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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 28, 2004

or

For the transition period from              to             

Commission File Number 000-26137

drugstore.com, inc.

(Exact name of registrant as specified in its charter)

13920 Southeast Eastgate Way, Suite 300, Bellevue, Washington 98005

(Address of principal executive offices including zip code)

(425) 372-3200

(Registrant’s telephone number, including area code)

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

As of April 30, 2004, the registrant had 78,771,713 shares of common stock outstanding.

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DRUGSTORE.COM, INC.

FORM 10-Q

For the three months ended March 28, 2004

INDEX

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PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of the Business

drugstore.com, inc. is a leading online provider of health, beauty, vision and pharmacy solutions. We sell health, beauty, wellness, personal care, sexual well-being and pharmacy products through our Web site at www.drugstore.com and prestige beauty products through our Web site located at www.beauty.com, which is also accessible through the drugstore.com Web site. As of April 28, 2003, we offer customized nutritional supplement programs through our wholly owned subsidiary, Custom Nutrition Services, Inc. (CNS). Additionally, as of December 8, 2003, we sell contact lenses and other vision products through our wholly owned subsidiary International Vision Direct Corp. (Vision Direct), through its Web sites located at www.visiondirect.com, www.lensmart.com and www.lensquest.com.

All customer orders are processed through our Web stores or via telephone through our toll-free telephone numbers, 1-800-DRUGSTORE and 1-800-VISIONDIRECT. We operate two distribution centers, one that provides fulfillment capabilities for all of our pharmaceutical and non-pharmaceutical orders delivered by mail, and another that fulfills our vision orders delivered by mail. Under the terms of an agreement with Rite Aid Corporation (Rite Aid), customers are also able to order existing drugstore.com and Rite Aid refill prescriptions for pickup at any Rite Aid store.

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. In our opinion, these financial statements include all adjustments, consisting of all normal and recurring adjustments, necessary for the fair presentation of the results of the interim periods presented. In addition, the accompanying balance sheet data at December 28, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements, and accompanying notes, included in our annual report on Form 10-K for the fiscal year ended December 28, 2003. Our results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

Comprehensive loss

Comprehensive loss is the same as net loss in all periods presented.

3. Accrued Liabilities

During the first quarter of 2004, we implemented a new employee vacation policy under which unused, accrued vacation balances are not paid upon termination of employment. The implementation of this policy change reduced our estimated accrued liability associated with employee vacation by approximately $400,000, and we recorded a corresponding reduction in operating expenses for the first quarter.

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4. Intangible Assets

The intangible assets balances as of March 28, 2004 and December 28, 2003 were as follows:

5. Goodwill

The following table summarizes the changes in goodwill, by business segment, at March 28, 2004 and December 28, 2003:

Goodwill in our over-the-counter (OTC) segment includes the goodwill related to the acquisition of CNS. Goodwill in our vision segment represents the goodwill related to the acquisition of Vision Direct.

6. Net Loss Per Share

Net loss per share is computed using the weighted average number of shares of common stock outstanding less the number of shares subject to repurchase or contingently issuable pursuant to contractual terms. Shares associated with stock options and warrants are not included in the calculation of diluted net loss per share because they are antidilutive.

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The following table sets forth the computation of basic and diluted net loss per share for the periods indicated:

As of March 28, 2004 and March 30, 2003, there were stock options and warrants outstanding to acquire 16,153,926 and 15,501,075 common shares, respectively, that were excluded from the computation of diluted net loss per share, as their effect was antidilutive. If we had reported net income, the calculation of per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method.

