Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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 29, 2002

Commission File Number: 0-26137

drugstore.com, inc.

(Exact Name of Registrant as Specified in its Charter)

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)

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)

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. ¨

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

The aggregate market value of Common Stock held by non-affiliates of the registrant was approximately $79,000,000 as of June 30, 2002, based upon the closing price of $2.69 on the Nasdaq National Market reported on such date. Shares of Common Stock held by each executive officer and director and by each person who beneficially owns more than 5% of the outstanding Common Stock have been excluded in that such persons may under certain circumstances be deemed to be affiliates. This determination of executive officer and affiliate status is not necessarily a conclusive determination for other purposes.

As of February 28, 2003, the number of shares of the registrant’s Common Stock outstanding was 68,665,461.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this Report, to the extent not set forth herein, is incorporated by reference from the registrant’s definitive proxy statement relating to the annual meeting of stockholders to be held on June 12, 2003, which definitive proxy statement shall be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Report relates.

Table of Contents

drugstore.com, inc.

FORM 10-K

For the Fiscal Year Ended December 29, 2002

Table of Contents

ii

Table of Contents

PART I

ITEM 1.    BUSINESS

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Special Note Regarding Forward-Looking Statements.”

Overview

drugstore.com^™ is a leading online drugstore and information site offering The Simple Way to Look and Feel Your Best^™. Located on the World Wide Web at www.drugstore.com, we sell health, beauty, wellness, and pharmacy products. We also sell prestige beauty products through Beauty.com^™, an online retailer that we acquired in February 2000 (located at www.beauty.com), and we sell sexual well-being products through our Web site located at www.sexualwellbeing.com (a URL that we acquired in January of 2003). We were incorporated in April 1998, commercially launched our Web site on February 24, 1999, and completed our initial public offering in July 1999. As of December 29, 2002, we have sold our products to approximately 3.2 million customers nationwide.

We have designed our Web site to provide a convenient, private, informative, and rewarding shopping experience that encourages consumers to purchase products essential to healthy, everyday living. Our Web site can be accessed via the Internet 24 hours a day, seven days a week from anywhere in the United States. We believe we offer a broader selection of products than typical brick and mortar retailers, along with a wealth of health-related information and other tools designed to help consumers make more educated purchasing decisions. Our navigational tools, shopping lists and e-mail reminders are designed to make it easy for our customers to regularly purchase their preferred products. We believe that our online solution provides customers with a superior shopping experience from other health, beauty, wellness and pharmacy retail solutions.

We currently operate only in the United States. During 2002, we organized our operations into two principal business segments which include over-the-counter health, beauty and wellness products (non-pharmaceutical segment) and prescription drugs (pharmaceutical segment). Additional information regarding our business segments can be found in the accompanying consolidated financial statements (see Note 11). Our business is generally affected by both seasonal fluctuations in Internet usage (which generally declines during the summer months) and traditional retail seasonality. Traditional retail sales for many of our specialty products usually increase significantly in the fourth calendar quarter of each year.

The Company’s quarterly and annual reports are available, free of charge, on our corporate Web site, www.drugstore.com, and are made available as soon as reasonably practicable following the filings thereof with the U.S. Securities and Exchange Commission (SEC) at http://www.sec.gov.

As used herein, “drugstore.com,” “we,” “our” and similar terms include drugstore.com, inc. and its subsidiaries, unless the context indicates otherwise.

Our Environment: Industry, Competition and Regulation

According to the National Association of Chain Drug Stores (NACDS), overall spending on health and wellness products, beauty aids and prescription drugs in the United States exceeded $240 billion in 2002. Within this group, prescription drugs is the largest and fastest growing category, representing nearly $180 billion in sales in 2002. This segment is expected to grow by 11-12% annually through 2005. Total online consumer sales of all types of products in the United States exceeded $40 billion in 2002 and are anticipated to grow to over $75 billion in 2005.

3

Table of Contents

The Growth of the Internet and Electronic Commerce

The Internet has become an important medium for communicating, finding information and purchasing products and services. The number of Web users in the United States has increased significantly since the launch of our Web site in 1999 and we believe that the number of Web users in the United States will continue to increase as a result of a number of factors, including:

The Internet has unique and powerful characteristics that differentiate it from traditional distribution channels and have facilitated its rapidly expanding use as a purchasing medium. We believe consumers who use 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 consumers to easily scroll through and search articles, pages of product data and related topics, gather relevant information and purchase products at their convenience.

