditional
retail store. Many consumers have encountered the unpleasant experience of
placing such a product on a checkout stand's conveyor belt in front of store
clerks and other waiting customers. Consumers may hesitate to ask store
personnel questions about which product best meets a need, or how to use a
product, especially if either the question or the answer is embarrassing or
may be overheard by others. Overcoming this limitation is very difficult for
traditional retail stores because the consumer must visit a physical store
frequented by other customers and must interact in person with store
employees.
The drugstore.com Solution
We are a leading online drugstore: a retail store and information site for
health, beauty, wellness, personal care and pharmacy products. We designed our
store to provide a convenient, private and informative shopping
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experience that encourages consumers to purchase products essential to
healthy, everyday living. We believe our online store provides customers with
a superior shopping experience, making buying What Every Body Needs(TM) less
of a chore.
We draw and retain consumers by emphasizing key attributes of our store:
Convenience. Our user-friendly Web store may be reached from wherever the
shopper has Internet access, such as the shopper's home or office. Further
convenience advantages at our store include:
. Shopping 24 hours a day, seven days a week;
. Direct delivery to the shopper's home or office, avoiding the need for a
trip to a physical store;
. The opportunity for customers to order refills of their existing Rite
Aid prescriptions on our Web site for pick up at a local Rite Aid store
or for delivery using one of our standard delivery options;
. A personal shopping list for every customer, allowing for quick and easy
reordering in future visits;
. Simplified searching for products and information using advanced search
technology;
. Confidential access by a customer to his or her individual medication
profiles at any time; and
. Ability to purchase and send products easily to others.
Selection. Because we do not have shelf-space limitations, we believe we
offer a significantly greater number of products than are available in a
traditional chain drugstore. Not only do we offer traditional chain drugstore
items (prescription drugs, over-the-counter medications and personal care), we
offer a broad selection of health, beauty and wellness products. Many
traditional chain drugstores do not carry a wide range of these products. We
believe that we offer one of the largest selections of drugstore products
available on the Internet. We are also the only online retailer that offers
GNC wellness products.
Information. Because the Web has become an increasingly important tool for
researching healthcare topics, we believe that providing useful information is
a critical aspect of enabling consumers to make informed purchasing decisions.
We have assembled a broad array of information on our Web site that can enable
our consumers to make informed purchasing decisions. This information is
focused on key aspects of our market segments and is produced in-house, by
third-party expert sources or submitted to our Web site's Test Drive feature
by customers who test our products. Consumers can either access our
information directly, through a number of content features on our Web site, or
can get free help directly from our advisors and experts by contacting them
through e-mail. Our information services include:
. Full Product Packaging Information. Almost every product available on
our Web site can be viewed in an expanded format where all package
information, including ingredients, directions and warnings, can be read
next to an enlarged photograph of the product. We believe we are the
only online retailer to provide all the information that is normally
found on the products' packaging.
. Solutions. Our Solutions area provides an easy way for customers to find
the information they need to make an informed purchasing decision. It
includes buying guides, reference information, interactive shopping
advisors and articles on beauty trends and products.
. Easy Access to Drug Information and Personalized Pharmacy
Advice. Consumers can access our extensive drug information library
directly at our Web site, anytime at their own convenience. Patient
information and drugstore.com drug prices can be accessed via our drug
index. We provide information to help consumers understand generic drug
alternatives. We also provide health- and pharmacy-related editorial
content in our online Solutions area. Our pharmacists can provide
personal guidance by phone
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or e-mail to ensure that each customer understands the correct usage,
possible side effects and expected beneficial outcomes of a prescription
or an over-the-counter medication.
Communication. We can communicate with customers on a regular basis through
the convenience of e-mail. In addition to our Ask Your Pharmacist and Ask Your
Beauty Expert features, we offer the following means of communication with our
store:
. Reminders. We have the ability to e-mail a customer when a prescription
or non-prescription product is about to run out, reminding him or her to
order a replacement product or a prescription refill. Customers simply
tell us how often they need a product and we can send them a notice
before it is scheduled to run out.
. Specialized Customer Care. To ensure timely and high-quality customer
service, we have established specialty teams within the drugstore.com
customer care department. Our Web site, product and insurance
specialists respond to customer e-mails and calls that are related to
shopping orders, insurance, prices, and shipping. Once an order is made,
customers can view order-tracking information on our Web site.
. Personalized Communications. As customers use our Web site, they can
provide us with information about their buying preferences and habits.
We can use this information to develop personalized communications and
deliver useful newsletters, special offers and new product announcements
to our customers via e-mail and other means. In addition, we use e-mail
to alert customers to important developments and merchandising
initiatives.
Privacy. Customers can shop in the privacy of their own homes or offices.
When shopping at a physical store, many shoppers feel embarrassed or
uncomfortable buying items that may reveal personally-sensitive aspects of
their health or lifestyle to store personnel or other shoppers. Shoppers at
drugstore.com avoid these problems. Through features such as Ask Your
Pharmacist and Ask Your Beauty Expert, customers can obtain answers to
questions that they would otherwise be uncomfortable asking in public.
Pharmacy. We employ licensed pharmacists and are able to ship prescription
products to all 50 U.S. states, and we offer customers the opportunity to order
refills of their existing Rite Aid prescriptions on our Web site for pick-up at
a conveniently located Rite Aid store or for delivery using one of our standard
delivery options. Through our relationships with Rite Aid, insurance companies
and PBMs, we are able to obtain insurance reimbursement coverage for many
insured prescriptions. Customers can ask our pharmacists about medications and
receive other information about prescriptions drugs and health-related products
using the Ask Your Pharmacist feature of our Web site.
Although we believe we offer significant advantages over traditional chain
drugstores, certain customers may feel that traditional chain drugstores offer
several advantages over our service, and we may not be able to meet the needs
of some customers. For example, we cannot serve emergency needs and we cannot
serve customers who do not have access to the Internet. Some customers may also
prefer to touch and see products in person, rather than view them on a computer
screen or prefer to talk to a pharmacist in person. Some customers may also
have general concerns about the privacy and security of information transmitted
over the Internet and will therefore prefer to shop in physical stores.
Shopping at drugstore.com
Shoppers at drugstore.com see a home page that highlights our five product
departments, as well as editorial content and promotions. A shopper can browse
through the store by clicking on the permanently displayed department names,
move directly to a department's home page and view promotions and featured
products. All product lists allow a shopper to select products based on brand
or unique attributes of the category, such as tartar control or whitening for
toothpaste, or color for lipstick or eye shadow. Shoppers can also search the
site by entering text in the search box at the top of any page.
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A customer can select products to purchase by clicking on the "buy" button
in the product list. The products are then added to the customer's shopping
bag. If a customer needs more information to make a purchase, we supply
interactive tools and content to aid in the decision, such as:
. Solutions. Our Solutions area provides an easy way for customers to find
the information they need to make an informed purchasing decision. Some
of the components of the Solutions area include:
Shopping Advisors. Our shopping advisors consist of interactive
tools to help consumers find the right products for their needs. We
currently feature a cold and cough advisor, a skin care advisor and
a vitamin and supplement advisor. Through an easy-to-use interactive
format, a customer provides information about what he or she needs,
and the advisor provides information that enables the customer to
choose the appropriate product.
Buying Guides. Our buying guides help consumers make informed buying
decisions. We currently feature buying guides on condoms, birth
control pills, cold and cough medicine, toothpaste, shampoo and
sunscreen. The buying guides provide helpful information about the
key benefits and characteristics of each of these products.
. Your List. Returning customers can easily view their previous purchases
by consulting their personalized shopping lists through our Your List
feature. The shopping lists make buying regularly-replenished items even
easier to purchase because the customer can move products into their
shopping bag directly from their personalized shopping list, without
browsing the site. If requested by the customer, we also send e-mail
reminders to consumers when items on their lists are scheduled to run
out and need to be replenished.
. Quick Lists. Our Quick Lists feature provides customers a starting point
for finding frequently used products for different product categories,
such as a medicine cabinet, beauty essentials and a travel bag. Within
each product category, the customer can choose a specific product and
move the product into his or her shopping bag. The customer can then
move directly from his or her shopping bag back to the Quick Lists and
choose another product or list.
. Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
ask our pharmacists questions about over-the-counter and wellness
products as well as prescription drugs.
. Ask Your Beauty Expert. Our Ask Your Beauty Expert feature allows
customers to ask our beauty experts questions about beauty needs. Our
beauty experts respond to questions via e-mail and seek to answer
questions within one business day.
. Getting Help. From every page of our Web site, a customer can click on a
"help" button to go to our customer care area. In this area, we assist
customers in searching for, shopping for, ordering and returning our
products. In addition, we provide customers with answers to the most
frequently asked questions and encourage our visitors to send us
feedback and suggestions via e-mail.
When the customer finishes selecting the desired products, he or she goes
to checkout. The only information required to checkout is an e-mail
identification, password (to protect account privacy), shipping address and a
valid credit card number. All of this information is maintained in a secure
format and remains available for the customer's future access.