7. Strategic Agreements

Rite Aid

In July 1999, we consummated a series of agreements with Rite Aid and General Nutrition Corporation (GNC) to issue 12,282,599 shares of our Series E preferred stock in exchange for an aggregate of $10 million in cash and other consideration, including access to insurance coverage, advertising commitments and a vendor agreement with an estimated fair value of $233.9 million. The $233.9 million non-cash portion of the consideration from the Rite Aid and GNC agreements was allocated to the following components based on a valuation obtained from an independent valuation expert (in millions):

Under our agreements with Rite Aid, customers are able to order refills of their existing Rite Aid or drugstore.com prescriptions using our Web site, and may choose to receive that prescription using our mail-order delivery service or pick up their prescription at any of Rite Aid’s approximately 3,400 stores nationwide. In addition to offering multi-channel delivery options, Rite Aid and drugstore.com agreed to promote each other’s services both online and offline. We also received the benefit of many of Rite Aid’s insurance and pharmacy benefit manager (PBM) relationships and are able to buy prescription products through Rite Aid, taking advantage of its buying power. During the first quarter of 2002, the relationship expanded as we began selling Rite Aid private label over-the-counter products on the drugstore.com Web site.

As part of this relationship, drugstore.com agreed to certain exclusivity provisions that limit our ability to promote, or affiliate with, any other physical retail drugstore or to operate as a traditional physical drugstore, and Rite Aid agreed not to offer or sell products or services on the Internet other than through our Web site. In addition, the agreement requires us to purchase all of our pharmaceutical products through 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 ends in 2009.

The access to insurance coverage and the vendor agreement have been classified as intangible assets, and the advertising commitments have been classified within prepaid marketing expenses. All of the assets are being amortized on a straight-line basis over their contractual life of 10 years.

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Amazon.com

Effective September 19, 2003, we entered into a new e-commerce agreement with Amazon.com, Inc. Under the new agreement, we are a nonexclusive wholesaler and fulfillment provider for certain OTC products sold through the Health & Personal Care store on the Amazon.com Web site. We ship the Amazon.com orders we fulfill in Amazon.com-branded boxes from our distribution facility. The new agreement replaced our then-existing marketing agreement with Amazon.com. The initial term of this agreement ends in April 2007.

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

8. Stock Options

The following table summarizes activity under our 1998 Stock Plan:

We account for employee stock options using the intrinsic value method, which follows the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related Interpretations. The intrinsic value method of accounting results in stock compensation expense to the extent option exercise prices are set below market prices on the date of grant. Also, to the extent employee stock awards have been subject to an exchange offer or other modifications, such awards are subject to variable accounting treatment. Variable accounting treatment results in expense or contra-expense recognition using the cumulative expense method, calculated based on quoted prices of our common stock and vesting schedules of underlying awards.

SFAS No. 123, Accounting for Stock-Based Compensation (SFAS 123), which has been updated by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, requires companies that continue to follow APB 25 to provide a pro forma disclosure of the impact of applying the fair value method of SFAS 123. We account for stock issued to non-employees in accordance with the provisions of SFAS 123 and the EITF consensus in Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.

Under APB 25, no compensation expense is recognized when the exercise price of our employee stock options equals the fair value of the underlying stock on the date of grant. Deferred stock-based compensation is recorded for those situations where the exercise price of an option was lower than the fair value for financial reporting purposes of the underlying common stock. For the quarters ended March 28, 2004 and March 30, 2003, we recorded aggregate deferred stock-based compensation of $224,000 and $0, respectively. This deferred stock-based compensation is being amortized over the vesting period of the underlying options using the multiple-option approach. For the quarters ended March 28, 2004 and March 30, 2003, we recognized amortization of stock-based compensation of $352,000 and $156,000, respectively. In those same periods, we reversed $403,000 and $20,000, respectively, of deferred stock-based compensation as a result of employee terminations.

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If the stock-based compensation for our 1998 Stock Plan had been determined based on the fair value method, as promulgated by SFAS 123, our net loss would have been adjusted to the following pro forma amounts for the periods ended March 28, 2004 and March 30, 2003:

The initial impact on pro forma net loss may not be representative of compensation expense in future years when the effect of amortization of multiple awards would be reflected in pro forma earnings.

For purposes of the pro forma amounts above, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model, assuming no expected dividends. The following weighted average assumptions were utilized in arriving at the fair value of each option granted during the periods indicated:

9. Commitments and Contingencies

Legal Proceedings.

