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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 December 31, 2000
Commission File Number: 0-26137
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drugstore.com, inc.
(Exact Name of Registrant as Specified in its Charter)
Delaware 04-3416255
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
13920 Southeast Eastgate Way, Suite 300 Bellevue, Washington 98005
(425) 372-3200
(Address, including zip code, and telephone number, including area code, of
Registrant's Principal Executive Offices)
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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 $34,557,954 as of March 1, 2001, based upon the
closing price of $1.3125 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 March 1, 2001, the number of shares of Common Stock outstanding was
66,067,272.
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drugstore.com, inc.
FORM 10-K
For the Fiscal Year Ended December 31, 2000
Index
Page
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PART I
ITEM 1. BUSINESS...................................................... 1
ITEM 2. PROPERTIES.................................................... 17
ITEM 3. LEGAL PROCEEDINGS............................................. 17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 17
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.......................................... 18
ITEM 6. SELECTED FINANCIAL DATA....................................... 19
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATION..................................... 20
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.... 42
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 42
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE..................................... 42
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 43
ITEM 11. EXECUTIVE COMPENSATION........................................ 43
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................... 43
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 43
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON
FORM 8- K.................................................... 44
PART I
ITEM 1. BUSINESS
Overview
drugstore.com is a leading online drugstore and information site offering A
Very Healthy Way to Shop(TM) for health, beauty, wellness, personal care and
pharmacy products. We also sell prestige beauty products through Beauty.com, an
online retailer of prestige beauty products that we acquired in February 2000.
As of December 31, 2000, we have sold our products to approximately 1,669,000
customers. We were incorporated in April 1998 and commercially launched our Web
site on February 24, 1999. We have 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.
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.
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,
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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. In February 2000 we acquired
Beauty.com, Inc., an online retailer of prestige beauty products. 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 General
Nutrition Companies, Inc. (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.
. 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 and determine whether their medicines interact with each
other. We also provide health- and pharmacy-related editorial content.
Our pharmacists can provide personal guidance by phone 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.
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Communication. We can communicate with customers on a regular basis through
the convenience of e-mail. In addition to our Ask Your Pharmacist feature, 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 Ask Your Pharmacist, 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 six 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:
. 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.
. 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.
. 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
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 are
fully licensed and 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
prescriptions on our Web site for pick-up at any of the almost 3,800 Rite Aid
stores in the United States or for delivery using one of our standard delivery
options.
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.
. eMedAlert. We innovated the eMedAlert(TM) program to alert our customers
to critical and timely information regarding prescriptions and over-the-
counter product warnings, updates and recalls. Through the eMedAlert
program, our goal is to rapidly communicate vital, complete and up-to-
date drug and product recall/warning information to customers in a
private, secure manner. The eMedAlert program combines public
notifications on our Web site with targeted e-mail messages sent to
customers who have purchased the drug or product that is the subject of
the recall/warning.
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. Consumer Drug Interaction Checker. Consumers can use this feature to
research interactions among prescription drugs, herbal supplements and
dietary supplements, as well as to identify ingredient duplications
between drugs. The checker also allows consumers to search for potential
interactions between medications and food, alcohol and tobacco products.
. Frequently Asked Questions. Working in conjunction with our pharmacists,
we have created a searchable database of almost 800 answers to
frequently asked health questions.
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 methods similar to
those used by 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.
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 of Advanced PCS that were formerly owned by PCS and
the retail pharmacy networks managed by WellPoint Health Networks, Inc.
(WellPoint). In total, these networks claim to provide pharmacy benefit
management services for more than 70 million individuals in the United States.
Pharmacy Supply. Until we opened our own distribution center facility, a
substantial majority of our pharmaceutical products delivered by mail were
supplied by RxAmerica. Upon the opening of our own
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distribution center in January 2000, 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 currently expect that Rite Aid will
continue to be the supplier for a majority 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.
We intend to continue to use the unique resources of the Internet as a means
of marketing in an effort to encourage traffic and repeat purchases. Our
advertising campaigns are 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, all of whom 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
site, 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 vials caps, in-store signs and permanent links from
its Web site. 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.
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, 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 without consulting store personnel or searching traditional store
shelves. Combination searching allows customers to find desired items easily
among our large selection of products.
Flexible & Unique Merchandising. 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. Our technology also allows us to customize the
shopping experience by personalizing the products that are presented to
customers.
Specialty Stores. We have created specialty stores in each of our product
categories. One 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. The specialty store format allows us to market products by life
stage, life style, health condition, specific consumer groups or seasonal
themes. Other specialty stores include natural, baby, salon, home spa and
holiday store.
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 to allow customers to make
more informed buying decisions and to comparison-shop more easily 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.
8
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.