Pharmacy Services
The pharmacy services at drugstore.com are provided by experienced clinical
professionals using advanced information technologies. We employ licensed
pharmacists who ensure private, personal customer service. We have received
Verified Internet Pharmacy Practice Sites (VIPPS) certification from the
National Association of Boards of Pharmacy. The VIPPS program sets standards
for Internet pharmacies and informs the public of those Web sites that have
agreed to comply with its standards. We are able to ship prescription products
to all 50 U.S. states, and through our arrangement with Rite Aid, customers
may also order refills of their existing Rite Aid
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prescriptions on our Web site for pick-up at any of the over 3,800 Rite Aid
stores in the United States or for delivery using one of our standard delivery
options. In connection with opening our distribution center, we also expanded
our pharmacy operations through our arrangement with Rite Aid.
Services. We seek to provide a high level of responsiveness and customer
support. In addition to our extensive drug information, specialized customer
care features and refill reminders, our pharmacy services include:
. Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
ask our pharmacists questions about medication, dosage, delivery
systems, common side effects and other information about prescription
drugs and health-related products. Our pharmacists seek to provide an
initial answer via e-mail within one business day.
. Private Access to drugstore.com Prescription History. Customers who fill
their prescriptions at drugstore.com can access their secure, individual
medication profiles at any time. A written patient information document
accompanies all medications dispensed to drugstore.com customers. This
service enables customers to maintain a record of their prescription
purchases for clinical, insurance and tax reporting purposes.
Filling Prescriptions. We only accept prescriptions from licensed health
care providers. We do not prescribe medications or otherwise practice
medicine. We focus on dispensing medications used by consumers on a chronic
basis. For acute care needs, meaning when a customer has a single episode of a
short-term illness or an exacerbation of a chronic condition in either case
requiring immediate attention, we recommend that customers pick up their
prescriptions from a local pharmacy because the treatment of acute care needs
are extremely time sensitive and the delivery time required by online
purchases could be too slow for the customer's needs. Medications used for
acute care needs include antibiotics and pain medications. We also do not
dispense certain controlled substances known as Schedule II pharmaceuticals at
this time because there are increased risks associated with their
dispensation, such as fraud, illegal resale of prescription drugs, and special
storage shipping and handling requirements. Schedule II Pharmaceuticals are
drugs classified by the Controlled Substance Act of 1970 as having a high
potential for abuse, such as opiates (including morphine) and products that
contain oxycodone stimulants (including amphetamine and methylphenidate) and
depressants (including secobarbital and amobarbital). We accept, verify and
cross-check prescriptions much like traditional retail and mail service
pharmacies:
. Accepting Prescriptions. For new prescriptions, customers can direct
their physicians to call or fax their prescriptions to us at 1-800-
DRUGSTORE, or request that we contact their physician directly to obtain
prescription information. For transfers, customers can direct their
pharmacy to transfer their prescriptions or request us to contact their
pharmacy to transfer the prescription to drugstore.com. For refills,
customers may order directly from our Web site or respond to one of our
e-mail refill reminders.
. Verifying Prescriptions. Our pharmacists verify the validity and
completeness of prescription drug orders utilizing the same methodology
as community-based pharmacists. The standard practice for verification
of prescription drug orders is that the pharmacist will contact the
physician's office by telephone or fax if there is any reason to
question the validity, accuracy or authenticity of any order. In
addition, our pharmacists call and verify the validity of prescription
drug orders for allowable controlled substances, i.e., Schedule III-V
drugs. In addition, our pharmacists verify that all legally required
information is recorded on the prescription drug order and utilize a
database to verify physician identifying information, if necessary.
. Drug Utilization Review. To use our prescription drug services, all
customers are asked to provide our pharmacists with information
regarding drug allergies, current medical conditions and current
medications. Our pharmacists use advanced technologies to cross-check
every prescription against the information we receive from the customer
for drug-, disease- and allergy-drug interactions.
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Payment. Customers may pay for their prescriptions with cash, by credit
card or by entering insurance information that shows that they are covered by
a managed care organization, insurance plan or PBM with whom we have a
contract. To date, the majority of our prescriptions have been submitted by
customers with insurance coverage. As a result of our relationship with Rite
Aid, we are able to fill prescriptions for most customers with pharmacy
benefits covered by a plan accepted by Rite Aid, and we participate in
substantially all of the retail pharmacy networks managed by PCS, one of the
leading pharmacy benefit management companies in the United States that claims
to provide pharmacy benefit management services for more than 50 million
individuals in the United States.
Pharmacy Supply. Since inception, a substantial majority of our
pharmaceutical products have been supplied by RxAmerica. Upon the opening of
our own distribution center, we became obligated to purchase all of our
pharmaceutical products from Rite Aid, unless we are able to obtain better
overall terms from another vendor. We expect that Rite Aid will account for an
increasingly significant portion of our pharmaceutical product purchases. This
purchase commitment will continue for the term of the Rite Aid relationship.
Marketing and Promotion of Our Site
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 advertising campaigns target both online and traditional audiences and
are designed to promote an enhanced customer experience. Our online
advertising efforts have been focused on highly-visited Internet portals,
health-related Web sites and other highly-visited Web sites. We also have
strategic relationships with Amazon.com, Rite Aid and GNC, who all promote our
Web site. We believe that the marketing benefits of our relationship with
Amazon.com include the integration of various shopping features of our Web
sites, the creation of a persistent drugstore.com shopping presence on
Amazon.com's Web site, and the promotion of our site by one of the premier e-
commerce companies. In addition, Rite Aid has agreed to include drugstore.com
in a significant portion of Rite Aid's own advertisements, as well as on
shopping bags, prescription vial caps, in-store signs and permanent links from
its Web site. In addition, we advertise on America Online and Yahoo!, as well
on other sites where our customers are likely to visit, including ThirdAge,
InteliHealth, OnHealth, Medscape and Women.com. We also extend our market
presence through our Associates Program, which enables associated Web sites to
make our products and services available to their audiences through a link to
our Web site. We intend to continue to use the unique resources of the
Internet as a means of marketing in an effort to drive traffic and repeat
purchases. For example, we recently entered into a five-year agreement with
ProVantage, a healthcare knowledge and benefit management company, to co-
develop and market Internet-based products and programs. Under the agreement,
the ProVantage Web site will act as a portal to the drugstore.com site,
enabling ProVantage members to fill prescriptions and access new Internet-
based programs and products.
We have also used traditional marketing and promotion efforts, including
special product promotions, print, television and radio advertising in
selected markets, promotional press releases and public appearances by our
executives. We intend to further intensify our advertising efforts through
traditional media channels to continue building our brand recognition.
Merchandising Strategy
We believe that the breadth and depth of our product selection, together
with the flexibility of our online store and our range of helpful and useful
shopping services, enables us to pursue a strong merchandising strategy.
Aspects of this strategy include:
Easy Access to a Wide Selection of Products. Our easy-to-use Web site and
robust search capabilities enable customers to browse our product selection by
brand, age, product and price, as well as combinations of these categories.
For example, a customer can easily search for all aspirin products or for
Tylenol for children
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without consulting store personnel or searching traditional store shelves.
Combination searching allows customers to find desired items easily among our
large selection of products.
Dynamic Product Offering. Our online store gives us flexibility to change
featured products or promotions without having to alter the physical layout of
a store. We are also able to dynamically adjust our product mix in response to
changing customer demand, new seasons or upcoming holidays and introduce
special promotions.
Specialty Stores. We are establishing specialty stores in each of our
product categories. Our first specialty store, the boutique, sells high-end
cosmetics. We have also established the GNC LiveWell Store, which is dedicated
to GNC nutritional products and other products typically sold in GNC stores.
We are the exclusive distributor of GNC brand products on the Internet subject
to our meeting performance parameters during the third and fifth years of the
relationship.
Extensive Product Information. A key component of our merchandising
strategy is the ability to use information as a tool for consumers. We combine
manufacturer information with editorial information or buying guides to allow
customers to make more informed buying decisions and to more easily comparison
shop for products. In addition, our Web site allows us to market products to
customers in many different ways, such as by product category or by product
characteristics, such as price or ingredients.
Targeted Promotions. We have the ability to offer products to individual
customers based on their affinities or conditions. In addition, we can present
merchandise to a customer tailored to personal interests and shopping
histories. We also cross-sell a brand across our departments to promote
impulse buying by customers. For example, we might promote mothers' products
in our Pregnancy and Infant Center.
Sampling. We have programs that allow us to provide samples of products to
customers as trials. We may also use sampling to work with manufacturers to
introduce new products.
Information Objectives
Our editorial strategy is to present helpful, value-added information to
consumers in a readable, user-friendly format. Our editors create, source and
maintain health, beauty, wellness, personal care and pharmacy related content
for our Web site. Our editors assemble content to provide both reference and
product-related information. To date, we have established relationships with
several leading information providers who provide content for our site. We
will continue to direct our editorial efforts toward enhancing existing
features as well as sourcing new content to help our customers. For example,
we have launched a variety of health and special interest content areas, such
as our Pregnancy and Infant Center, Breast Health Center, and Cold and Flu
Center. Working in conjunction with our pharmacists, we have created a
searchable database of over 500 answers to frequently asked health questions.
We also have published over 260 product reviews by our customers through a
feature called Test Drive.