Class Action Laddering Litigation. On and after July 6, 2001, eight shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York naming drugstore.com, inc. as a defendant, along with the underwriters and certain of our present and former officers and directors (the Individual Defendants), in connection with our July 27, 1999 initial public offering and March 15, 2000 secondary offering (together, the Offerings). The complaints against drugstore.com have been consolidated into a single action and a Consolidated Amended Complaint, which is now the operative complaint, was filed on April 19, 2002. The suit purports to be a class action filed on behalf of purchasers of our common stock during the period July 28, 1999 to December 6, 2000.

In general, the complaint alleges that the prospectuses through which we conducted the Offerings were materially false and misleading for failure to disclose, among other things, that (i) the underwriters of the Offerings allegedly had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of the restricted number of shares issued in connection with the Offerings and (ii) the underwriters allegedly entered into agreements with customers whereby the underwriters agreed to allocate drugstore.com shares to customers in the Offerings in exchange for which customers agreed to purchase additional drugstore.com shares in the after-market at predetermined prices. The complaint asserts violations of various sections of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. The action seeks damages in an unspecified amount and other relief.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, we moved to dismiss all claims against us and the Individual Defendants. On October 9, 2002, the Court dismissed the

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Individual Defendants from the case without prejudice based on stipulations of dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against drugstore.com. In 2003, drugstore.com approved a Memorandum of Understanding (MOU) and related agreements, which set forth the terms of a settlement between drugstore.com, the plaintiff class and the vast majority of the other approximately 300 issuer defendants. Among other provisions, the settlement contemplated by the MOU provides for a release of drugstore.com and the Individual Defendants for the conduct alleged in the action to be wrongful. We would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims we may have against our underwriters. It is anticipated that any potential financial obligation of drugstore.com to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, we do not expect that the settlement will involve any payment by drugstore.com. The MOU and related agreements are subject to a number of contingencies, including the negotiation of a settlement agreement and its approval by the Court. We can give no assurances as to whether or when a settlement will occur or be finalized. Because our liability, if any, cannot be reasonably estimated, no amounts have been accrued for this matter. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

Arlington Contact Lens Service Litigation. On November 14, 2003, Arlington Contact Lens Service (AC Lens) filed a complaint against drugstore.com, inc. in the Court of Common Pleas, Franklin County, Ohio. In the complaint, AC Lens alleged that we breached our contract with AC Lens, and that we defamed AC Lens by disclosing our acquisition of International Vision Direct Corp. in a press release dated November 3, 2003. The complaint sought compensatory damages exceeding $25,000 but of an otherwise unspecified amount, along with an unspecified amount of punitive damages.

On January 14, 2004, we filed motions for a more definite statement of count one (breach of contract) and to dismiss count two of the complaint (defamation). On January 29, 2004, AC Lens filed an amended complaint alleging breach of contract with greater specificity and removing the defamation claim. Consequently, we withdrew our motions. On February 27, 2004, we filed an answer to the amended complaint and asserted a counterclaim for breach of contract. AC Lens replied to the counterclaim on March 3, 2004. The parties are now engaged in discovery. At this time, we are unable to predict the outcome of this litigation. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

Vision Direct – 1-800 Contacts Litigation. On October 9, 2002, plaintiff 1-800 Contacts, Inc. filed a complaint in the United States District Court for the Southern District of New York (the District Court) against defendants WhenU.com, Inc. and Vision Direct, Inc. (VDI), a subsidiary of International Vision Direct Corp. The complaint alleged copyright and trademark violations based on defendants’ use of “pop-up” advertising over 1-800 Contacts’ Web site, a “cyber squatting” claim against VDI based on its registration of the domain name www.www1800Contacts.com (the Domain Name) and unspecified damages. 1-800 Contacts also moved for a preliminary and permanent injunction against both defendants to stop their use of pop-up advertisements and compel VDI to relinquish its registration of the Domain Name. Both defendants answered the complaint and VDI denied the substantive allegations of the complaint. The defendants also opposed the motion for a preliminary injunction.