Marketing Programs for Suppliers. We host programs for branded manufacturers
to strategically market their brands. These programs motivate the manufacturers
to invest resources in marketing on our Web site. We believe that these branded
promotions improve the customer's shopping experience, because the
manufacturers provide our customers with purchase incentives along with the
information to make informed purchase and treatment decisions.
Delivery of Our Customer's Orders
In January 2000, we began operating our own 290,000 square foot distribution
center in New Jersey to achieve greater control over the distribution process
and to ensure adequate supplies of products to our customers. As of June 2000,
all of our orders delivered by mail are processed from our distribution center.
In connection with opening our distribution center, we also expanded our
pharmacy operations through our arrangement with Rite Aid. Operating our own
distribution center facility has required us 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 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. For
prescriptions filled through the pharmacy, we operate under our arrangement
with Rite Aid. For prescriptions filled through our distribution center
facility, our pharmacists perform all aspects of the prescription fulfillment
process and all aspects of customer service working together with a Rite Aid
"pharmacist in charge."
Our warehouse management system 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 and other vendors consist of items typically
found in traditional chain drugstores. Rite Aid purchases its pharmaceutical
products from a variety of manufacturers as well as wholesalers.
For nonpharmaceutical orders, we generally charge our customers a shipping
charge that covers a portion of our expenses of shipping. We offer a variety of
shipping options, including next-day delivery for orders received during the
business week. We ship anywhere in the United States that is 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, our goal is to ship within 24 hours of the time the order is placed.
For prescription products, our goal is to ship as soon as the prescription has
been verified and our pharmacists have completed drug utilization reviews.
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 almost 3,800 Rite Aid stores or for delivery using one of our standard
delivery options.
9
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 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 SSL technology with Verisign
issued 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 facility in 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.
10
Competition
The online commerce market for health, beauty, wellness, personal care and
pharmacy products is intensely competitive and highly fragmented. 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; specialty
retailers and major department stores, such as Nordstrom, Macys and
Bloomingdale's; prescription benefit managers, such as Express Scripts and
Merck-Medco; Internet portals and online service providers that feature
shopping services, such as America Online, MSN and Yahoo!; and other online
retailers and/or mail order retailers of health, beauty, wellness, personal
care and/or pharmaceutical products. Each of these competitors operates within
one or more of the health, beauty, wellness, personal care and pharmacy product
categories.
We believe that the following are principal competitive factors in our
market:
. Brand recognition;
. Product selection;
. Convenience;
. Price;
. Web site features, functionality and performance;
. Customer service;
. Quality of information services; and
. Reliability and speed of order shipment.
Many of our current and potential 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 as the use of the Internet and
other online services increases.
Some of our current and potential 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.
Strategic Relationships
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 of 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 provides for
the license of substantially all of each company's technology to the other for
use within their
11
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 site 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 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. The consideration for the agreement included 1,066,667
shares of our common stock with a fair value of $30.0 million issued
immediately in a private placement transaction and minimum cash payments
totaling $75.0 million over the three-year term of the agreement. In July 2000,
Amazon.com agreed to reduce the remaining minimum cash payments due over the
three-year term of the agreement from $75.0 million to $30.0 million.
Additionally, we agreed to pay additional amounts in cash if the advertising
services exceed certain performance thresholds in the second and third year of
the agreement. We also issued to Amazon.com a fully vested, nonforfeitable and
exercisable warrant to purchase 2.5 million shares of our common stock at $4.94
per share. The agreement may be terminated for breach or on the occurrence of
certain other events.
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 almost 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
March 1, 2001, owned approximately 14.1% 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.
12
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 we are 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 GNC whereby we are the
exclusive online provider of GNC-branded products. We have the exclusive right
to sell GNC's wellness 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. GNC is a subsidiary of Royal Numico N.V., a
European maker of nutrition products.
Other Relationships
In June 2000, we entered into a five-year agreement with WellPoint a leading
health plan owned pharmacy benefit management company. Pursuant to this
agreement, we are designated WellPoint's preferred Internet pharmacy and
drugstore and have access to WellPoint's members. In exchange, we issued
WellPoint 750,000 shares of our common stock with a fair value of approximately
$5.0 million and will make certain cash payments to WellPoint over the five-
year term of the agreement.
Also in June 2000, we entered into a five-year agreement with CIGNA
HealthCare companies (CIGNA), one of the nation's leading providers of health
benefit programs. Pursuant to this agreement, we will provide health and beauty
products to CIGNA's plan participants by providing them direct access to our
Web site from the home page of CIGNA's Internet site and through CIGNA's mail
order pharmacy. In exchange, we issued CIGNA a warrant to purchase 500,000
shares of our common stock at $7.76 per share.
Government 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
13
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 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.