Delivery of Our Customer's Orders
In January 2000, we began limited operations at our own 290,000 square foot
distribution center in New Jersey, and we are in the process of transitioning
our distribution capabilities for pharmaceutical and non-pharmaceutical
products from third party distributors to our center. We currently outsource a
substantial majority of our distribution and fulfillment operations on a non-
exclusive basis through Walsh Distribution and RxAmerica, although we expect
that the transition to our own distribution facilities will be completed by
the end of the second quarter of 2000. We believe that operating our own
distribution center will allow us to achieve greater control over the
distribution process and help us to ensure adequate supplies of products to
our customers. In connection with opening our distribution center, we also
expanded our pharmacy operations through our arrangement with Rite Aid.
Operating our own distribution facility will require us, in the near term, to
hire and train a significant number of new employees, increase inventory
levels substantially and establish a significant number of direct
relationships with manufacturers. In addition, as we transition to our own
distribution center, order fulfillment through multiple channels and
underutilization of our own distribution capacity could result in cost and
service level inefficiencies.
9
For the period from inception to January 2, 2000, Walsh Distribution
accounted for 68% of our cost of sales for health, beauty, wellness and
personal care products. As we transition customer order fulfillment to our own
distribution center, we intend to establish relationships directly with
product manufacturers, and we expect that order fulfillment through Walsh
Distribution will cease by the end of the second quarter of 2000. At the Walsh
facility, our employees package for shipment all customer orders, including
drugstore.com inventory purchased directly from other vendors that Walsh holds
for us at their facility. We staff our own customer care specialists at the
Walsh facility to monitor quality control and order fulfillment. Walsh
provides inventory and services under a supply and services agreement that
expires on March 31, 2000. This agreement may be extended for three months at
our sole discretion and may be terminated earlier by us upon accelerated
payment of minimum fees that would not exceed approximately $1 million.
We currently purchase substantially all of our pharmaceutical products from
one vendor, RxAmerica, in accordance with a pharmacy services agreement. In
connection with establishing our own distribution center, we became obligated
to buy our pharmaceutical products from Rite Aid, unless we are able to obtain
better overall terms from other vendors. As the number of orders filled out of
the pharmacy operation in our distribution center increases, we expect that
purchases from Rite Aid will account for an increasingly significant portion
of our total pharmaceutical product purchases. We staff our own pharmacists,
pharmacy technicians and customer care specialists at the RxAmerica facility.
For prescriptions filled at the RxAmerica facility, our pharmacists perform
all aspects of the prescription fulfillment process and all aspects of
customer service, except for the physical filling and packaging of
prescription drugs, which is performed by RxAmerica pharmacists. For
prescriptions filled through the pharmacy we operate under our arrangement
with Rite Aid, our pharmacists perform all of these functions working together
with a Rite Aid "pharmacist in charge." drugstore.com and RxAmerica are
licensed and in good standing in each state where licensure is required by
law. The pharmacy services agreement with RxAmerica has a one-year term (to
February 2000) and has been extended to June 2000. The agreement is non-
exclusive and does not prevent us from using other vendors for pharmaceutical
products.
Our warehouse management system, which is integrated with RxAmerica's and
Walsh's information systems, provides us real-time data on inventory
receiving, shipping, inventory quantities and inventory location. This enables
us to notify customers on a real-time basis if the product is in stock. In
addition, we offer an order tracking system for our customers on our Web site.
The inventories of Rite Aid, RxAmerica and Walsh consist of items typically
found in traditional chain drugstores. We charge our customers a shipping
charge that covers all or a portion of our expenses of shipping. Walsh
purchases substantially all of its inventory directly from the manufacturers
of the products. Rite Aid and RxAmerica purchases their pharmaceutical
products from a variety of manufacturers as well as wholesalers.
We offer a variety of shipping options, including next-day delivery for
orders received during the business week. We ship to anywhere in the United
States served by the United Parcel Service or the U.S. Postal Service.
Priority orders are flagged and expedited through our fulfillment processes.
For non-prescription product orders received before 9:00 p.m. Central time
Monday through Friday or before 5:00 p.m. Central time on Saturday, our goal
is to ship the product the same day. For prescription products, our goal is to
ship the product as soon as the prescription has been verified and our
pharmacists have completed drug utilization review.
In addition, customers are able to order refills of their existing Rite Aid
prescriptions online at our Web site for pick-up at their choice of any one of
the over 3,800 Rite Aid stores or for delivery using one of our standard
delivery options. We intend to expand this service to enable our customers to
order any prescription on our Web site for pick-up at a Rite Aid store.
Customer Care
We believe that a high level of customer service and support is critical to
retaining and expanding our customer base. Our customer care specialists are
available 24 hours a day, 7 days a week to provide assistance via e-mail or
phone. We strive to answer all customer inquiries within 24 hours. Our
customer care specialists
10
handle questions about orders and how to use our Web site, assist customers in
finding desired products and register customers' credit card information over
the telephone. Our customer care specialists are a valuable source of feedback
regarding user satisfaction. Our Web site also contains a customer care page
that outlines store policies and provides answers to frequently asked
questions. In addition, our pharmacists can provide advice to our customers
about medication, dosage, delivery systems, common side effects and other
information about prescription drugs.
Operations and Technology
We have implemented a broad array of services and systems for site
management, searching, customer interaction, transaction processing and
fulfillment. We use a set of software applications for:
. Accepting and validating customer orders;
. Organizing, placing and managing orders with vendors and fulfillment
partners;
. Receiving product and assigning it to customer orders; and
. Managing shipment of products to customers based on various ordering
criteria.
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. To enhance the online and
offline experience for Rite Aid and drugstore.com customers, we have
integrated certain of our information and pharmacy systems with Rite Aid's.
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 also have a technology license and advertising agreement with Amazon.com
under which we mutually agreed to license certain existing and future
technology used in the operation of our Web sites as long as we do not use the
technology to compete with each other. We currently are not using any
Amazon.com technology but could do so in the future if it would benefit us.
See "--Relationship with Amazon.com" for a further description of our
agreements with Amazon.com.
Our core merchandise catalog, customer interaction, order collection,
fulfillment and back-end systems are proprietary to drugstore.com, but are
available to Amazon.com under our agreement with them. Our software platform
and architecture are integrated with an Oracle database system. The systems
were designed to provide real-time connectivity to the distribution center
systems for pharmacy and the non-pharmacy products. These include an
inventory-tracking system, real-time order tracking system, executive
information system and replenishment system. Our Internet servers use Verisign
digital certificates to help conduct secure communications and transactions.
Our systems infrastructure is hosted at Exodus Communications in Tukwila,
Washington, which provides communication lines from multiple providers
including UUNet and AT&T, as well as 24 hour monitoring and engineering
support. Exodus has its own generators and multiple back up systems in
Tukwila.
We maintain customer care centers in our Bellevue, Washington office and in
our prescription distribution facilities in Texas and New Jersey, and use a
real time interactive voice response system with transfer capabilities between
our customer care centers in these locations. We also operate a toll-free
number, 1-800-DRUGSTORE, through which customers can place orders and receive
information. In addition, customers who choose not to transmit their credit
card information via the Internet have the option of submitting their credit
card information by telephone.
Competition
The online commerce market is new, rapidly evolving and intensely
competitive. In particular, the health, beauty, wellness, personal care and
pharmacy categories are intensely competitive and are also highly fragmented,
11
with no clear dominant leader in any of our market categories. Our competitors
can be divided into several groups: chain drugstores, such as Walgreen's, CVS
and Eckerd; mass market retailers such as Wal-Mart, Kmart and Target;
supermarkets, such as Safeway, Albertson's and Kroger; warehouse clubs; online
retailers of health, beauty, wellness, personal care and/or pharmaceutical
products such as PlanetRx.com, MotherNature.com, VitaminShoppe.com and
More.com; mail order pharmacies; prescription benefits managers, such as
Express Scripts and Merck-Medco; Internet-portals and online service providers
that feature shopping services such as America Online, Yahoo!, Excite and
Lycos; cosmetics departments at major department stores, such as Nordstrom,
Macys and Bloomingdale's; and hair salons. Each of these competitors operate
within one or more of the health, beauty, wellness, personal care and pharmacy
product categories. In addition, nearly all of our competitors have, or have
announced their intention to have, the capability to accept orders for
products online. In particular, Walgreen's, CVS, Albertson's and Wal-Mart
already are accepting prescription refill or other orders on their Web sites.
We believe that the following are principal competitive factors in our
market:
. Brand recognition;
. Selection;
. Convenience;
. Price;
. Web site performance and accessibility;
. Customer service;
. Quality of information services; and
. Reliability and speed of order shipment.
Many of our current and potential traditional store-based and online
competitors have longer operating histories, larger customer or user bases,
greater brand recognition and significantly greater financial, marketing and
other resources than we do. Many of these current and potential competitors
can devote substantially more resources to their Web site and systems
development than we can. In addition, larger, well-established and well-
financed entities may acquire, invest in or form joint ventures with online
competitors or drugstore retailers as the use of the Internet and other online
services increases.