On December 22, 2003, the District Court granted 1-800 Contacts’ motion for a preliminary injunction, notwithstanding the fact that VDI had voluntarily ceased the use of pop-up advertisements before the commencement of the action and relinquished its registration of the Domain Name. Both defendants filed timely notices of appeal from the District Court’s order to the United States Court of Appeals for the Second Circuit, which have been fully briefed. The Second Circuit heard oral arguments on April 5, 2004 and is now considering the appeals. At this time, we are unable to predict the outcome of VDI’s appeal or the litigation in the District Court. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

Vision Direct – Coastal Contacts Litigation. On December 11, 2002, plaintiffs VDI and International Vision Direct, Inc. (together, Vision Direct) filed a complaint in the District Court against WhenU.com, Inc. and Coastal Contacts, Inc., alleging copyright and trademark violations based on the defendants’ use of “pop-up” advertisements over Vision Direct’s Web site. Vision Direct also moved for a preliminary injunction to stop defendants’ use of the pop-up advertisements. On December 20, 2002, the District Court denied Vision Direct’s motion for a preliminary injunction. WhenU.com and Coastal Contacts subsequently answered Vision Direct’s complaint and denied the substantive allegations in the complaint. Coastal Contacts also asserted certain counterclaims against Vision Direct, including a claim that Vision Direct had brought the action in bad faith. Vision Direct filed a reply to Coastal Contacts’ counterclaims on March 12, 2003.

On February 5, 2004, the District Court granted Vision Direct’s request to adjourn a status conference scheduled for February 6, 2004, pending resolution of the appeals in the 1-800 Contacts litigation discussed above. At this time, we are unable to predict the outcome of this litigation. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

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State Sales Tax Claims. In early 2002, we received an Arbitrary Assessment notice from the state of New Jersey for past sales tax due from fiscal years 2000 and 2001, based upon its best estimate of sales revenue numbers during those periods. In December 2002, we received a Revised Assessment from the State of New Jersey based on sales revenue numbers we provided. In March 2003, we filed an appeal of the Revised Assessment with the Tax Court of New Jersey, based on the fact that the State of New Jersey is pursuing its claim specifically against one of our consolidated subsidiaries that is not the retailing entity in that state. Due to the uncertainty of the appeal, no amounts have been recorded in the accompanying financial statements with respect to the sales tax alleged to be due. We believe that the ultimate resolution of this sales tax assessment will not have a material adverse effect on our financial position or operating results. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

Other. From time to time, we are subject to other legal proceedings and claims in the ordinary course of business. We are not currently aware of any such legal proceedings or claims that we believe will have, individually or in the aggregate, a material adverse effect on our business prospects, financial condition or operating results.

10. Segment Information

During fiscal year 2003, we organized our operations into four operating segments: mail-order pharmacy, local pick-up pharmacy, OTC, and vision. We do not allocate assets to our reporting segments, as assets are generally not specifically attributable to these segments. The information presented below for these segments is information used by our chief operating decision maker (our chief executive officer) in evaluating operating performance.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this quarterly report.

Special Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this quarterly report are forward-looking. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from those stated or implied in the forward-looking statements for a variety of reasons, including, among others, the rate of growth of the economy in general, the Internet and online commerce, customer spending patterns, our ability to attract and retain customers, the mix of products sold to customers, the anticipated benefits and risks of our key strategic relationships, risks of inventory management, seasonality, the future value of our common stock, the anticipated size or trends of the market segments in which we compete and the anticipated competition in those markets, potential government regulation, and our future capital requirements and the ability to meet those capital needs. These and other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are described in the following discussion and in the section entitled “Business – Factors That May Affect Our Business” in Part I, Item 1 of our annual report on Form 10-K for the fiscal year ended December 28, 2003, filed with the Securities and Exchange Commission. A forward-looking statement should not be relied upon as representing our views as of any date other than the date on which we made the statement. We expressly disclaim any intent or obligation to update any forward-looking statement after the date on which we make it, except as we otherwise specifically state.