Congress and the federal agencies continue to scrutinize the benefits and risks
of online pharmacies, focusing especially on those sites that illegally issue
prescriptions and illegally sell prescription drugs. To combat the illegal
issuance of prescriptions and illegal sale of prescription drugs over the
Internet, certain members of Congress have proposed additional regulation of
Internet pharmacies, primarily regarding disclosure of certain identifying
information on Web sites, as well as additional enforcement mechanisms and
funding for such efforts. In addition, a federal effort initiated by the
previous administration is the Internet Working Group, charged with studying
the issue of whether existing federal laws provide a sufficient basis for
effective investigation and prosecution of unlawful conduct involving use of
the Internet, including the sale of prescription drugs. This study has yet to
be completed. 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.
At the end of December 2000, former President Clinton and the Department of
Health and Human Services (HHS) released regulations to protect the privacy of
individually identifiable health information. The regulations are required
under the Health Insurance Portability and Accountability Act of 1996 (HIPPA).
HIPPA mandated the development of standards and requirements to control the
flow of health information throughout the health care system. The HIPPA
regulations are still open for public comment and have not been finalized.
Covered organizations and practitioners will have two years to comply with the
regulations once they become effective. Several of the requirements in the
regulaitons could create financial and administrative
14
burdens for pharmacies, including online pharmacies. Other 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,
state legislatures may add or amend legislation related to the regulation of
nonresident pharmacies.
The inclusion of outpatient 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, 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.
15
Employees
As of December 31, 2000, we had 553 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.
Executive Officers of the Registrant
The following table sets forth information with respect to our executive
officers as of March 2, 2001:
Name Age Position
---- --- --------
Peter M. Neupert....... 44 Chairman of the Board of Directors, President
and Chief Executive Officer
Kal Raman.............. 31 Senior Vice President and Chief Operating
Officer
Robert A. Barton....... 34 Vice President of Finance and Chief Financial
Officer
Christopher G. Hauser.. 49 Vice President, Operations
Sean P. Nolan.......... 32 Vice President of Technology and Chief
Technology Officer
Alesia L. Pinney....... 37 Vice President, General Counsel and Secretary
Peter M. Neupert has served as a director and the President and Chief
Executive Officer of drugstore.com since July 1998 and as chairman of the board
of directors since July 1999. From March 1987 to July 1998, he worked for
Microsoft Corporation in several positions, most recently as Vice President of
News and Publishing for Microsoft's interactive media group. Mr. Neupert holds
an M.B.A. from the Amos Tuck School of Business at Dartmouth College and a B.A.
from Colorado College.
Kal Raman (formerly known as Kalyanaraman Srinivasan) has served as Senior
Vice President and Chief Operating Officer of drugstore.com since November
1999. He served as Vice President, Technology and Chief Information Officer of
drugstore.com from August 1998 to May 1999, as Vice President, Technology and
Operations and Chief Information Officer from March 1999 to May 1999 and as
Senior Vice President, Operations and Chief Information Officer from May 1999
to November 1999. From March 1998 to August 1998, Mr. Raman served as the Chief
Information Officer and Vice President of Nations Rent and from February 1997
to March 1998, he served as Senior Director, Information Systems of Blockbuster
Inc. From May 1992 to February 1997, Mr. Raman served as Director,
International Division of Wal-Mart Stores Inc.
Robert Barton has served as Vice President of Finance and Chief Financial
Officer of drugstore.com since January, 2001. He has been with drugstore.com
since September of 1998 serving in various senior financial management and
operational roles, including Vice President and General Manager of Pharmacy
from June, 2000 to January, 2001. Prior to joining drugstore.com, Mr. Barton
was the Director of Business Planning and also managed various accounting and
analysis groups for AT&T Wireless Services from August 1995 to August 1998, and
was an Accounting and Auditing Manager with Deloitte & Touche LLP from February
1989 to August 1995. Mr. Barton holds a CPA license in the state of Washington
and a B.A. in business administration from Washington State University.
Christopher G. Hauser has served as Vice President, Operations of
drugstore.com since July 1999. Prior to that time, he was Senior Vice
President, Information Technologies and Operations for Multiple Zones
International. From 1994 to 1996, Mr. Hauser was Director of Distribution for
Fingerhut Companies, Inc., and from 1991 to 1994, he commanded the largest
distribution center in the U.S. Department of Defense. Mr. Hauser received an
M.S. in Logistics Operations and an M.B.A. from the United States Naval
Academy.