Competition

The commerce market for health, beauty, wellness, 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, Target and, to a certain extent, Amazon.com; warehouse clubs, such as Costco and Sam’s Club; supermarkets, such as Safeway, Albertson’s and Kroger; specialty retailers and major department stores, such as Nordstrom, Macy’s and Bloomingdale’s; prescription benefit managers, such as 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, and/or pharmaceutical products both domestic and abroad. Each of these competitors operates within one or more of the health, beauty, wellness, and pharmacy product categories.

We believe that the following are the principal competitive factors in our market:

4

Table of Contents

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 regarding medication, dosage, delivery systems, common side effects, adverse effects or interactions and therapeutic contraindications, proper storage, prescription refill and other information deemed significant. Entities such as drugstore.com that distribute “controlled substances” are also subject to the Controlled Substances Act of 1970 and regulations issued by the U.S. Drug Enforcement Administration and state laws and regulations pertaining to controlled substances.

We also sell dietary supplements, medical devices, cosmetics, conventional foods, drug products (prescription, over-the-counter (OTC) and homeopathic) and consumer products subject to regulation, as applicable, by the Food and Drug Administration (FDA), the Federal Trade Commission (FTC), the Consumer Product Safety Commission (CPSC) and state regulatory authorities. In addition to regulating the claims made for specific types of products, the FDA and the 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 regulations.

We have structured our business, and entered into arrangements with our business partners, in order to comply with pharmacy regulatory and licensing requirements, in addition to requirements applicable to distributors of controlled substances and regulations 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. (See Risk Factor, “Governmental Regulation of Our Business Could Require Significant Expenses, and Failure to Comply With Certain Regulations Could Result in Civil and Criminal Penalties”.)

Regulatory requirements to which we are subject may expand over time. Congress and 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 the 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. 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. The National Association of Boards of Pharmacy (NABP) has developed the Verified Internet Pharmacy Practice Sites (VIPPS) program, which is 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.

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) mandates the development of standards and requirements to control the flow of health information throughout the health care system and to protect the privacy of personal health records. The HIPAA regulations have been finalized for Standardization of Transactions and Code Sets and for Privacy of Individually Identifiable Health Information (also known as the privacy standards rule). Covered organizations and practitioners, including drugstore.com, have until April 14, 2003, to comply with the privacy standards rule, and until October 16, 2003, to comply with the Standardization of Transactions and Code Sets rules. Several of the requirements in these regulations could create financial and administrative burdens for pharmacies, including online pharmacies such as us, may restrict the manner in which

5

Table of Contents

we transmit and use information and may cause us to use additional resources in order to comply with the requirements of these regulations, which could have an adverse effect on our results of operations. Other legislation and regulations currently being considered at the federal and state level, including legislation or regulations relating to confidentiality of patient records, electronic access and storage, could affect our business. 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. The Bush Administration has proposed Medicare-endorsed prescription discount cards. In addition, certain state governments have proposed prescription discount card programs to control the rise in drug costs. If these proposed discounts were to come primarily from retail pharmacy concessions on drug prices and dispensing fees, we could be adversely affected. (See Risk Factors – “Governmental Regulation of Our Business Could Require Significant Expenses, and Failure to Comply With Certain Regulations Could Result in Civil and Criminal Penalties” and “We Face Uncertainty Related to Pharmaceutical Costs and Pricing, Which Could Affect Our Revenues and Profitability”.)

Although it is currently illegal to import most prescription drugs into the U.S. from any foreign country, the FDA has taken an unofficial position that allows Canadian pharmacies to ship prescriptions to U.S. consumers. Legislation allowing for importation of prescription drugs by individuals for personal use has been introduced into the U.S. Congress each year for at least the past three years. If enacted, this legislation could adversely affect our business since consumers may increasingly use foreign-based online prescription drug Web sites instead of U.S.-based online pharmacies to fill their prescription needs. Most recently the FDA has indicated that they may begin to seek action against those who support or facilitate the illegal re-importation of prescription drugs, but it is too soon to tell what impact, if any, this action may have on the Company. (See Risk Factor—“We Face Significant Competition From Both Traditional and Online Retailers”.)

The drugstore.com Solution

We believe our online store provides customers with a superior shopping experience that provides consumers with The Simple Way to Look and Feel Your Best^™. We draw and retain our customers by emphasizing the following 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:

6

Table of Contents

Privacy.    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 by shopping from the privacy of their home or office and are able to ask a drugstore.com pharmacist questions that they may otherwise feel uncomfortable asking in public.