We operate on a retail calendar. References in the following discussion to yearly periods are to fiscal years, unless the context indicates otherwise. For example, “2003” refers to the fiscal year ended December 28, 2003.

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision and pharmacy solutions. We believe that our Web stores, including those located on the Internet at www.drugstore.com, www.beauty.com and www.visiondirect.com, offer a better way for consumers to shop for these products. We operate primarily in the United States and Canada, but our products are available to consumers worldwide.

Business Segments; Growth Strategies. As a result of our acquisition of Vision Direct and our current growth strategies within our pharmacy product category, in the fourth quarter of 2003 we organized our business into four primary business segments: mail-order pharmacy, local pick-up pharmacy, over-the-counter, or OTC, and vision. The organization of our business into these four distinct segments allows our management to gain a comprehensive financial view of each of our key businesses and our business as a whole. In addition, this segmentation better allows us to align strategies in operations, marketing and customer care to optimize the overall customer experience, within each segment and across all segments, and maximize growth.

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Revenues. We generate revenue primarily from product sales and shipping fees. In the first quarter of 2004, we reported consolidated total net sales of $84.4 million, which reflected a 47.8% increase over net sales in the first quarter of 2003. Improved performance in our OTC and mail-order pharmacy business segments, in which net sales grew by 48.5% and 23.1%, respectively, in the first quarter of 2004 compared to the first quarter of 2003, contributed substantially to our growth in total net sales in the quarter. Net sales in the local pickup pharmacy segment were flat in the first quarter of 2004 compared to the first quarter of 2003. Net sales in the vision segment in the first quarter of 2004, which was the first full quarter of vision operations as part of drugstore.com, generated $12.8 million in net sales, representing 15.1% of our total net sales.

Expenses. Our operating expenses, including cost of goods sold, declined as a percentage of net sales from 110.2% in the first quarter of 2003 to 105.5% in the first quarter of 2004. This decline resulted from our efforts to reduce our cost of goods as a percentage of total net sales by increasing our mix of higher-margin OTC and vision products relative to lower-margin pharmacy products. Increased utilization of our primary distribution center reduced our fulfillment expenses to 11.0% of total net sales in the first quarter of 2004, down from 12.5% in the first quarter of 2003. Our technology and general and administrative expenses increased in dollar amounts year-over-year primarily due to the acquisition of Vision Direct and the incorporation of its operations into our business, but declined year-over-year as a percentage of net sales as we spread our fixed costs over a growing order volume and net sales base. As a result of implementing a new employee vacation policy, we recorded a $400,000 reduction in operating expenses in the first quarter of 2004.

Net Loss; Cash Position. The combination of our revenue growth and continued cost containment efforts resulted in a year-over-year decline in our net loss of $1.1 million, or 18.9%, to $4.6 million in the first quarter of 2004. We ended the first quarter of 2004 with over $39.4 million in cash and marketable securities and no debt. Uses of cash in the quarter included increased spending on OTC inventory to stock up for anticipated sales growth, annual employee bonuses and funding ongoing operations. Assuming that we are able to implement our growth initiatives, increase sales and continue to reduce total expenses as a percentage of sales, we anticipate net losses in 2004 to be in the range of $9.8 million to $13.8 million. Although we expect a net loss for 2004, we do not expect our cash balance to decline significantly in 2004 because we anticipate that a substantial portion of our 2004 net loss will reflect non-cash expenses, such as amortization and depreciation.

Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and that require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the significant accounting policies and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments and assumptions that are significant to understanding our results. Additional information about our significant accounting policies is included in Note 1 of our consolidated financial statements included in Part IV, Item 15 of our annual report on Form 10-K for the fiscal year ended December 28, 2003. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. In addition, any significant unanticipated changes in any of our assumptions could have a material adverse effect on our business, financial condition and results of operations.