Some of our competitors may be able to secure products from vendors on more
favorable terms, fulfill customer orders more efficiently and adopt more
aggressive pricing or inventory availability policies than we can. Traditional
store-based retailers also enable customers to see and feel products in a
manner that is not possible over the Internet. Traditional store-based
retailers can also sell products to address immediate, acute care needs, which
we and other online sites cannot do. Some of our competitors such as
Walgreen's and Wal-mart have significantly greater experience in selling
drugstore products.
Relationship with Amazon.com
We have a strategic relationship with Amazon.com whereby Amazon.com
advertises our Web service. We believe that the benefits of our relationship
with Amazon.com include their advertising our Web site and the beneficial
aspects of our being associated with one of the premier e-commerce companies.
Amazon.com is our largest shareholder, and Jeffrey P. Bezos, Amazon.com's
chairman of the board and chief executive officer is a member of our board of
directors. As part of our relationship with Amazon.com, we entered into a
technology license and advertising agreement. This agreement extends for ten
years and can be terminated for breach or in the event that we are acquired by
a competitor of Amazon.com. This agreement contains provisions generally
relating to the sharing of technology and technical support; however, we have
decided to develop our own technology and there has been no exchange of
technology by either party to date. Specifically, this agreement
12
provides for the license of substantially all of each company's technology to
the other for use within their respective businesses that may be developed
through August 10, 2008. Neither company may use the other's technology to
compete against the other. In addition, each party has committed to providing
the other with advertising on our respective Web sites through the term of the
agreement as mutually agreed upon. In addition, we agreed not to place
advertisements competitive to Amazon.com's business on our site. We have also
agreed not to sell advertising on our Web site to, link our Web site to, or
promote on our Web site any company that sells products or services
competitive with those which Amazon.com offers or which Amazon.com is
preparing to produce or market. We are currently restricted with respect to
books, music, videos electronics, toys, home improvement products, software,
gift centers, cards, auctions and third party marketplace services through
which third parties may advertise and sell products or services. If Amazon.com
expands into other areas this may further limit the companies we can promote
on our Web site. If we are acquired by an Amazon.com competitor and Amazon.com
does not vote in favor of the transaction, we would lose our rights to
advertise on Amazon.com's website, to restrict Amazon.com's ability to compete
in the online drugstore business, and to use Amazon.com's technology (if we
are then using any).
On January 24, 2000, we entered into an agreement with Amazon.com to
integrate various shopping features of our Web sites and to create a
persistent drugstore.com shopping presence on Amazon.com's Web site.
Amazon.com has agreed to promote the drugstore.com health and beauty product
section of its Web site to its customer base in a manner similar to its
efforts with respect to its other product sections. Under the agreement, the
parties will also work to implement additional features on the Amazon.com Web
site designed to improve customer shopping experiences, including integrated
search and browse capabilities and a shared shopping basket. The agreement
also contains exclusivity provisions restricting (1) the percentage of total
revenues we can obtain from the sale on our Web site of products or services
other than health, beauty (including cosmetics, fragrance, bathing and hair
and skin care products), wellness, personal care and prescription drug
products, and (2) the percentage of revenues Amazon.com or any other
Amazon.com marketing partner can receive from the sale of these types of
products on its Web site other than through its relationship with us. We will
pay Amazon.com a total of $105 million over the three-year term of the
agreement. The agreement may be terminated for breach or in certain other
events. Concurrently with this agreement, we sold Amazon.com 1,066,667 shares
of our common stock in a private placement transaction for $28.125 per share,
or approximately $30 million in the aggregate.
Relationship With Rite Aid
In June 1999, we entered into a strategic relationship with Rite Aid. Under
the relationship, customers are able to order refills of their existing Rite
Aid prescriptions from us at our site and either use our standard delivery
options or pick up the prescriptions at the more than 3,800 Rite Aid stores
nationwide. We recognize revenues on all orders filled by us or picked up at
Rite Aid stores where our customer has used our Web site to order
prescriptions. In the case of orders from customers who have elected to pick
up their prescriptions in a Rite Aid store, we pay Rite Aid for the cost of
such products based on a contractually agreed upon price. In addition,
Rite Aid and drugstore.com have agreed to promote each other's services both
online and offline, including a link from Rite Aid's Web site to our Web site.
We believe that potential benefits of our relationship with Rite Aid include
additional revenue and traffic generated by customers who visit our Web site,
the pharmacy benefit coverage provided by the insurance companies and PBMs
with which Rite Aid has a relationship, including PCS, and the co-promotion
and co-branding activities both companies have undertaken. In connection with
this relationship, Rite Aid also became one of our largest stockholders, and
as of February 3, 2000, owned approximately 20.3% of our outstanding common
stock. In addition, Mary Sammons, Rite Aid's president and chief operating
officer, is a member of our board of directors.
As part of the relationship, both Rite Aid and drugstore.com agreed to
certain exclusivity provisions that limit drugstore.com's ability to promote
or affiliate with any other physical retail drugstore and from operating a
traditional physical drugstore, and preclude Rite Aid from offering or selling
products or services on the Internet other than through our Web site. In
addition, the agreement provides that if we establish our own distribution
13
center, we will be obligated to purchase all of our pharmaceutical
requirements from Rite Aid unless we are able to obtain better overall terms
from another vendor. The agreement contains additional provisions providing
for the licensing by Rite Aid to drugstore.com of information technology
systems and the integration of the information technology and pharmacy systems
of the two companies. This agreement extends for ten years, but can be
terminated for breach prior to such time.
Relationship With GNC
In June 1999, we entered into a relationship with General Nutrition
Companies, Inc. (GNC) whereby we are the exclusive online provider of GNC-
branded products. We have the exclusive right to sell GNC's nutrition products
over the Internet, including the PharmAssure brand of pharmacist recommended
vitamins and nutritional supplements, subject to our meeting performance
parameters based on traffic to our Web site and sales of GNC products in the
third and fifth year of the relationship. As long as we have the exclusive
right to distribute GNC's products over the Internet, we will not promote any
other retail health food store or operate a physical retail health food store.
If the exclusivity provisions of the agreement terminate, we have the non-
exclusive right to sell these products for the remaining term of the
agreement. As part of this relationship, we have created a separate part of
our Web site called the GNC LiveWell Store that is dedicated to selling on a
consignment basis GNC products. We are entitled to retain a percentage of the
gross revenues that we collect from sales of GNC products and will recognize
only the net amount retained as revenues. In connection with this
relationship, GNC acquired 2,947,853 shares of our Series E preferred stock
(all of which was converted into common stock, on a one-for-one basis, at the
closing of our initial public offering). GNC and drugstore.com also agreed to
co-promote each other's products and services in both their traditional and
online marketing efforts, including GNC's placement of a link to our Web site
on their Web site. The agreement extends for ten years, but can be terminated
for breach prior to such time. In August 1999, GNC was acquired by Royal
Numico N.V., a European maker of nutrition products.
Governmental Regulation
Our business is subject to extensive federal, state and local regulations.
In particular, entities engaging in the practice of pharmacy are subject to
federal and state regulatory and licensing requirements. For example, pursuant
to the Omnibus Budget Reconciliation Act of 1990 and related state and local
regulations, pharmacists are required to offer counseling, without additional
charge, to customers about medication, dosage, delivery systems, common side
effects, adverse effects or interactions and therapeutic contraindications,
proper storage, prescription refill, and other information deemed significant.
Entities that distribute "controlled substances" are also subject to the
Controlled Substances Act and regulations issued by the federal Drug
Enforcement Administration. Entities engaged in the practice of medicine are
also subject to state and local regulatory and licensing requirements.
We also sell dietary supplements, medical devices, cosmetics, conventional
foods, drug products (prescription, over-the-counter, and homeopathic), and
consumer products subject to regulation by the Food and Drug Administration
(FDA), Federal Trade Commission (FTC), Consumer Product Safety Commission
(CPSC), and state regulatory authorities. In addition to regulating the claims
made for specific types of products, the FDA and FTC may also attempt to
regulate the format of Web sites that offer products to consumers. As we
expand our product and service offerings, more of our products and services
will likely be subject to FDA, FTC, CPSC, and state regulation.
We have structured our business, and entered into arrangements with our
business partners, in order to comply with pharmacy regulatory and licensing
requirements, requirements applicable to distributors of controlled
substances, and requirements associated with the practice of medicine. We have
also structured our business in order to comply with FDA, FTC, CPSC, and state
regulatory requirements applicable to the sale of products to consumers.
Regulations in all of the above-mentioned areas often require subjective
interpretation, and we cannot be certain that our attempts to comply with the
above regulations will be deemed sufficient by the
14
appropriate regulatory agencies. Violations of any regulations could result in
various civil and criminal penalties, including but not limited to suspension
or revocation of any applicable licenses or registrations, seizure of our
inventory, or monetary fines that could adversely affect our operations.