Product Assortment.    Because we do not have shelf-space limitations, we believe we offer a significantly broader range of products, and also greater depth within each product category, 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 products), we believe we offer a broader selection of health, beauty, and wellness products, sexual well-being and natural products, household products, and pet health solutions than can be found in many traditional chain drugstores. We believe that we offer the largest selection of drugstore products available on the Internet. We are also the only online retailer that offers General Nutrition Companies, Inc. (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 enables consumers to make informed purchasing decisions. This information is focused on key aspects of our market segments and is produced in-house and by third-party expert sources. Consumers can either access the information directly, through a number of content features on our Web site, or get free help directly from our customer care representatives and experts by contacting them through e-mail or via telephone at 1-800-DRUGSTORE. Our information services include:

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:

7

Table of Contents

Value.    Through the combination of shopping convenience, privacy, product assortment, information, communication (each described above), and competitive pricing, we believe we offer our customers superior value versus the typical retail solution. We believe we can save our customers time and money. For more information regarding our pricing strategy refer to the section entitled “How We Merchandise” below.

Product Categories

The market we address can be divided into four primary categories: health, beauty, wellness, and pharmacy. We offer several solutions to address these categories using a multi-store format within the drugstore.com store umbrella. Our stores include: medicine cabinet, beauty and spa, nutrition and wellness, personal care, household, pharmacy and sexual well being. Many of the products sold in our stores are essential, personal in nature, and are purchased repeatedly. Vendors frequently introduce new products, drive new trends and cause us to adjust and update our store offering and content throughout the year. Key aspects of the primary store categories available at drugstore.com are as follows:

Medicine Cabinet.    The medicine cabinet category includes OTC 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. Consumers in this category often seek significant amounts of product information to determine which products will meet their health needs. Representative brands carried in our health product category include Advil, Tylenol, Pepcid, Bausch & Lomb and Metamucil.

Beauty and Spa.    The beauty and spa category includes cosmetics, fragrances, home spa products 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. In February 2000 we acquired Beauty.com, Inc., an online retailer of prestige beauty products. Consumers for prestige products generally shop in department stores and beauty specialty stores or in spas and salons. Representative brands carried in our mass-market beauty product category include Philosophy, Revlon, L’Oreal, Cover Girl and Neutrogena; representative brands carried in our prestige beauty product category include shu uemura, LORAC, Sue Devitt Studios, Calvin Klein, and tarte.

Nutrition and Wellness.    The nutrition and 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. Representative brands carried in our wellness product category include Centrum, One-A-Day, Nature Made, Twinlab, Natrol and Nature’s Way. We are also the exclusive online retailer of GNC wellness products.

Personal Care.    The personal care market category includes products related to hair, body and shaving, oral hygiene, baby 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.

Sexual Well-Being.    The sexual well-being category provides both information and a wide selection of sexual well-being products, all provided in an environment where customers can explore their sexual wellness needs in the privacy of their own home. The unique retail offering provides a full range of adult consumer

8

Table of Contents

shopping choice—from novelty, to relationship building, to individual pleasure and relaxation. Representative brands include Kama Sutra, Astroglide, Lover’s Choice, Shunga and Vibratex. In January 2003 the Company launched a new Web site, sexualwellbeing.com, in order to more effectively market the products in this category.

Household.    The household category features easy and unique household solutions. This category offers a wide selection of household products ranging from easy cleaning solutions, new and innovative cleaning appliances and healthy house products, such as air and water purification systems. We feature items that create ambiance, that make cleaning easier and healthier, and that make entertaining simple. Representative brands include Hunter, Braun, OxiClean, Vicks, Caldrea and Shark.

Pharmacy.    This category consists primarily of prescription medication for chronic illnesses and needs, such as high blood pressure, diabetes, osteoporosis, depression, hair loss and birth control. Over the past ten years, mail order pharmacies have become an increasingly important source of pharmaceuticals for chronic illnesses.

The Shopping Experience at drugstore.com

Shoppers at drugstore.com see a home page that highlights our seven product departments in tabs across the top of the page, as well as editorial content and promotions. A shopper can browse through the Web site 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 and eye shadow. Shoppers can also search the site by entering text in the search box at the top of any page.

A customer can select products for 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:

When the customer finishes selecting the desired products, he or she proceeds to checkout. The only information required to checkout is an e-mail identification, a password (to protect account privacy), a billing address, a shipping address and a valid credit card number and expiration date. All of this information is maintained in a private and secure format and remains available for the customer’s future access.

We continue to evaluate and launch new features and services that will improve a customer’s shopping experience and also help drugstore.com create awareness of the higher-end, higher margin products that we offer. We have improved our search tool, personalized the product suggestion features to offer complementary and previously shopped items, and improved site navigation to make it easier for customers to locate items within our store.

9

Table of Contents

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 and we are licensed to fill prescriptions in all 50 states in the U.S. We have also received VIPPS certification from the NABP, a coalition of state pharmacy boards. The VIPPS program sets standards for Internet pharmacies and informs the public of those sites that are fully licensed and have agreed to comply with its standards.

New prescriptions may be ordered on the drugstore.com Web site for mail order delivery. Refill prescriptions that have previously been filled at a Rite Aid store or our mail order facility may be either mailed to the customer, or the customer can choose to pick-up their prescription at any one of Rite Aid’s 3,400 stores nationwide. We service both cash paying pharmacy customers and customers with insurance coverage. Through our relationships with Rite Aid Corporation (Rite Aid), insurance companies and Pharmacy Benefit Managers (PBMs), we are able to obtain insurance reimbursement coverage for many insured prescriptions, but we are limited to those plans that allow us to fill prescriptions on their behalf. Customers can ask our pharmacists about medications and receive other information about prescription drugs and health-related products using the Ask Your Pharmacist feature of our Web site. Although most prescriptions are ordered via the Web site, we also accept orders for prescriptions via telephone at 1-800-DRUGSTORE.

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:

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, when a customer has a single episode of a short-term illness or an exacerbation of a chronic condition requiring immediate attention in the form of antibiotics or pain medications, we recommend that customers pick up their prescriptions from a local pharmacy. This is because the treatment of acute care needs are extremely time sensitive and the delivery time required by online purchases could be too

10

Table of Contents

slow to meet the customer’s needs. We 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), products that contain oxycodone stimulants (including amphetamine and methylphenidate) and depressants (including secobarbital and amobarbital). We accept, verify and crosscheck prescriptions much like traditional retail and mail service pharmacies.

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. During 2002, approximately 70% of our prescriptions were paid for by insurance plans, while the balance reflected prescriptions submitted by customers who pay for the prescription directly. As a result of our relationship with Rite Aid, we are able to fill prescriptions for a majority of 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 (PCS), that were formerly owned by PCS Healthcare Systems, Inc., the retail pharmacy networks managed by WellPoint Health Networks, Inc. (WellPoint), Express Scripts (through our relationship with Rite Aid) and Aetna US Healthcare, Inc.

Pharmacy Supply.    Until we opened our own distribution center facility, a substantial amount of our pharmaceutical products delivered by mail were supplied by RxAmerica LLC. At the time of opening our distribution center in January 2000, we also entered into an agreement with Rite Aid whereby we became required to purchase all of our pharmaceutical products through Rite Aid from McKesson, unless we are able to obtain better overall terms from another vendor. To date we have not been able to obtain better overall terms from any other supplier and we currently expect that Rite Aid will continue to be the supplier for a majority of our pharmaceutical product purchases. This purchase requirement will continue for the term of the Rite Aid relationship through June 2009, and enables us to take advantage of volume discounts as a result of our relationship with Rite Aid.

11

Table of Contents

How We Merchandise

Merchandising Strategy

We believe that the breadth and depth of our product selection, together with the flexibility of our online store and the 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 specific products such as 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 and 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 and introduce special promotions in response to changing customer demand, customer demographics, new consumer trends, new seasons or upcoming holidays. Our technology also allows us to customize the shopping experience by personalizing the products that are presented to customers.

Specialty Shops.    We have created specialty shops in each of our product categories and have made them available via our tab navigation on our Web site. These specialty shops sell a wide range of products including natural and organic products, home spa, salon hair care products, baby care products, and pet care products. Our GNC LiveWell Store is dedicated to GNC nutritional products and other products typically sold in GNC stores. We are currently the exclusive distributor of GNC brand products on the Internet, and will continue to be the exclusive online distributor subject to our meeting performance parameters during the fifth year of the relationship in 2004. Our natural store carries wholesome products by brands such as Burt’s Bees and Tom’s of Maine. The specialty store format and navigation allows us to market products by life stage, lifestyle, health condition, specific consumer groups or seasonal themes.

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 consumers 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, including by product category or by product characteristics, such as price or ingredients.

Targeted Promotions.    We have the ability to offer products to individual customers based on their affinities or conditions. In addition, we can present merchandise to a customer tailored to personal interests and shopping histories. We also cross-sell our departments to promote impulse buying by customers.

Sampling.    We have programs that allow us to provide samples of over-the-counter products to customers as trials. We may also use broad-based and targeted sampling to work with manufacturers to introduce new products.

Marketing Programs for Suppliers.    We host programs for consumer product manufacturers to strategically market their brands within our Web site. 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, the ability to buy many “first-to-market” products, and the information needed to make informed purchase decisions. Additionally, we continue to partner with product manufacturers to market new products and are demonstrating that drugstore.com is a valuable marketing partner. Recently, we have provided pre-sell product launch platforms, which means that we work with a vendor to offer a specific new product first to consumers, for RESPeRate by Intercure, Inc., which is a blood pressure lowering device, Pre-Seed by Bio-OriGyn Inc. (a sperm-friendly intimate moisturizer

12

Table of Contents

for customers trying to conceive), Colgate Simply White, and Sonicare’s Elite model toothbrush. We also partnered with Dreamtime, Inc. during the previous holiday season by becoming their exclusive online retail solution.

Pricing Strategy

Our goal is to offer our customers the largest assortment of health, beauty, wellness and pharmacy products with value pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can afford to pass along the savings to our customers in the form of lower prices and exclusive deals. We also attempt to make additional cost savings opportunities known to our customers when they are available. For example, in our pharmacy we proactively highlight lower cost generic drug alternatives versus higher priced brand solutions where both the customer and drugstore.com save on the price of the drug. We also work to migrate our pharmacy customers from 30-day to 90-day supplies of medication, by providing quantity price breaks as incentives. Again, this strategy allows our customers to take advantage of price savings and we enjoy fulfillment cost savings and higher customer retention. We believe our overall pricing strategy will increase unit retail growth, and lead to further operating efficiencies.

How We Serve Our Customers

Delivery of Our Customers’ Orders

In January 2000, we began operating a leased 290,000 square foot distribution center in New Jersey. Since June 2000, all of our orders delivered by mail are processed from this distribution center.

We purchase our non-pharmaceutical inventory directly from various manufacturers and wholesalers. Under the terms of our agreement with Rite Aid, we are required to buy our pharmaceutical products through Rite Aid directly from McKesson, unless we are able to obtain better overall terms from other vendors. This arrangement enables us to take advantage of the buying power of Rite Aid, and therefore decreases our cost on pharmaceutical products. For prescriptions filled through our pharmacy at our distribution center, we operate under our arrangement with Rite Aid. Our pharmacists, working together with a Rite Aid “pharmacist in charge,” perform all aspects of the prescription fulfillment process and all aspects of customer service.

Our warehouse management system provides us with real-time data on inventory receiving and shipping, quantities and location. This enables us to notify customers about product availability on a real-time basis. In addition, we offer an order tracking system for our customers on our Web site that enables a customer to see where their order is en route, and when it is expected to be delivered. Due to the relatively short lead time required to fill orders for our products, backlog of orders is not material to our business.

We generally charge our customers a shipping charge that covers a portion of our expense of shipping. During 2002 we began to offer free standard shipping on any non-pharmaceutical order over $49. 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 January 2002, we began to charge shipping on most pharmaceutical orders shipped from our distribution center.

In addition, customers are able to order refills of their existing Rite Aid or drugstore.com prescriptions online at our Web site for pick-up at their choice of any Rite Aid store or for delivery using one of our standard delivery options.

13

Table of Contents

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 customer 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 customers about medication, dosage, delivery systems, common side effects and other information about prescription drugs.

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 have not been significant to date.

We maintain a customer care center in our Bellevue, Washington headquarters. We also operate a toll-free telephone 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 calling in their credit card information via telephone.

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:

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 some of our information and pharmacy systems with Rite Aid’s systems. Rite Aid has granted us a nonexclusive, fully paid license to the Rite Aid systems that are integrated with our systems, subject to third-party rights to such technology.

We also have a technology license and advertising agreement with Amazon.com under which we have 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, a real-time order tracking system, an executive information system and an inventory 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

14

Table of Contents

Cable & Wireless (formerly Exodus Inc.) in Tukwila, Washington, which provides communication lines from multiple providers, including UUNet and AT&T, as well as 24-hour monitoring and engineering support. Cable & Wireless has its own generators and multiple backup systems in Tukwila.

Our Target Customer

Our target customer is the busy, working female between the ages of 35 and 54. This customer tends to be married with children, makes most of the household buying decisions and uses online shopping as a means of maximizing the use of her time, browses multiple categories and finds online shopping a relaxing and rewarding experience. We also cater to a secondary target market which reflects a more senior male who uses online shopping as a means of maximizing the use of his time, and as he ages tends to increase his utilization of prescription medications.

Marketing Our Products and Services

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 purchas