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Revenue Recognition

Revenues from sales of products delivered to customers (net of promotional discounts, cancellations, rebates and returns allowances) are recorded when the products are shipped and title passes to the customer. Products are considered shipped upon delivery to the common carrier, at which time both title and risk of loss are transferred pursuant to our contracts with our carriers. This arrangement is commonly referred to as “F.O.B. Shipping Point.” Return allowances, which reduce product sales by our best estimate of expected product returns, are estimated using historical experience. If our estimate of return allowances is too high, our revenues will be understated; if our estimate of these allowances is too low, our revenues will be overstated. Product returns, and differences between our estimates and actual returns, have not been significant historically.

Revenues from sales of certain pharmaceutical products ordered through our drugstore.com Web store for pick-up at a Rite Aid store are recognized when the customer collects the product. In these circumstances, we utilize Rite Aid as a fulfillment partner. According to the criteria outlined in Emerging Issues Task Force Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, or EITF 99-19, we record revenues in our local pick-up pharmacy segment on a gross basis, because we believe we act as a principal, based on the fact that, among other things, we bear both credit risk and inventory risk associated with these sales.

Periodically, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, which we refer to as Diamond Deals^™, or future rebates based upon a percentage of the current purchase, which we refer to as drugstore.com Dollars^™, and Vision Rewards (for contact lens purchases), as well as other offers. Diamond Deals, when accepted by our customers, are treated as a reduction to the sales price of the related transaction and are presented as a net amount in net sales. Rebates we offer are treated as a reduction to sales price based on estimated redemption rates. Redemption rates are estimated using our historical experience for similar offers. Historically, our redemption rates, which are adjusted quarterly, have not differed materially from our estimates.

Inventory

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

Goodwill

In accordance with SFAS No. 142, Accounting for Goodwill and Other Intangibles, we do not amortize goodwill but instead test for impairment at least annually. We test for impairment at the beginning of the fourth quarter or whenever indicators of impairment exist. The first phase of the test screens for impairment and the second phase (if necessary) measures for impairment. The first phase is performed by comparing the fair value of the applicable reporting unit to its carrying value. Fair value is determined using a discounted cash flow methodology. If our estimates of revenue growth or future cash flows prove to be inaccurate, we may have a future impairment of goodwill.

Accrued Liabilities

During the first quarter of 2004, we implemented a new employee vacation policy under which unused, accrued vacation balances are not paid upon termination of employment. The implementation of this policy change reduced our estimated accrued liability associated with employee vacation by approximately $400,000, and we recorded a corresponding reduction of operating expenses for the first quarter. Going forward, we will be assessing in each quarter our liability associated with accrued employee vacation, which will be adjusted as necessary based on our historical and anticipated future forfeiture rates.

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Results of Operations

Net Sales

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. Net sales also include service fees from our agreement with Amazon.com, Inc., under which we act as a nonexclusive wholesaler and fulfillment provider for certain OTC products sold through the Health & Personal Care store on the Amazon.com Web site, and consignment services fees earned from our GNC arrangement, under which we do not take title to the inventory and cannot establish pricing. Consignment service fees are booked on a net basis and constitute less than 2% of total net sales in each period presented. Orders are 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. Sales made to Amazon.com under our wholesale and fulfillment agreement are billed directly to Amazon.com.

Total net sales grew by 47.8% in the first quarter of 2004 compared to the first quarter of 2003, as a result of increased order volume and growth in average net revenue per order. The total number of orders in the first quarter of 2004 grew by 33% to 1,077,000, compared to 808,000 in the first quarter of 2003, as a result of new customer acquisition and increases in repeat orders from existing customers. Average net sales per order increased by 11%, or $7, to $78 in the first quarter of 2004 compared to the first quarter of 2003, as a result of customers purchasing an increasing number of items per order. Sales growth in the quarter also benefited significantly by the addition of sales from our newly acquired vision business.