Regulatory requirements to which we are subject may expand over time. For
example, the U.S. House of Representatives' Committee on Commerce recently
held a one-day hearing on the benefits and risks of online pharmacies,
especially focused on those sites that sell prescriptions based upon
information solicited in a brief questionnaire filled out by the customer
online. The U.S. General Accounting Office is conducting a review of online
pharmacies, including the current laws that govern pharmacy operations, and
the potential for abuses by some online sites, again focusing on those that do
not require the submission of a valid prescription issued by the customer's
physician. In addition, a federal interagency task force is preparing a report
on the effectiveness of current laws, and the availability of technology to
law enforcement, in addressing possible unlawful activity over the Internet,
including in connection with the sale of prescription drugs. In December 1999,
the Clinton Administration announced a proposal to eliminate the illegal sale
of prescription drugs over the Internet by unlicensed Web site operators. If
approved by Congress, the proposal would, among other things, establish new
federal requirements for Internet pharmacies to ensure that they comply with
state and federal laws, create new civil penalties for the illegal sale of
pharmaceuticals, and authorize additional federal enforcement powers. We
believe we are in compliance with existing federal and state requirements for
pharmacy licensing and registration, and with laws relating to dispensing of
prescription drugs, security, record-keeping and reporting of pharmacy sales.
Thus, we believe that our business would not be negatively affected by any
laws or regulations that result from this government oversight or the Clinton
Administration's proposal. However, we do believe that any resulting laws or
regulations will likely increase our reporting and monitoring requirements.
The National Association of Boards of Pharmacy, a coalition of state
pharmacy boards, has developed the VIPPS program, a model for voluntary
regulation for online pharmacies that provides certification of compliance
with all state laws and regulations and other criteria established to ensure
good pharmacy practice. We have received VIPPS program certification.
Legislation and regulations currently being considered at the federal and
state level could affect our business, including legislation or regulations
relating to confidentiality of patient records, electronic access and storage.
In addition, various state legislatures are considering new legislation
related to the regulation of nonresident pharmacies.
The inclusion of prescription drugs as a Medicare benefit has been the
subject of numerous bills in the U.S. Congress. Should legislation on
prescription drug coverage for Medicare recipients be enacted into law, we
would be subject to compliance with any corresponding rules and regulations.
Intellectual Property
We regard the protection of our copyrights, service marks, trademarks,
trade dress and trade secrets as critical to our future success and rely on a
combination of copyright, trademark, service mark and trade secret laws and
contractual restrictions to establish and protect our proprietary rights in
products and services. We have entered into confidentiality and invention
assignment agreements with our employees and contractors, and nondisclosure
agreements with our vendors, fulfillment partners and strategic partners to
limit access to and disclosure of our proprietary information. We cannot be
certain that these contractual arrangements or the other steps taken by us to
protect our intellectual property will prevent misappropriation of our
technology. We have licensed in the past, and expect that we may license in
the future, certain of our proprietary rights, such as trademarks or
copyrighted material, to third parties. For example, as noted above, we have
licensed our technology to Amazon.com and we have also granted nonexclusive
rights to our trademarks in connection with advertising and affiliate
relationships. While we attempt to ensure that the quality of the
drugstore.com products brand is maintained by such licensees, we cannot assure
that such licensees will not take actions that might hurt the value of our
proprietary rights or reputation. We also rely on technologies that we license
from third parties,
15
such as Oracle and Microsoft, the suppliers of key database technology, the
operating system and specific hardware components for our service. As part of
our relationship with Rite Aid, we have also licensed information technology
systems from Rite Aid. We cannot be certain that these third-party technology
licenses will continue to be available to us on commercially reasonable terms.
The loss of such technology could require us to obtain substitute technology
of lower quality or performance standards or at greater cost, which could harm
our business.
We have filed applications for the registration of some of our trademarks
and service marks in the United States and in some other countries, including
for drugstore.com(TM). We have not secured registration of any of our marks to
date. DRUGSTORE.COM(TM), the drugstore.com logo, THE BOUTIQUE(TM), WHAT EVERY
BODY NEEDS(TM), WHERE EVERY BODY SHOPS(TM), WHAT YOUR BODY NEEDS(TM), HEALTH .
BEAUTY . WELLNESS(TM), WELLNESS CONNECTIONS(TM), LET THE DRUGSTORE COME TO
YOU(TM), QUICK LISTS, TEST DRIVE(TM), ONE VERY HEALTHY ATTITUDE(TM) and
EPUNCHCARD(TM) are our trademarks. We may be unable to secure such registered
marks. It is also possible that our competitors or others will use marks
similar to ours, which could impede our ability to build brand identity and
lead to customer confusion. In addition, there could be potential trade name
or trademark infringement claims brought by owners of other registered
trademarks or trademarks that incorporate variations of the term
drugstore.com(TM). Any claims or customer confusion related to our trademark,
or our failure to obtain trademark registration, would negatively affect our
business. In addition, the laws of some foreign countries do not protect our
proprietary rights to the same extent as do the laws of the United States, and
effective copyright, trademark and trade secret protection may not be
available in such jurisdictions. Our efforts to protect our intellectual
property rights may not prevent misappropriation of our content. Our failure
or inability to protect our proprietary rights could substantially harm our
business.
Employees
As of January 2, 2000, we had 408 full-time employees. None of our
employees is represented by a labor union. We have not experienced any work
stoppages and consider our employee relations to be good.
Item 2. Properties
Our principal executive offices are located in Bellevue, Washington, where
we lease approximately 55,000 square feet under a lease that expires in July
2005. In addition, we have entered into a lease for additional executive
office space of approximately 49,000 square feet in Bellevue, Washington that
we expect to occupy during the first quarter of 2000. We also lease an
approximately 18,750 square feet facility in Redmond, Washington, which we
vacated after moving to our new Bellevue facility, under a lease that expires
in September 2003. We have subleased the Redmond facility for a 12 month
period ending in May 2000 and currently intend to sublease such space
thereafter, if possible. We anticipate that we will require additional space
as more personnel are hired and as we establish other facilities. In addition,
our distribution facility is located in Bridgeport, New Jersey, where we lease
approximately 290,000 square feet for a five-year term, with options to renew
for two additional five-year periods, pursuant to a lease executed in
September 1999.
Item 3. Legal Proceedings
We are not a party to any material legal proceedings at this time.
Item 4. Submission of Matters to a Vote of Security Holders
None.
16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Information
Our common stock has been quoted on the Nasdaq National Market under the
symbol "DSCM" since our initial public offering on July 27, 1999. Prior to
that time, there was no public market for our common stock. The following
table sets forth, for the periods indicated, the high and low reported
intraday sales prices per share of our common stock.
Common Stock
Price
---------------
High Low
------- -------
Fiscal Year Ended January 2, 2000:
Third Quarter (from July 27, 1999)............................ $70 $32 1/2
Fourth Quarter................................................ $55 $27 1/8
Fiscal Year Ended December 31, 2000:
First Quarter (through February 24, 2000)..................... $39 3/8 $18 1/8
On February 25, 2000, the reported last sale price of our common stock on
the Nasdaq National Market was $19.125 per share. On February 3, 2000, there
were approximately 208 holders of record of our common stock.
Dividend Policy
We have never declared or paid cash dividends on our capital stock. We
currently intend to retain all available funds and any future earnings for use
in the operation and expansion of our business and do not anticipate paying
any cash dividends in the foreseeable future.
17
Item 6. Selected Financial Data
Period from
April 2, 1998
Year Ended (Inception) to
January 2, 2000 December 31, 1998
--------------- -----------------
(in thousands, except share and
per share data)
Consolidated Statements of Operations Data:
Net sales.................................................... $ 34,848 $ --
Cost and expenses:
Cost of sales.............................................. 38,440 --
Marketing and sales........................................ 61,492 3,092
Technology and content..................................... 14,918 2,178
General and administrative................................. 11,126 1,861
Charitable contribution.................................... 3,600 --
Amortization of intangible assets.......................... 10,640 33
Amortization of stock-based compensation................... 15,375 1,037
---------- -------
Total cost and expenses.................................. 155,591 8,201
---------- -------
Operating loss............................................... (120,743) (8,201)
Other income (expense):
Interest income............................................ 5,036 177
Interest expense........................................... (124) (3)
---------- -------
Net loss..................................................... $ (115,831) $(8,027)
========== =======
Basic and diluted net loss per share......................... $ (6.13) $(14.70)
========== =======
Weighted average shares outstanding used to compute
basic and diluted net loss per share........................ 18,880,969 546,149
========== =======
Pro forma basic and diluted net loss per share (unaudited)... $ (3.73)
==========
Weighted average shares outstanding used to compute
pro forma basic and diluted net loss per share (unaudited).. 31,045,835
==========
January 2, 2000 December 31, 1998
--------------- -----------------
(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable securities............. $ 132,754 $14,408
Working capital.............................................. 106,960 17,050
Total assets................................................. 395,708 22,517
Capital lease obligations, less current portion.............. 2,687 975
Total stockholders' equity................................... 350,749 19,347
18
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operation
The following discussion should be read in conjunction with the financial
statements and notes thereto included elsewhere in this report.
Overview
drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products and
information. We offer a larger selection of products than typical store-based
retailers at competitive prices, along with a wealth of health-related
information, buying guides and other tools designed to help consumers make
more educated purchasing decisions.
We were incorporated in April 1998 and commercially launched our Web site
on February 24, 1999. From the period from inception through the commercial
launch of our site, our primary activities consisted of:
. Developing our business model;
. Raising funds and developing strategic alliances;
. Designing and developing our Web site;
. Recruiting and training employees;
. Selecting our fulfillment partners and integrating their systems and
processes with ours;
. Negotiating advertising contracts with several of the major Web portals;
and
. Developing the drugstore.com brand.
Since the commercial launch of our site, we have continued these operating
activities and have also focused on acquiring and retaining customers,
expanding our product offerings, building vendor relationships, promoting our
brand name, improving the efficiency of our order fulfillment processes,
establishing customer service operations and developing our own distribution
capabilities.
All customer orders are processed through our Web store and can be either
shipped to the customer or, in the case of refills of existing Rite Aid
prescriptions, picked up by the customer at any Rite Aid store in the United
States. Orders are either billed to the customer's credit card or, in the case
of prescriptions covered by insurance, billed to third parties. Sales of
pharmaceutical products covered by third parties are recorded at the net
amount to be received. Generally, we collect cash from credit card sales in
two to five days from the date the order is shipped. Amounts billed to third
parties are, on average, collected in approximately 30 days; however, such
timing can vary depending on the payor. Sales billed to third party insurance
companies and PBMs through our relationship with Rite Aid currently represent
a significant percentage of our pharmacy sales. We expect that sales billed to
these third parties will continue to represent a significant percentage of our
pharmacy sales for the forseeable future.
We routinely offer discounts and coupons to customers. In addition, if a
customer is not satisfied with a particular product or the level of customer
service we provide, we generally refund all or a portion of the sale.
Allowances for refunds and sales price incentives, including discounts and
coupons, are netted against the related sales price in net sales. We may in
the future expand or increase the coupons and discounts we offer to our
customers.
In January 2000, we began limited operations at our own 290,000 square foot
distribution center, and we are in the process of transitioning our
distribution capabilities for pharmaceutical and non-pharmaceutical products
from third party distributors to our center. In connection with opening our
distribution center, we also opened our own pharmacy as part of our agreement
with Rite Aid. Operating our own distribution facility will require us, in the
near term, to hire and train a significant number of new employees, increase
inventory levels substantially and establish a significant number of direct
relationships with manufacturers. In addition, as we transition to our own
distribution center, order fulfillment through multiple channels and
underutilization of our own distribution capacity could result in cost and
service level inefficiencies.
19
Currently, we purchase substantially all of our pharmaceutical products from
RxAmerica and more than half of our nonpharmaceutical products from Walsh. We
also purchase pharmaceutical products from Rite Aid. Products are purchased
from RxAmerica, Walsh and Rite Aid after the customer submits an order, and we
maintain an inventory of nonpharmaceutical products that are not available from
Walsh. As we transition customer order fulfillment to our own distribution
center, we intend to establish relationships directly with product
manufacturers, and we expect that order fulfillment through Walsh will cease by
the end of the second quarter of 2000. In addition, in connection with
establishing our own distribution center, we are obligated to buy our
pharmaceutical products from Rite Aid, unless we are able to obtain better
overall terms from other vendors. As the number of orders filled out of the
pharmacy operation in our distribution center increases, we expect that
purchases from Rite Aid will account for an increasingly significant portion of
our total pharmaceutical product purchases.
On February 2, 2000, we acquired Beauty.com, a Web store specializing in
prestige beauty products, and entered into an agreement to retain the
employment of its founder, Roger Barnett, for a total of 1,266,289 shares of
drugstore.com common stock (approximately $40.4 million based on the price of
our common stock on January 12, 2000, the date the transaction was announced).
Beauty.com maintains an inventory of all products that it sells and we expect
our inventory to increase significantly relative to our current levels as a
result of the acquisition. Beauty.com currently outsources its fulfillment
operations to Keystone Corporation and we expect to begin integrating
Beauty.com's fulfillment operations into our own while keeping the Beauty.com
Web store intact. A significant portion of the shares of common stock that we
issued under the acquisition agreement are subject to the terms of an escrow
agreement and will be forfeited by Mr. Barnett if he does not remain employed
at Beauty.com for the two year period following the acquisition. We will
account for the acquisition as a purchase.
We have incurred net losses of $123.9 million from inception to January 2,
2000. We believe that we will continue to incur net losses for at least the
next four years (and possibly longer) and that the rate at which we will incur
such losses will likely increase significantly from current levels. We have a
limited operating history on which to base an evaluation of our business and
prospects. Our prospects must be considered in light of the risks, expenses,
and difficulties encountered by companies in their early stage of development,
particularly companies in new and rapidly-evolving markets, such as e-commerce.
In view of our limited operating history and the rapidly evolving nature of
our business, we believe that period-to-period comparisons of our operating
results are not meaningful and should not be relied upon as an indication of
future performance. It is likely that in some future quarter our operating
results may fall below the expectations of securities analysts and investors.
In this event, the trading price of our common stock may fall significantly.
Organizations responsible for promulgating accounting standards are
reviewing the financial statement classification of, and accounting for,
fulfillment and order processing costs and other items by a number of
e-commerce companies, including drugstore.com. Our fulfillment and order
processing costs include distribution center equipment and packaging supplies,
per-unit fulfillment fees charged by third parties, and payroll and related
expenses for personnel engaged in customer service, purchasing, and
distribution and fulfillment activities, including pharmacists engaged in
prescription verification activities and warehouse personnel. These expenses
also include rent expense and depreciation related to our distribution center.
We classify all of these costs in marketing and sales expense. The review by
these accounting organizations may lead to new accounting standards that could
require that some or all of our fulfillment and order processing costs be
classified as costs of sales. These new standards could also require us to
capitalize certain of our fulfillment and order processing costs in inventory.
We currently expense these costs as incurred. We will adjust our accounting and
classification of fulfillment and order processing costs if required by the
SEC. Any such adjustments or reclassifications are not expected to have a
significant impact on our sales, operating profit or loss, net income or loss,
or cash flow, although such adjustments or reclassifications could result in an
increase in our cost of sales as a percentage of our net sales.
20
Net Sales. Net sales includes gross revenues from sales of products and
related shipping fees, net of discounts and provisions for sales returns,
third-party reimbursement and other allowances. We generally refund all or a
portion of the selling price, including related shipping fees, if applicable,
in the event the customer is not satisfied with the product purchased or the
quality of customer service provided. Sales returns and allowances have not
been significant to date.
Revenues from sales of products shipped to customers, and related shipping
fees, are recognized upon shipment. We arrange for shipment of products to
customers through various contractual relationships with third-party
fulfillment partners. Revenues from sales of certain pharmaceutical products
ordered through our Web store for delivery at a Rite Aid store are recognized
when the product is delivered to the customer.
Upon receiving and validating a customer's order for products that will be
purchased by us from a fulfillment partner, and subsequently shipped or
delivered to the customer by that fulfillment partner, we submit relevant order
information and, if applicable, shipping instructions to that fulfillment
partner for processing. We believe we act as a principal in connection with
orders shipped or delivered to customers by fulfillment partners on our behalf
because, among other things, we establish the retail prices of our non-
pharmaceutical and non-insured pharmaceutical products (and accept contractual
reimbursement amounts from third-party payors for insured pharmaceutical
products) and shipping fees; contractually take title to, and assume risk of
loss of, products prior to their shipment; bear credit and collection risk from
the customer or, in the case of certain pharmaceutical sales, third-party
payors; and bear the risk that the product will be returned. Title to products
ordered by customers and shipped or delivered by a fulfillment partner passes
to us at the fulfillment partners' distribution center or, for certain
pharmaceutical sales, when the pharmaceuticals are made available for customer
retrieval at a Rite Aid store.
In the future, the level of our net sales will depend on a number of factors
including, but not limited to, the following:
. The number of customers we are able to obtain;
. The frequency of our customers' purchases;
. The quantity and mix of products our customers purchase;
. The quantity of the types of products we are able to offer for sale;
. The price we charge for our products;
. The amount we charge for shipping;
. The extent of sales price incentives, including coupons and discounts we
offer;
. The extent of reimbursement available from third-party payors;
. The level of customer returns we experience; and
. The seasonality that we may experience in our business.
Cost of Sales. Cost of sales consists primarily of the cost of products sold
to our customers, including allowances for shrinkage and slow moving and
expired inventory, as well as outbound and inbound shipping costs. Payments
that we expect to receive from vendors in connection with joint merchandising
activities, net of related costs, will be netted against cost of sales in the
period in which the related inventory is sold. We expect cost of sales to
increase in absolute dollars to the extent that our sales volume increases.
Cost of sales as a percentage of net sales will fluctuate based on a number of
factors, including, but not limited to, the following:
. The cost of our products, including the extent of promotional
allowances, payments for joint merchandising activities and purchase
volume discounts that we are able to obtain from suppliers;
. Our pricing strategy relative to the cost of our products, including the
extent to which we offer coupons or promotional discounts;
21
. The mix of products our customers purchase;
. The mix of consignment service fees vs. product sales;
. The mix of cash payments vs. insurance reimbursement for our pharmacy
products;
. Our shipping pricing strategy relative to the cost of shipping; and
. The extent to which we are able to control product damage, shrinkage and
expiration though inventory management practices.