Sean P. Nolan has served as Vice President of Technology and Chief Technical
Officer of drugstore.com since May 4, 2000. Mr. Nolan joined drugstore.com in
August 1998 as Development Manager. Prior to joining drugstore.com, Mr. Nolan
served as Chief Executive Officer of Turtleback Software from August 1997 to
August 1998. In 1996, Mr. Nolan co-founded and served as Vice President of
Technology for Cognisoft, Inc.,
16
which was acquired in 1997 by Verity, where Mr. Nolan served as Vice President
of Technology for the Information Application Division until July 1997. From
1991 through 1996, Mr. Nolan worked at Microsoft Corporation. Mr. Nolan holds a
B.A. in Cognitive Science and Psychology from Dartmouth College.
Alesia L. Pinney has served as Vice President, General Counsel and Secretary
of drugstore.com since October 2000. From January 1999 through October 2000,
she served as Assistant Secretary and Associate General Counsel of
drugstore.com. Prior to joining drugstore.com, Ms. Pinney was a lawyer with
Perkins Coie LLP, a limited liability partnership from May 1994 through July
1997 and from January 1998 to January 1999. From July 1997 through December
1997, Ms. Pinney was Corporate Counsel to RealNetworks, Inc. Ms. Pinney holds a
J.D. from the Seattle University School of Law (formerly, the University of
Puget Sound School of Law), an M.T. from the University of Denver and a B.A.
from Seattle University.
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 lease for additional executive office space of
approximately 34,000 square feet in Bellevue, Washington under a lease that
expires in February 2003. Our distribution facility is located in Bridgeport,
New Jersey, where we lease approximately 290,000 square feet under a lease that
expires in April 2005, with options to renew for two additional five-year
periods.
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.
17
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)............................ $70.00 $32.50
Fourth Quarter................................................ $55.00 $27.13
Fiscal Year Ended December 31, 2000:
First Quarter................................................. $39.38 $12.38
Second Quarter................................................ $13.38 $ 5.88
Third Quarter................................................. $ 8.13 $ 3.06
Fourth Quarter................................................ $ 4.56 $ 0.72
On March 1, 2001, the reported last sale price of our common stock on the
Nasdaq National Market was $1.3125 per share, and there were approximately 448
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.
18
ITEM 6. SELECTED FINANCIAL DATA
Period from
April 2, 1998
Year Ended Year Ended (Inception) to
December 31, January 2, December 31,
2000 2000 1998
------------ ---------- --------------
(in thousands, except share and
per share data)
Consolidated Statements of Operations
Data:
Net sales.............................. $ 109,979 $ 34,848 $ --
Costs and expenses:
Cost of sales........................ 100,711 43,332 --
Fulfillment and order processing(1).. 37,464 15,985 --
Marketing and sales(2)............... 76,183 40,615 3,092
Technology and content(3)............ 27,377 14,918 2,178
General and administrative(4)........ 20,002 11,126 1,861
Charitable contribution.............. -- 3,600 --
Amortization of intangible assets.... 34,774 10,640 33
Amortization of stock-based
compensation........................ 15,115 15,375 1,037
---------- ---------- -------
Total costs and expenses........... 311,626 155,591 8,201
---------- ---------- -------
Operating loss......................... (201,647) (120,743) (8,201)
Interest income, net................... 8,632 4,912 174
Net loss............................... $ (193,015) $ (115,831) $(8,027)
========== ========== =======
Basic and diluted net loss per share... $ (3.56) $ (6.13) $(14.70)
========== ========== =======
Weighted average shares outstanding
used to compute basic and diluted net
loss per share........................ 54,212,080 18,880,969 546,149
========== ========== =======
December 31, January December 31,
2000 2, 2000 1998
------------ -------- ------------
(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
securities................................ $129,888 $132,754 $14,408
Working capital............................ $134,088 $106,960 $17,050
Total assets .............................. $458,523 $395,708 $22,517
Capital lease obligations, less current
portion................................... $ 2,399 $ 2,687 $ 975
Total stockholders' equity................. $411,989 $350,749 $19,347
- --------
(1) Excludes amortization of stock-based compensation of $1,630 for the year
ended December 31, 2000, $1,549 for the period ended January 2, 2000 and
$26 for the period from April 2, 1998 (inception) to December 31, 1998.
(2) Excludes amortization of stock-based compensation of $1,561 for the year
ended December 31, 2000, $2,181 for the period ended January 2, 2000 and
$163 for the period from April 2, 1998 (inception) to December 31, 1998.
(3) Excludes amortization of stock-based compensation of $3,976 for the year
ended December 31, 2000, $3,153 for the year ended January 2, 2000 and $209
for the period from April 2, 1998 (inception) to December 31, 1998.
(4) Excludes amortization of stock-based compensation of $7,948 for the year
ended December 31, 2000, $8,492 for the year ended January 2, 2000 and $639
for the period from April 2, 1998 (inception) to December 31, 1998.
19
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 drugstore.com or
Rite Aid prescriptions, picked up by the customer at any Rite Aid store in the
United States. If ordered on our Web store, 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 operating our own 290,000 square foot distribution
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 has required us to hire and train a significant number of
new employees, increase inventory levels substantially and establish a
significant number of direct relationships with nonpharmaceutical product
manufacturers. We are obligated to buy our pharmaceutical products from Rite
Aid unless we are able to obtain better overall terms from other vendors.
20
In February 2000, we acquired Beauty.com, a Web store specializing in
prestige beauty products. We currently operate Beauty.com as a separate Web
store, and perform all of Beauty.com's fulfillment activities from our own
distribution center.
In January 2001, we laid off approximately 100 employees. As a result of the
layoffs, we decided to consolidate certain of our corporate facilities and are
attempting to sublease or exit the leases associated with the excess
facilities. In March 2001, we negotiated the cancellation of a lease for new
corporate office space in exchange for forfeiting a portion of our lease
deposit, thereby reducing our minimum commitments through 2012 by approximately
$46.9 million. Accordingly in the first quarter of 2001, we expect to record a
charge ranging from approximately $7.0 million to $8.0 million associated with
the costs of exiting such leases, forfeiting our lease deposit and writing off
the related leasehold improvements and equipment.
We have incurred net losses of $316.9 million from inception to December 31,
2000. We believe that we will continue to incur net losses for at least the
next four years (and possibly longer). We have a limited operating history on
which to base an evaluation of our business and prospects. Our prospects must
be considered in light of the risks, expenses, and difficulties encountered by
companies in their early stage of development, particularly companies in new
and rapidly-evolving markets, such as e-commerce.
In view of our limited operating history and the rapidly evolving nature of
our business, we believe that period-to-period comparisons of our operating
results are not meaningful and should not be relied upon as an indication of
future performance. It is likely that in some future quarter our operating
results may fall below the expectations of securities analysts and investors.
In this event, the trading price of our common stock may fall significantly.
Results of Operations
Net Sales
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 1998
----------- -------- ----------- -----------
($ in thousands)
Net sales..................... $109,979 216% $ 34,848 $ --
New customers................. 974,000 40% 695,000 --
Orders from repeat customers
as a percentage of total
orders....................... 59% 36% --
% of net sales from
pharmaceutical products...... 51% 54% --
Net sales includes gross revenues from sales of product and related shipping
fees, net of discounts and provision for sales returns, third-party
reimbursement and other allowances. We generally refund to customers all or a
portion of the selling price, including related shipping fees if applicable, in
the event a 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 product shipped to customers, and related shipping
fees, are recognized upon shipment. Prior to opening our own distribution
center, we arranged for shipment of product 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.
We currently utilize Rite Aid as a fulfillment partner, and prior to opening
our own distribution center, utilized RxAmerica L.L.C. for pharmaceutical
products and Walsh Distribution, Inc. for non-pharmaceutical products as
fulfillment partners. 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
21
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 significantly all of its 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.
Net sales also includes consignment service fees earned under arrangements
in which we do not take title to the inventory and cannot establish pricing.
Consignment service fees earned have not been significant to date.
Our net sales in both the pharmaceutical and non-pharmaceutical categories
have increased each year since we commenced operations in February 1999 due to
increases in new customers and repeat orders. Additionally, the average net
sales per order has increased from approximately $32 in the year ended January
2, 2000 to approximately $46 in the year ended December 31, 2000. Such increase
is primarily attributable to higher average basket sizes for repeat customers
and changes in the mix of products merchandised in our Web store, including
seasonal and prestige beauty products. The decrease in pharmaceutical product
sales as a percent of total net sales was primarily related to higher net sales
of seasonal and prestige beauty products more than offsetting the full year of
Rite Aid in-store pickup service for prescription refills in 2000, which
commenced service in the third quarter of 1999.
We currently expect that net sales for fiscal year 2001 will range from
approximately $135 million to $145 million. The level of our net sales that we
actually achieve will depend on a number of factors including, but not limited
to, the following:
. The number of customers we are able to acquire and retain;
. The frequency of our customers' purchases;
. The quantity and mix of products our customers purchase;
. The quantity of the types of products we are able to offer for sale;
. The price we charge for our products;
. The amount we charge for shipping;
. The extent of sales price incentives, including coupons and discounts
that we offer;
. The extent of reimbursement available from third-party payors;
. The level of customer returns we experience; and
. The seasonality that we may experience in our business.
Cost of Sales
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 1998
----------- -------- ----------- -----------
($ in thousands)
Cost of sales.................. $100,711 132% $43,332 $ --
Percentage of net sales........ 92% 124% --
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.
22
Additionally, expenses related to promotional inventory included in shipments
to customers are included in cost of sales. Payments that we receive from
vendors in connection with joint merchandising activities, net of related
costs, are netted against cost of sales in the period in which the activities
take place.
Cost of sales as a percent of net sales decreased as a result of fewer sales
incentives offered to customers, including promotional inventory, coupons and
discounts. Additionally, we experienced a more favorable mix of product sales
in fiscal year 2000, associated primarily with seasonal merchandise and
prestige beauty products. We continue to offer promotional merchandise, coupons
and discounts as a strategy to attract new customers, although such amounts
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 both fiscal year 2000 and 1999. We expect to continue to
subsidize a portion of our shipping costs for the foreseeable future as a
strategy to attract and retain customers.
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 is
expected to range from 84% to 86% in fiscal year 2001, and 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 promotional merchandise, coupons or discounts;
. The mix of products our customers purchase;
. The mix of consignment service fees versus 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 through inventory management practices.
Fulfillment and Order Processing
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 1998
----------- -------- ----------- -----------
($ in thousands)
Fulfillment and order
processing.................. $37,464 134% $15,985 $ --
Percentage of net sales...... 34% 46% --
Fulfillment and order processing expenses include expenses related to
distribution center equipment and packaging supplies, per-unit fulfillment fees
charged by third parties, bad debt expense, credit card processing fees, 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 the Company's
distribution center.
Fulfillment and order processing expenses decreased as a percentage of net
sales as a result of the efficiencies gained through higher volumes and in
operating our own distribution center in fiscal year 2000. We expect that
fulfillment and order processing expenses in 2001 will decrease both in
absolute dollars and as a percentage of net sales due to the elimination of the
costs associated with certain duplicative fulfillment activities incurred
during the transition to our own distribution center in fiscal year 2000 and
increased operational efficiencies in fiscal year 2001.
23
Marketing and Sales
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 % Change 1998
----------- -------- ----------- -------- -----------
($ in thousands)
Marketing and sales..... $76,183 88% $40,615 1,214% $3,092
Percentage of net
sales.................. 69% 117% --
Marketing and sales expenses include advertising and marketing expenses,
promotional expenditures, and payroll and related expenses for personnel
engaged in marketing and merchandising activities. Advertising expenses include
media, agency and production costs associated with our branding campaign as
well as costs associated with Web portal advertising contracts.
The increases in marketing and sales expenses are primarily attributable to
increases in headcount and related expenses as well as increased media, agency
and production costs associated with our branding campaign in fiscal year 1999
and the first half of fiscal year 2000. Additionally in fiscal year 2000, we
acquired and began promoting Beauty.com, and we incurred additional expenses
associated with our portal advertising agreement with Amazon.com.
We expect that marketing and sales expenses will decrease both in absolute
dollars and as a percentage of net sales in fiscal year 2001 due to
significantly reduced spending on branding and promotional activities and
reductions in headcount and related expenses.
Technology and Content
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 % Change 1998
----------- -------- ----------- -------- -----------
($ in thousands)
Technology and content.. $27,377 84% $14,918 585% $2,178
Percentage of net
sales.................. 25% 43% --
Technology and content expenses consist primarily of payroll and related
expenses for personnel engaged in maintaining and making minor upgrades and
enhancements to our Web site and content. These expenses also include payroll
and related expenses for information technology personnel, Internet access and
hosting charges and Web site content and design expenses.
Technology and content expenses increased in each of the past two years,
primarily due to increased expenses associated with the depreciation of Web
servers and other equipment and the addition of information technology
personnel and additional use of consultants and contract labor. Such personnel
assisted in maintaining and making minor upgrades and enhancements to our Web
store as well as maintaining the systems supporting the Web site.
We expect that technology and content expenses will decrease both in
absolute dollars and as a percentage of net sales in fiscal year 2001 due to
reduced headcount and related expenses.
General and Administrative
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 % Change 1998
----------- -------- ----------- -------- -----------
($ in thousands)
General and
administrative......... $20,002 80% $11,126 498% $1,861
Percentage of net
sales.................. 18% 32% --
General and administrative expenses consist of payroll and related expenses
for executive and administrative personnel, corporate facility expenses,
professional services expenses, travel and other general corporate expenses.
24
General and administrative expenses increased in each of the past two years,
primarily due to increased expenses associated with the addition of general and
administrative personnel, additional professional fees and the cost of
corporate facilities, including those associated with Beauty.com, which we
acquired in February 2000.
We expect general and administrative expenses will decrease both in absolute
dollars and as a percentage of net sales in fiscal year 2001 due to reduced
headcount and related expenses.
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 $3,600,000
in that quarter based on the fair value of the donated common stock.
Amortization of Intangible Assets
Fiscal Year Fiscal Year Fiscal Year
2000 % Change 1999 % Change 1998
----------- -------- ----------- -------- -----------
($ in thousands)
Amortization of
intangible assets...... $34,774 227% $10,640 32,142% $33
Amortization of intangible assets includes the amortization expense
associated with the assets received in connection with agreements with Rite Aid
and with GNC, including access to insurance coverage and a vendor agreement;
assets acquired in connection with the purchase of Beauty.com, including
goodwill and domain names; and other intangibles, including a technology
license agreement, domain names and trademarks.
Amortization of intangible assets increased in each of the last two years
due to the amortization of intangible assets received in connection with the
Rite Aid and the GNC transactions completed in July 1999 and the amortization
of the goodwill, domain names and other intangible assets acquired in the
Beauty.com acquisition in February 2000.
We expect that amortization of intangible assets will increase in fiscal
year 2001 due to a full year of amortization expense being recorded in
connection with the Beauty.com acquisition.
Intangible assets are reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount may not be recoverable. Such
events could include, but are not limited to, our inability to achieve our
planned penetration rate with respect to insured prescriptions, our inability
to achieve the planned growth rates for our Rite Aid local pickup, GNC-branded
product or prestige beauty businesses, a decision by Rite Aid to substantially
curtail its marketing spending with respect to us for an extended period of
time, or the loss of key prestige beauty vendors. Impairment is measured by
comparing the carrying value of the intangible assets to the estimated
undiscounted future cash flows expected to result from use of the assets and
their ultimate disposition. In circumstances where impairment is determined to
exist, we will write down the asset to its fair value based on the present
value of estimated expected future cash flows. To date, no such impairment has
been indicated.
Amortization of Stock-based Compensation
Fiscal Year % Fiscal Year % Fiscal Year
2000 Change 1999 Change 1998
----------- ------ ----------- ------ -----------
($ in thousands)
Amortization of stock-
based compensation..... $15,115 (2)% $15,375 1,383% $1,037
Percentage of net
sales.................. 14% 44% --
25
We record deferred stock-based compensation 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. The amortization expense relates to options awarded to
employees in all operating expense categories. Deferred stock-based
compensation as of December 31, 2000 for stock options and restricted stock
issued to our employees will be subsequently recognized as expense for each of
the next four fiscal years as follows:
Fiscal Year Amount
----------- --------------
(in thousands)
2001...................................................... $9,897
2002...................................................... 1,865
2003...................................................... 464
2004...................................................... 82
Interest Income and Expense
Fiscal Year % Fiscal Year % Fiscal Year
2000 Change 1999 Change 1998
----------- ------ ----------- ------ -----------
($ in thousands)
Interest income, net....... $8,632 76% $4,912 2,723% $174
Interest income consists of earnings on our cash, cash equivalents and
marketable securities and interest expense consists of interest associated with
capital lease obligations. Net interest income has increased for each of the
past two years, primarily due to higher average outstanding cash, cash
equivalents and marketable securities balances associated with our equity
financings. We expect net interest income to decrease in fiscal year 2001 as
our average outstanding balance of cash, cash equivalents and marketable
securities reduces over time.
Income Taxes. There was no provision or benefit for income taxes for any
period since inception due to our operating losses. As of December 31, 2000, we
had approximately $261.1 million of net operating loss carryforwards for
federal income tax purposes, which expire beginning in 2018. Due to the
issuance and sale of Series E preferred stock in 1999 and our acquisition of
Beauty.com, 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
$63.0 million of net operating losses incurred prior to the date of the
ownership change would be limited to approximately $15.5 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 and
subsequent equity financings in 2000 did not cause additional ownership changes
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.
Liquidity and Capital Resources
We have incurred net losses of $316.9 million from inception to December 31,
2000. We believe that we will continue to incur net losses for the foreseeable
future. From our inception through December 31, 2000, we have financed our
operations primarily through the sale of equity securities, included common and
preferred stock, yielding net cash proceeds of $377.6 million.
26
Net cash used in operating activities was $142.3 million of the year ended
December 31, 2000, $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 changes in working capital.
Net cash provided by investing activities was $61.0 million for the year
ended December 31, 2000. For the year ended January 2, 2000 and the period from
April 2, 1998 (inception) to December 31, 1998, net cash used in investing
activities was $120.0 million, and $1.5 million, respectively. Net cash
provided by investing activities in fiscal year 2000 was primarily related to
the sales of marketable securities outstanding as of January 2, 2000 net of
capital expenditures primarily attributable to establishing our own
distribution center. 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
all periods presented includes leasehold improvements and purchases of
equipment and systems, computer equipment and fixtures and furniture.
For the year ended December 31, 2000, net cash provided by financing
activities was $162.8 million and consisted primarily of cash proceeds from our
secondary public offering consummated in March 2000 yielding net cash proceeds
of $101.6 million and our private placement of common and preferred stock in
August 2000 yielding net cash proceeds of $62.3 million. 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 $22.2 million from the issuance of
convertible preferred stock.
As of December 31, 2000 we had $129.9 million of cash, cash equivalents and
marketable securities. As of that date, and excluding a lease for our new
corporate headquarters that we cancelled in March 2001, our principal
commitments consisted of obligations outstanding under capital and operating
leases and strategic agreements with Amazon.com and WellPoint, aggregating
approximately $59.0 million through 2005.
We believe that our existing cash, cash equivalents and marketable
securities will be sufficient to fund our operations until we begin generating
operating cash flow. We currently expect to begin generating operating cash
flow in 2004, although there can be no assurances as to such timing or that we
will ever generate operating cash flow. We may need to raise additional funds
if, for example, we pursue business or technology acquisitions or experience
operating losses that exceed our current expectations. If we raise additional
funds through the issuance of equity, equity-related or debt securities, such
securities may have rights, preferences or privileges senior to those of the
rights of our common stock and our stockholders may experience additional
dilution. We cannot be certain that additional financing will be available to
us on acceptable terms when required, or at all.
Factors That May Affect Our Business
An investment in our securities involves certain risks. In evaluating us and
our business, investors should give careful consideration to the factors listed
below. If any of the following risks actually occurs, our business, financial
condition or operating results could be materially adversely affected. In such
case, the trading price of our common stock could decline.
We Are an Early Stage Company in a New and Rapidly Evolving Market, Which
Makes It Difficult for Investors to Determine Whether We Will Accomplish Our
Objectives
Because drugstore.com was founded in April 1998 and we only began selling
products in February 1999, we have a limited operating history on which
investors can base an evaluation of our business strategy. We have limited
insight into trends that may emerge and affect our business. An investor in our
common stock
27
must consider the risks and difficulties frequently encountered by early stage
companies, as well as the risks we face due to our participation in a new and
rapidly-evolving market. These challenges include our:
. Need to increase our brand awareness;
. Need to attract and retain customers at a reasonable cost;
. Need to achieve a critical mass of customers;
. Need to improve our gross margin and fulfillment cost;
. Dependence on Web site and transaction processing performance and
reliability;
. Need to compete effectively;
. Need to establish ourselves as an important participant in the evolving
market for healthcare products and services on the Internet; and
. Need to establish and develop relationships in the healthcare industry,
particularly in the areas of reimbursement and managed care.
Consumers of Health, Beauty, Wellness, Personal Care and Pharmacy Products May
Not Accept Our Solution, Which Would Harm Our Revenues and Prevent Us From
Becoming Profitable
If we do not attract and retain a high volume of online customers to our
store at a reasonable cost, we will not be able to increase our revenues or
achieve profitability. We may not be able to convert a large number of
customers from traditional shopping methods to online shopping for health,
beauty, wellness, personal care and pharmacy products. Even if we are
successful at attracting online customers, we expect it will take several years
to build a critical mass of these customers. Specific factors that could
prevent widespread customer acceptance include:
. Shipping charges, which do not apply to shopping at traditional
drugstores;
. Delivery time associated with Internet orders, as compared to the
immediate receipt of products at a physical store;
. Pricing that does not meet customer expectations of "finding the lowest
price on the Internet;"
. Additional steps and delays in ensuring insurance coverage for
prescription products;
. Lack of coverage of customer prescriptions by some insurance carriers;
. Lack of consumer awareness of our online pharmacy;
. Customer concerns about the security of online transactions and the
privacy of their personal health information;
. Product damage from shipping or shipments of wrong or expired products
from us or other vendors, resulting in a failure to establish customers'
trust in buying drugstore items online;
. Delays in responses to customer inquiries or in deliveries to customers;
. Inability to serve the acute care needs of customers, including
emergency prescription drugs and other urgently needed products; and
. Difficulties in returning or exchanging orders.
We Expect Continuing Losses for the Next Several Years
We incurred net losses of $316.9 million for the period from inception
through December 31, 2000. We have not achieved profitability. We only began
selling products in February 1999 and cannot be certain that we will obtain
enough customer traffic or a high enough volume of purchases to generate
sufficient revenues and
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achieve profitability. We believe that we will continue to incur operating and
net losses for at least the next three years (and possibly longer) as we:
. Fulfill more customer orders as the volume of purchases increases;
. Increase our sales and marketing activities;
. Provide our customers with promotional benefits, such as selling
selected products or offering shipping below our actual costs;
. Increase our general and administrative functions to support our growing
operations; and
. Develop enhanced technologies, features and fulfillment processes to
improve our Web site.
We may find that these efforts are more expensive than we currently
anticipate, which would further increase our losses.
We May Not Succeed in Establishing the drugst