Net sales in the mail-order pharmacy segment grew by 24.4%, and order volume increased by 8%, year-over-year as a result of our initiatives to grow the segment by providing third-party pharmacy fulfillment services to PBMs. This strategy has resulted in customers purchasing an increasing number of 90-day supplies. Average net sales per order in this segment increased by 16% to $129 in the first quarter of 2004 compared to the first quarter of 2003, as a result of customers purchasing an increasing number of 90-day supplies.

Our net sales in the local pick-up pharmacy segment remained largely unchanged compared to the first quarter of 2003 as we continued to focus on our mail-order pharmacy segment. Average net sales per order in this segment increased by 10% to $101 in the first quarter of 2004 compared to the first quarter of 2003 as a result of an increase in the average price per prescription, as well as an increase in the average number of prescriptions per order.

Our net sales in the OTC segment grew by 48.1%, and order volume increased by 24%, in the first quarter of 2004 compared to the first quarter of 2003 as a result of new customer acquisition and significant increases in repeat orders from existing customers. Average net sales per order increased by 20% to $60 in the first quarter of 2004 compared to the first quarter of 2003 as a result of customers purchasing an increasing number of items per order and an increase in the average price per item.

Our net sales in the vision segment for the first quarter of 2004 were $12.9 million. Average net sales per order were $77.

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We acquired 306,000 new customers during the first quarter of 2004, increasing our total customer base to 5.1 million customers since inception, compared to 3.5 million customers at the end of the first quarter of 2003. Sales from repeat customers made up 73% of total net sales in the first quarter of 2004. Repeat orders continue to increase in both absolute dollars and as a percentage of total orders as we continue to focus our marketing efforts on acquiring high-value customers. These efforts were supported by our anchor loyalty programs of Everyday Free Shipping, drugstore.com Dollars and Diamond Deals, which we believe help drive increases in average sales per order and order volume.

Cost of Sales

Total cost of sales increased in absolute dollars in the first quarter of 2004 compared to the first quarter of 2003 as a result of growth in net sales and increased order volume. Cost of sales as a percentage of net sales decreased primarily as a result of a higher mix of higher-margin OTC and vision sales relative to lower-margin mail-order pharmacy and local pick-up pharmacy sales.

For both the mail-order and local pick-up pharmacy segments, we maintained and improved our product margins through selling generic pharmaceutical products, which generally saves the customer money and reduces our product costs. We emphasize to our customer the cost savings of choosing to buy generic drugs and alert our customers to the anticipated release of new generic alternatives to the brand drugs they may be currently purchasing.

We continue to improve product margins in the OTC segment through a more favorable mix of product sales that include higher-margin items in specialty, seasonal and prestige beauty merchandise and customized nutritional supplements.

Cost of sales in our vision segment was $9.4 million for the first quarter of 2004. Vision Direct charges a standard shipping charge on all orders under $99, which provides a nominal benefit to overall gross margin.

Shipping costs, which are included in cost of sales, continue to exceed the amount we charge customers for shipping. We expect to continue to subsidize a portion of our OTC shipping costs for the foreseeable future, through free shipping on nonprescription orders of $49 or more, as a strategy to attract and retain customers.

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Fulfillment and Order Processing Expense

Fulfillment and order processing expenses include expenses related to distribution center equipment and packaging supplies, per-unit fulfillment fees charged by Rite Aid, credit card processing fees, payroll and related expenses for personnel engaged in purchasing, fulfillment, distribution, and customer care activities (including warehouse personnel and pharmacists engaged in prescription verification activities), rent and depreciation related to equipment and fixtures in our distribution center and call center facilities.

Fulfillment and order processing expenses decreased as a percentage of net sales in the first quarter of 2004 compared to the first quarter of 2003 primarily as a result of increased order volumes and net sales per order spread over our primary distribution center’s fixed cost infrastructure. Fulfillment and order processing expenses increased in absolute dollars year-over-year as a result of larger order volumes.