Marketing and Sales. Marketing and sales expenses consist primarily of
fulfillment and order processing expenses and customer acquisition and
marketing expenses. Fulfillment and order processing expenses include
distribution center equipment and packaging supplies, per-unit fulfillment fees
charged by third parties, and payroll and related expenses for personnel
engaged in customer service, purchasing, and distribution and fulfillment
activities, including pharmacists engaged in prescription verification
activities and warehouse personnel. These expenses also include rent expense
and depreciation related to our distribution center. We expect fulfillment and
order processing expenses to increase during the next two quarters due to
duplicative costs that we will incur while we complete the transition of our
customer order fulfillment operations from third party distributors, including
those operated on behalf of Beauty.com, to our own distribution facilities.
Additionally, to the extent that our sales volume increases in future periods,
we expect fulfillment and order processing expenses to increase in absolute
dollars as we expand the accompanying distribution and fulfillment activities.
Customer acquisition and marketing expenses include advertising and
marketing expenses, promotional expenditures, credit card processing fees and
payroll and related expenses for personnel engaged in marketing and
merchandising activities. Promotional expenses include the cost of certain
items we give away to our customers in connection with our customer acquisition
and retention activities and our branding campaign. These items include sample
merchandise in sizes or quantities not normally sold on our Web site, certain
drugstore.com-branded products and the cost of products given away in our one
cent sales promotions. Advertising expenses include media, agency and
production costs associated with our branding campaign. We intend to continue
to pursue an aggressive branding and marketing campaign and, therefore, we
expect customer acquisition and marketing expenses to increase significantly in
absolute dollars. Customer acquisition and marketing expenses may also vary
considerably from quarter to quarter, depending on the timing of our
advertising campaigns. We currently intend to pursue an independent branding
and marketing strategy for the Beauty.com Web store. Accordingly, we expect
that customer acquisition and marketing expenses will increase after the
Beauty.com acquisition is consummated.
Technology and Content. Technology and content expenses consist primarily of
payroll and related expenses for personnel engaged in maintaining and making
minor upgrades and enhancements to our Web site and content. These expenses
also include payroll and related expenses for information technology personnel,
Internet access and hosting charges and Web site content and design expenses.
Over the next several months, we expect that our technology and content
expenses will increase as we:
. Continue to make minor upgrades to improve our systems relating to in-
store prescription pickup at Rite Aid stores;
. Make minor enhancements to our Web site to display additional product
offerings; and
. Maintain our Web site product listings and content.
We believe that continued investment in these areas is critical to attaining
our strategic objectives and, as a result, we expect technology and content
expenses to increase significantly in absolute dollars.
General and Administrative. General and administrative expenses consist of
payroll and related expenses for executive and administrative personnel,
corporate facility expenses, professional services expenses, travel and
22
other general corporate expenses. We expect general and administrative expenses
to increase in absolute dollars as we expand our staff and incur additional
costs related to the anticipated growth of our business and being a public
company.
Amortization of Intangible Assets. In July 1999, we consummated a series of
agreements with Rite Aid and GNC to issue 12,282,599 shares of Series E
preferred stock in exchange for an aggregate of $10 million in cash and other
consideration, including access to insurance coverage, advertising commitments,
exclusivity agreements, a technology licensing agreement and other obligations
with an estimated fair value of $233.9 million. The $233.9 million non-cash
portion of the consideration from the Rite Aid and GNC agreements was allocated
to the following components based on a valuation obtained from an independent
valuation expert (in millions):
Access to insurance coverage .................................... $182.0
Advertising commitments.......................................... 22.9
Vendor agreement................................................. 29.0
------
$233.9
======
The access to insurance coverage and the vendor agreement have been
classified as intangible assets and the advertising commitments have been
classified within prepaid marketing expenses. All of the assets are being
amortized on a straight-line basis over their contractual lives of 10 years,
which is also their estimated useful lives. Amortization of the advertising
commitments is included in marketing and sales expense. As a result of our
acquisition of Beauty.com, we expect that amortization of intangible assets
will increase substantially from current levels. We intend to obtain an
independent valuation in order to allocate the purchase price to the net assets
acquired, including any goodwill. We expect that such valuation will be
completed in the first quarter of 2000.
Amortization of Stock-based Compensation. We have recorded total deferred
stock-based compensation of $27,596,000 in connection with stock options
granted and restricted stock issued to our employees. The deferred stock-based
compensation amounts represent the difference between the exercise price of
stock option grants and the deemed fair value of our common stock at the time
of such grants. In the case of restricted stock, the deferred stock-based
compensation represents the difference between the purchase price of the
restricted stock and the deemed fair value of our common stock on the date of
purchase. Such amounts are amortized to expense over the vesting periods of the
applicable agreements, resulting in amortization of stock-based compensation
totaling $1,037,000 for the period from April 2, 1998 (inception) to December
31, 1998 and $15,375,000 for the fiscal year ended January 2, 2000. The
amortization expense relates to options awarded to employees in all operating
expense categories. Deferred stock-based compensation as of January 2, 2000 for
stock options and restricted stock issued to our employees will be subsequently
recognized as expense for each of the next five fiscal years as follows:
Fiscal Year Amount
----------- --------------
(in thousands)
2000 $5,715
2001 2,976
2002 1,500
2003 468
2004 111
We expect that a significant percentage of the consideration for the
Beauty.com acquisition will be deemed to be deferred stock-based compensation.
Any deferred stock-based compensation will be amortized over a two-year period
and, accordingly, we expect that amortization of stock-based compensation for
fiscal 2000 and 2001 will be significantly higher than the amounts in the above
table.
Interest Income and Expense. Interest income consists of earnings on our
cash and cash equivalents and interest expense consists of interest associated
with capital lease obligations.
23
Income Taxes. There was no provision or benefit for income taxes for any
period since inception due to our operating losses. As of January 2, 2000, we
had approximately $98.4 million of net operating loss carryforwards for federal
income tax purposes, which expire beginning in 2018. In 1999, due to the
issuance and sale of Series D and Series E preferred stock, we incurred
ownership changes pursuant to applicable regulations in effect under the
Internal Revenue Code of 1986, as amended. Therefore, our use of losses
incurred through the date of these ownership changes will be limited during the
carryforward period. We estimate that the use of the approximately $53.9
million of net operating losses incurred prior to the date of the ownership
change would be limited to approximately $6.6 million per year in order to
offset future taxable income. To the extent that any single-year loss is not
utilized to the full amount of the limitation, such unused loss is carried over
to subsequent years until the earlier of its utilization or the expiration of
the relevant carryforward period. Our initial public offering did not cause an
additional ownership change that would result in additional limitations on the
utilization of net operating loss carryforwards. We have provided a full
valuation allowance on the deferred tax asset, consisting primarily of such net
operating loss carryforwards, because management has determined that it is more
likely than not that we will not earn income sufficient to realize the deferred
tax assets during the carryforward period.
Quarterly Results of Operations
Because we were a development stage company prior to the launch of our Web
site in February 1999 and have a short operating history, we believe that
period-to-period comparisons for periods prior to 1999 are less meaningful than
an analysis of recent quarterly operating results. Accordingly, we are
providing a discussion and analysis of our results of operations that is
focused on the seven quarters ended January 2, 2000.
The following table sets forth unaudited quarterly statement of operations
data for the seven quarters ended January 2, 2000. This unaudited quarterly
information has been derived from our unaudited financial statements and, in
the opinion of management, include all adjustments, consisting only of normal
recurring adjustments necessary for a fair presentation of such information in
accordance with accounting principles generally accepted in the United States.
The operating results for any quarter are not necessarily indicative of the
operating results for any future period.
Quarter Ended
-----------------------------------------------------------------
Sept. Dec.
June 30, 30, 31, April 4, July 4, Oct. 3, Jan. 2,
1998 1998 1998 1999 1999 1999 2000
-------- ------- ------- -------- -------- -------- --------
(in thousands)
Net sales............... $ -- $ -- $ -- $ 652 $ 3,550 $ 12,158 $ 18,488
Cost and expenses:
Cost of sales......... -- -- -- 672 4,879 14,066 18,823
Marketing and sales... -- 313 2,779 5,189 11,328 16,471 28,504
Technology and
content.............. 104 522 1,552 2,713 3,229 4,232 4,744
General and
administrative....... 71 511 1,279 1,713 2,204 3,120 4,089
Charitable
contribution......... -- -- -- -- -- 3,600 --
Amortization of
intangible assets.... 8 10 15 18 20 5,300 5,302
Amortization of stock-
based compensation... 166 350 521 1,257 2,326 9,267 2,525
----- ------- ------- -------- -------- -------- --------
Total cost and
expenses............ 349 1,706 6,146 11,562 23,986 56,056 63,987
----- ------- ------- -------- -------- -------- --------
Operating loss.......... (349) (1,706) (6,146) (10,910) (20,436) (43,898) (45,499)
Other income (expense):
Interest income....... -- 36 141 332 701 1,958 2,045
Interest expense...... -- -- (3) (14) (26) (33) (51)
----- ------- ------- -------- -------- -------- --------
Net loss................ $(349) $(1,670) $(6,008) $(10,592) $(19,761) $(41,973) $(43,505)
===== ======= ======= ======== ======== ======== ========
24
Quarterly Periods from Inception to April 4, 1999
Net Sales and Cost of Sales. We commercially launched our Web site on
February 24, 1999. There were no net sales or cost of sales prior to the
quarter ended April 4, 1999. Net sales approximated the cost of sales in the
quarter ended April 4, 1999 due to promotional sales discounts and coupons
associated with the commercial launch of the Web site.
Marketing and Sales. Marketing and sales expenses increased in each of the
four quarters ended April 4, 1999, primarily due to expenses associated with
the addition of marketing and merchandising personnel. We also increased our
advertising on major Web portals, including AOL, Excite and Yahoo!, in the
quarter ended April 4, 1999 in connection with the commercial launch of our Web
site. Additionally, we recognized $1,007,000 of non-cash advertising expenses
under our technology license and advertising agreement with Amazon.com in the
quarter ended April 4, 1999.
Technology and Content. Technology and content expenses increased in each of
the four quarters ended April 4, 1999, primarily due to increased expenses
associated with the addition of information technology personnel and additional
use of consultants and contract labor to help maintain the systems supporting
our Web site.
General and Administrative. General and administrative expenses increased in
each of the four quarters ended April 4, 1999, primarily due to increased
expenses associated with the addition of general and administrative personnel,
additional professional fees and the cost of corporate facilities.
Amortization of Intangible Assets. Amortization of intangible assets during
the four quarters ended April 4, 1999 primarily represented the amortization of
the technology license obtained from Amazon.com and certain domain names owned
by us.
Amortization of Stock-based Compensation. Amortization of stock-based
compensation increased in each of the four quarters ended April 4, 1999,
primarily due to the grant of stock options to new employees prior to our
initial public offering on July 27, 1999, as well as an increase in the
difference between the grant price and the deemed fair value of our common
stock, particularly in the quarter ended April 4, 1999.
Three Quarterly Periods Ended January 2, 2000
Net Sales and Cost of Sales. We have been operating our Web store for three
full fiscal quarters. The following table sets forth net sales for each of
these quarters by category:
Quarter Ended
------------------------------------
July 4, Oct. 3, Jan. 2,
1999 1999 2000
---------- ----------- -----------
Category Amount % Amount % Amount %
-------- ------ --- ------- --- ------- ---
(dollars in thousands)
Pharmaceutical products................. $1,094 31% $ 7,107 58% $10,453 57%
Non-pharmaceutical products and other... 2,456 69 5,051 42 8,035 43
------ --- ------- --- ------- ---
Total................................. $3,550 100% $12,158 100% $18,488 100%
====== === ======= === ======= ===
New customers........................... 150,000 260,000 267,000
Orders from repeat customers as a
percentage of total orders............. 26% 33% 44%
Our net sales in each category have increased in each quarter since we
commenced operations due to increases in new customers and increased repeat
orders. The substantial increase in pharmaceutical product sales as a percent
of total net sales in the quarter ended October 3, 1999 was primarily related
to the commencement
25
of the Rite Aid in-store pickup service for prescription refills. Consignment
fees related to our agreement with GNC are included in net sales of non-
pharmaceutical products and other and were insignificant relative to the total.
Cost of sales exceeded net sales in each of the three quarters ended January
2, 2000. Such excess was primarily the result of a decrease in net sales due to
sales price incentives offered to customers, including promotional coupons and
discounts. We continue to offer promotional coupons and discounts as a strategy
to attract new customers, although such discounts and coupons have decreased
over time as a percentage of net sales. Promotional coupons can only be used by
customers to offset the price of non-pharmaceutical products. Additionally, our
shipping costs exceeded the amount we charged our customers for shipping in
each of the three quarters ended January 2, 2000. We expect to continue to
subsidize a portion of our shipping costs for the foreseeable future as a
strategy to attract and retain customers.
Marketing and Sales. Marketing and sales expenses increased in each of the
three quarters ended January 2, 2000 due to increases in both fulfillment and
order processing expenses and customer acquisition and marketing expenses.
Fulfillment and order processing expenses increased in each of the three
quarters ended January 2, 2000 primarily due to the increases in order volume.
Volume-related expenses primarily responsible for the increased costs include
permanent and temporary labor required to validate prescriptions and fulfill
both pharmaceutical and non-pharmaceutical orders, per-unit fulfillment fees
charged by our fulfillment partners, depreciation expense related to additional
capital investments and packaging materials.
The increases in customer acquisition and marketing expenses are primarily
attributable to increased media, agency and production costs associated with
our branding campaign which commenced in the quarter ended July 4, 1999.
Additionally, the cost of promotional items given to new and existing customers
has increased in each quarter. We expect to continue to pursue an aggressive
branding and marketing campaign for the foreseeable future and expect such
expenditures to increase accordingly. Included in customer acquisition and
marketing expenses are $2,293,000, $1,074,000 and $573,000 of non-cash
advertising expenses incurred under our agreements with Amazon.com and Rite Aid
for the second, third and fourth quarters of fiscal 1999, respectively.
Technology and Content. Technology and content expenses increased in each of
the three quarters ended January 2, 2000, primarily due to increased expenses
associated with the addition of information technology personnel and additional
use of consultants and contract labor. Such personnel assisted in maintaining
and making minor upgrades and enhancements to our Web store as well as
maintaining the systems supporting the Web site.
General and Administrative. General and administrative expenses increased in
each of the three quarters ended January 2, 2000 primarily due to increased
expenses associated with the addition of general and administrative personnel,
additional professional fees and the cost of corporate facilities.
Charitable Contribution. In the third quarter of fiscal 1999, we donated
200,000 shares of our common stock to a foundation established by us and
recognized an expense of $3,600,000 in that quarter based on the fair value of
the donated common stock.
Amortization of Intangible Assets. Amortization of intangible assets
increased significantly in the quarters ended October 3, 1999 and January 2,
2000, to $5,300,000 and $5,302,000, respectively, primarily due to the
amortization of intangible assets received in connection with the Rite Aid and
GNC transactions completed in July 1999.
Amortization of Stock-based Compensation. Amortization of stock-based
compensation increased in the third quarter of fiscal 1999, primarily due to a
separation agreement we entered into with our founder.
26
Liquidity and Capital Resources
In July 1999, we completed our initial public offering and issued 5,750,000
shares of our common stock at an initial public offering price of $18.00 per
share. Net cash proceeds to us from the initial public offering were
approximately $94.6 million. Concurrently with our initial public offering, we
received $10 million in cash from our private placement of 555,555 shares of
our common stock with Amazon.com. From our inception until our initial public
offering, we financed our operations primarily through private sales of
preferred stock which yielded net cash proceeds of $106.8 million.
We have incurred net losses of $123.9 million from inception to January 2,
2000. We believe that we will continue to incur net losses for the foreseeable
future and that the rate at which we will incur such losses will increase
significantly from current levels. Net cash used in operating activities was
$56.8 million for the year ended January 2, 2000, and $6.3 million in the
period from April 2, 1998 (inception) to December 31, 1998. Net cash used in
operating activities for each of these periods primarily reflects our net
losses offset by a net source of funds from working capital.
Net cash used in investing activities was $120.0 million for the year ended
January 2, 2000, and $1.5 million in the period from April 2, 1998 (inception)
to December 31, 1998. Net cash used in investing activities for the year ended
January 2, 2000 was primarily related to the investment of the proceeds from
our initial public offering in marketable securities with an original maturity
greater than 90 days. Additionally, net cash used in investing activities for
both periods included leasehold improvements and purchases of equipment and
systems, including warehouse handling equipment, computer equipment and
fixtures and furniture.
For the year ended January 2, 2000, net cash provided by financing
activities was $188.9 million and consisted primarily of $104.6 million in net
proceeds from the issuance of common stock in our initial public offering and
the concurrent private placement, and $84.6 million in net proceeds from the
issuance of convertible preferred stock.
During the period from April 2, 1998 (inception) to December 31, 1998, net
cash provided by financing activities was $22.3 million, consisting primarily
of cash proceeds of $4.0 million from the issuance of 10,000,000 shares of
Series A preferred stock and cash proceeds of $18.2 million from the issuance
of 5,446,268 shares of Series B preferred stock.
As of January 2, 2000, we had $132.8 million of cash, cash equivalents and
marketable securities. As of that date, our principal commitments consisted of
obligations outstanding under capital and operating leases and marketing
agreements with certain Web portals, including America Online, MSNBC and
Discovery Channel, aggregating approximately $80.0 million through 2012.
Subsequent to January 2, 2000, we entered into a strategic agreement with
Amazon.com to integrate various shopping features of our Web sites and create a
persistent drugstore.com shopping presence on Amazon.com's Web site. Under the
terms of the agreement, we agreed to pay Amazon.com a total of $105 million
over a three-year period, of which $30 million was paid at the time the
agreement was executed. In addition, in January 2000, we provided letters of
credit totaling $16.4 million as security for leases and certain other
operating agreements. These letters of credit must be fully collateralized by
an equivalent amount of our cash. If our cash balance falls below $25 million
we are contractually obligated to increase these letters of credit and related
cash collateral to $20.7 million. Although we have no material commitments for
capital expenditures, we anticipate a substantial increase in our capital
expenditures and lease commitments consistent with anticipated growth in
operations, infrastructure and personnel. We recently began limited operations
at our own distribution center to improve the customer experience by locating
closer to a greater percentage of our customers, exerting greater control over
the distribution pro