Marketing and Sales Expense

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 included various advertising contracts.

Marketing and sales expenses increased in absolute dollars but remained relatively flat as a percentage of net sales. The dollar increase in marketing and sales expense was attributable to spending to grow our newly acquired vision business as well as continued marketing expenses to accelerate the growth of our OTC business. Marketing and sales expense per new customer in the first quarter of 2001 was approximately $20, reflecting an increase of $4 from the first quarter of 2003, as we integrated the marketing activities of Vision Direct and tested various new promotional programs associated with the new vision business.

Technology and Content Expense

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 sites and their content. Technology and content expenses also include Internet access and hosting charges, depreciation on hardware and IT structures, and content and design expenses for our Web sites.

Technology and content expenses increased by $0.3 million in the first quarter of 2004 compared to the first quarter of 2003. This increase was due primarily to a greater number of employees working on the integration of our 2003 acquisitions of CNS and Vision Direct, as well as various maintenance activities. Our integration activities also resulted in a $200,000 increase in capitalized labor.

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General and Administrative Expense

General and administrative expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, professional service expenses, travel and other general corporate expenses. General and administrative expenses decreased as a percentage of net sales as a result of more net sales being spread over our fixed corporate infrastructure costs. General and administrative expenses grew in absolute dollars in the first quarter of 2004 compared to the first quarter of 2003 largely due to the addition of Vision Direct general and administrative expenses into our infrastructure.

Amortization of Intangible Assets

The increase in amortization of intangible assets is related to the acquisitions of Vision Direct and CNS in 2003.

Amortization of Stock-based Compensation

We record deferred stock-based compensation in connection with stock options granted below market value on the date of grant to our employees in all operating expense categories. 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. Such amounts are amortized to expense over the vesting periods of the options granted using the multiple-option approach. Additional amortization of stock-based compensation results from the modification of certain stock options for terminated employees. In the first quarter of 2004, we recorded $224,000 in additional stock-based compensation expense as a result of modifying certain stock options for employees terminated during the quarter.

Deferred stock-based compensation for stock options issued to our employees will be recognized as expense, subject to continuing employment, for each of the next two fiscal years, when amortization of deferred stock compensation will be complete on all existing grants, as follows:

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Interest Income and Expense

Net interest income consists of earnings on our cash, cash equivalents and marketable securities. Interest expense consists of interest associated with capital lease obligations. Net interest income decreased in the first quarter of 2004 compared to the first quarter of 2003 as a result of decreasing cash, cash equivalents and marketable securities balances. We expect net interest income to decrease during future fiscal quarters to the extent our average outstanding balance of cash, cash equivalents and marketable securities is reduced in order to fund our operations.

Income Taxes

There has been no provision or benefit for income taxes for any period since inception due to our ongoing operating losses.

Liquidity and Capital Resources

We have incurred net losses of $673.2 million since inception. We believe that we will continue to incur net losses for the next year, and possibly longer. From our inception through March 28, 2004, we have financed our operations primarily through the sale of equity securities, including common and preferred stock, yielding net cash proceeds of $380.7 million.

Discussion of Cash Flows

Net cash used in operating activities for the first quarter of 2004 and the first quarter of 2003 primarily reflects net losses, growth in inventory and changes in other operating assets and liabilities.

Net cash provided by investing activities in the first quarter of 2004 consisted primarily of the net proceeds from the sale from marketable securities, partially offset by the acquisition of fixed assets. Net cash used in investing activities in the first quarter of 2003 related to the purchase of marketable securities and acquisition of fixed assets.

Net cash provided by financing activities in the first quarter of 2004 and the first quarter of 2003 resulted primarily from cash provided from exercises of employee stock options.

Until required for other purposes, our cash and cash equivalents are maintained in deposit accounts or highly liquid investments with remaining maturities of 90 days or less at the time of purchase.

The following table provides information regarding our balances of cash and cash equivalents and marketable securities at March 28, 2004 and March 30, 2003: