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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

Amendment No. 1

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.

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EXPLANATORY NOTE

This Amendment No. 1 on Form 10-K/A (Form 10-K/A) amends the Annual Report on Form 10-K of drugstore.com, inc. (the Company) for the fiscal year ended December 29, 2002, which was previously filed with the Securities and Exchange Commission on March 31, 2003 (the Annual Report) by correcting the inadvertent errors specified below:

The Company is also amending the Annual Report to update the Exhibit list in Item 15(a)(3) of Part IV of the Form 10-K to reflect documents filed with this Form 10-K/A, which include the Amended and Restated Bylaws of the Company adopted by the Board of Directors of the Company on April 23, 2003 and the Independent Auditors’ consent. In addition, as required by Rule 12b-15, promulgated under the Securities Exchange Act of 1934 (the Exchange Act), the registrant’s principal executive officer and principal financial officer are providing new certifications as specified in Exchange Act Rule 13a-14 or 15d-14 in connection with this Form 10-K/A and are also furnishing, but not filing, written statements pursuant to Title 18 United States Code Section 1350, as added by Section 906 of the Sarbanes-Oxley Act of 2002.

This Form 10-K/A amends only the items of the Annual Report specified above and amends those items solely to reflect the changes described above. This Form 10-K/A does not update the disclosures in the Annual Report as original filed and does not reflect events occurring after the original filing of the Annual Report on March 31, 2003.

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drugstore.com, inc.

FORM 10-K

For the Fiscal Year Ended December 29, 2002

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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.

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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:

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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

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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:

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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:

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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

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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.

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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

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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.

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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

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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.

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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

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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 purchases and develop incremental revenue opportunities.

We intend to continue to use the unique resources of the Internet as a means of marketing in an effort to encourage traffic and repeat purchases. Our advertising campaigns are focused on frequently visited Internet portals, health-related Web sites and other frequently visited Web sites, search engines and associated Web sites, and direct to consumer marketing programs using email and U.S. mail. We have strategic relationships with Amazon.com, Rite Aid and GNC, all of which promote our Web site. We believe the marketing benefits of our relationship with Amazon.com include the integration of various shopping features of our Web site, the creation of a drugstore.com shopping presence on Amazon.com’s Web site and the promotion of our site by one of the premier e-commerce companies. In addition, Rite Aid has agreed to include drugstore.com in a significant portion of Rite Aid’s own advertisements (weekly circulars), as well as on shopping bags, prescription vial caps, in-store signs and permanent links from its Web site. We are also extending our market presence through our Associates Program, which enables associated Web sites to make our products and services available to their audiences through a link to our Web site. In addition to the marketing strategies outlined above, we continue to evaluate and test new ways to drive customer orders in a cost effective manner. Towards that end, we launched three new programs in the fourth quarter of 2002 to increase customer loyalty; they include Everyday Free Shipping, drugstore.com dollars^™ and Diamond Deals^™ (each are described below).

Everyday Free Shipping.    With the Everyday Free Shipping program, customers receive free standard shipping on their nonprescription orders of $49 or more. Once an order has qualified for free shipping, prescription items will be shipped free with that order. Products eligible for free shipping are marked with a shipping truck icon.

drugstore.com dollars^™.    Through the drugstore.com dollars^™ program, customers automatically earn a five percent credit on every nonprescription purchase made during a calendar quarter. drugstore.com dollars^™ automatically apply to the next nonprescription order during the following calendar quarter.

Diamond Deals^™.    The Diamond Deal^™ feature allows customers to choose one of six personalized, limited-time product offers at significant savings from the everyday low prices available at the drugstore.com web store. Each week, customers are presented with program offers that are relevant to each customer and their lifestyle, based on their previous purchases and drugstore.com shopping experiences.

We will continue to evaluate and adjust these programs as well as other marketing strategies in our pursuit of cost effective customer acquisition and retention strategies.

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Key Strategic Relationships

Relationship with Amazon.com

We have a strategic relationship with Amazon.com that allows us to share technologies and to advertise as a health and beauty retailer on Amazon.com’s Web site. We believe that our association with Amazon.com is beneficial to the development of drugstore.com’s presence on the Internet and its brand recognition. Amazon.com is our largest stockholder owning 19% of our company as of December 29, 2002, and Jeffrey P. Bezos, Amazon.com’s chairman of the board, president and chief executive officer, is a member of our board of directors.

As part of our relationship with Amazon.com, we entered into a technology license and advertising agreement. This agreement extends for ten years and can be terminated for breach or in the event that we are acquired by a competitor of Amazon.com. This agreement contains provisions generally relating to the sharing of technology and technical support; however, we have decided to develop our own technology and there has been no exchange of technology by either party to date. Specifically, this agreement provides for the license of substantially all of each company’s technology that may be developed through August 10, 2008, to the other for use within their respective businesses. Neither company may use the other’s technology to compete against the other. In addition, we agreed not to place advertisements competitive to Amazon.com’s business on our site. If Amazon.com expands into other areas, this may further limit the companies we can promote on our Web site.

On January 24, 2000, we entered into a marketing agreement with Amazon.com to integrate various shopping features of our Web site and to create a persistent drugstore.com shopping presence on Amazon.com’s Web site. Amazon.com agreed to promote the drugstore.com health and beauty product section of its Web site to its customer base in a manner similar to its efforts with respect to its other product sections. Under the agreement, the parties agreed to implement additional features on the Amazon.com Web site designed to improve customer shopping experiences, including integrated search and browse capabilities. The agreement also contained exclusivity provisions restricting (1) the percentage of total revenues we can obtain from the sale on our Web site of products or services other than health, beauty (including cosmetics, fragrance, bathing and hair and skin products), wellness, and prescription drug products and (2) the percentage of revenues Amazon.com or any other Amazon.com marketing partner can receive from the sale of these types of products on its Web site other than through its relationship with us. The consideration for the agreement included 1,066,667 shares of our common stock with a fair market value at the date of issuance of $30 million issued immediately in a private placement transaction and minimum cash payments totaling $75 million over the three-year term of the agreement. In July 2000, Amazon.com agreed to reduce the remaining minimum cash payments due over the three-year term of the agreement from $75 million to $30 million. Additionally, we agreed to pay additional amounts in cash if the advertising services exceed certain performance thresholds in the second and third years of the agreement. We also issued to Amazon.com a fully vested, nonforfeitable and exercisable warrant to purchase 2.5 million shares of our common stock at $4.94 per share; this warrant expired in July 2002 without being exercised. In June 2001, we further amended this agreement, changing the termination date from April 2003 to June 2002 and revised the total consideration under the agreement from $67.3 million over 36 months, including stock consideration of $37.3 million and cash payments of $30 million, to $46.3 million over 27 months, representing stock consideration of $37.3 million and cash payments of $9 million. Prior to the amendment, on an annualized basis, amortization was $22.4 million and was reduced to $19.9 million after the amendment. As of July 2002, there were no remaining amounts to be amortized under this marketing agreement, as this agreement expired as of the end of June 2002.

In June 2002 we entered into a cost-per-new-customer marketing agreement with Amazon.com whereby we pay Amazon for each new, unique customer that places an order, and Amazon continues to maintain a persistent drugstore.com presence in their Web site while we retain an ability to serve Amazon.com shoppers who are searching for health, beauty, wellness and pharmacy products. The new agreement has been extended and now expires in March of 2004.

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Relationship with Rite Aid

In June 1999, we entered into a strategic relationship with Rite Aid. As part of that relationship, 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 may pick up their prescription at any of Rite Aid’s 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, including a link from Rite Aid’s Web site to our Web site. drugstore.com also received the benefit of many of Rite Aid’s insurance and PBM relationships, and is able to buy prescription products through Rite Aid, taking advantage of their buying power. During the first quarter of 2002 the relationship expanded as we began selling Rite Aid private label over-the- counter products. This opportunity gave us an entry into the private label market and we now offer over 200 Rite Aid brand SKU’s throughout our store. As of result of this agreement, Rite Aid became one of our largest suppliers.

As part of this relationship, both Rite Aid and drugstore.com agreed to certain exclusivity provisions that limit drugstore.com’s ability to promote, or affiliate with, any other physical retail drugstore or to operate as a traditional physical drugstore, and preclude Rite Aid from offering or selling products or services on the Internet other than through our Web site. In addition, the agreement requires us to purchase all of our pharmaceutical products from Rite Aid unless we are able to obtain better overall terms from another vendor. The agreement contains additional provisions providing for the licensing by Rite Aid to drugstore.com of information technology systems and the integration of the information technology and pharmacy systems of the two companies. This agreement ends in 2009 but can be terminated for breach by either party prior to such time.

In connection with this ten-year agreement, Rite Aid received 9,334,746 shares of our common stock, making them one of our largest stockholders until 2002, at which time Rite Aid liquidated its holdings in the Company’s common stock.

Relationship with GNC

In June 1999, we entered into a relationship with GNC whereby we became the exclusive online provider of GNC-branded products. We have the exclusive right to sell GNC’s wellness products over the Internet, including the PharmAssure brand of pharmacist-recommended vitamins and nutritional supplements, subject to our meeting performance parameters based on traffic to our Web site and sales of GNC products in 2002 and 2004. We met these performance parameters in 2002 and continue to be the exclusive online provider of GNC branded-products. As long as we have the exclusive right to distribute GNC’s products over the Internet, we will not promote any other retail health food store or operate a physical retail health food store. If the exclusivity provisions of the agreement terminate, we will have the non-exclusive right to sell these products for the remaining term of the agreement. As part of this relationship, we have created the GNC LiveWell Store within the drugstore.com Web site that is dedicated to selling GNC products on a consignment basis. We are entitled to retain a percentage of the gross revenues that we collect from sales of GNC products and recognize only the net amount retained as revenues. In connection with this relationship, GNC received 2,947,853 shares of our common stock. GNC and drugstore.com also agreed to co-promote each other’s products and services in both their traditional and online marketing efforts, including GNC’s placement of a link to our Web site on their Web site. The agreement extends for ten years but can be terminated for breach prior to such time. GNC is a subsidiary of Royal Numico N.V., a European manufacturer of nutrition products.

Other Relationships

WellPoint.    In June 2000, we entered into a five-year agreement with WellPoint Health Networks, Inc., a leading health plan owned PBM. Pursuant to this agreement, we were designated WellPoint’s preferred Internet pharmacy and drugstore and have access to WellPoint’s members. In exchange, we issued WellPoint 750,000 shares of our common stock with a fair value, at the date of issuance, of approximately $5 million and

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are obligated to make certain cash payments to WellPoint over the five-year term of the agreement. Under the terms of the original agreement, if the 750,000 shares of stock issued to WellPoint did not have a fair market value of $10 million at the end of two years, we were required to pay WellPoint, in stock or cash, the difference between $10 million and the fair market value of the stock. During the third quarter of 2001, drugstore.com and WellPoint agreed to amend certain terms of the agreement which reduced the guaranteed fair market value of the 750,000 shares held by WellPoint from $10 million to $2.5 million and reduced the cash payments required to be paid to WellPoint over the 5-year term. In June 2002 the guarantee value was satisfied with the issuance of 252,406 additional shares of restricted common stock.

CIGNA.    Also in June 2000, we entered into a five-year agreement with CIGNA HealthCare, Inc, one of the nation’s leading providers of health benefit programs. Pursuant to this agreement, we will provide health and beauty products to CIGNA’s plan participants by providing them with direct access to our Web site from the home page of CIGNA’s Internet site and through CIGNA’s mail order pharmacy. In exchange, we issued CIGNA an immediately exercisable warrant to purchase 500,000 shares of our common stock at $7.76 per share, which is currently still outstanding and unexercised (see Note 8 of the accompanying financial statements).

Intellectual Property

We regard the protection of our copyrights, service marks, trademarks, trade dress and trade secrets as critical to our future success and we rely on a combination of copyright, trademark, service mark and trade secret laws and contractual restrictions to establish and protect our proprietary rights in products and services. We enter into confidentiality and invention assignment agreements with all of our employees and contractors and nondisclosure agreements with our vendors, fulfillment partners and strategic partners to limit access to and disclosure of our proprietary information. We cannot be certain that these contractual arrangements or the other steps taken by us to protect our intellectual property will prevent misappropriation of our technology. We have licensed in the past, and expect that we may license in the future, certain of our proprietary rights, such as trademarks or copyrighted material, to third parties. For example, as noted above, we have licensed our technology to Amazon.com, and we have also granted nonexclusive rights to our trademarks in connection with advertising and affiliate relationships. While we attempt to ensure that such licensees maintain the quality of the drugstore.com brand, we cannot ensure that such licensees will not take actions that might hurt the value of our proprietary rights or reputation. We also rely on technologies that we license from third parties, such as Oracle Corporation and Microsoft Corporation, which are the suppliers of key database technology, the operating system and specific hardware components for our service. As part of our relationship with Rite Aid, we have also licensed information technology systems from Rite Aid. We cannot be certain that these third-party technology licenses will continue to be available to us on commercially reasonable terms. The loss of such technology could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could harm our business. (See Risk Factor, “We Cannot Be Certain That We Will Be Able to Protect Our Intellectual Property, and We May Be Found to Infringe Proprietary Rights of Others, Which Could Harm Our Business”.)

We have filed applications for the registration of some of our trademarks, including drugstore.com and service marks in the United States and in some other countries. Although we have secured registration of very few of our marks to date, many are currently pending registration. DRUGSTORE.COM, the drugstore.com logo, THE SIMPLE WAY TO LOOK AND FEEL YOUR BEST^™, WHAT EVERY BODY NEEDS^™, WHERE EVERY BODY SHOPS^™, WHAT YOUR BODY NEEDS^™, HEALTH . BEAUTY . WELLNESS^™, WELLNESS CONNECTIONS^™, LET THE DRUGSTORE COME TO YOU^™, YOUR LIST^™, QUICK LISTS^™, TEST DRIVE^™, ONE VERY HEALTHY ATTITUDE^™, EPUNCHCARD^™, BEAUTY.COM, SEXUAL WELL BEING.COM, and EMEDALERT^™ are our trademarks. We may be unable to secure registrations for all of them. All other trademarks and source marks referred to herein are the property of their respective owners. It is also possible that our competitors or others will use marks similar to ours, which could impede our ability to build brand identity and lead to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks

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that incorporate variations of the term drugstore.com. Any claims or customer confusion related to our trademarks, or our failure to obtain trademark registrations, would negatively affect our business. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States, and effective copyright, trademark and trade secret protection may not be available in such jurisdictions. Our efforts to protect our intellectual property rights may not prevent misappropriation of our content. Our failure or inability to protect our proprietary rights could substantially harm our business. (See Risk Factor, “We May Not Be Able to Protect Our Domain Names In All Countries or Against All Infringers, Which Could Decrease the Value of Our Brand Name and Proprietary Rights”.)

Employees

As of December 29, 2002, we had 395 full-time employees. None of our employees are represented by a labor union.

Executive Officers and Directors

The following table sets forth information with respect to our executive officers as of December 29, 2002:

Kal Raman (also known as Kalyanaraman Srinivasan) has served as a director and as President and Chief Executive Officer of drugstore.com since April 2001. Mr. Raman served as Senior Vice President and Chief Operating Officer of drugstore.com from November 1999 to April 2001, as Senior Vice President, Operations and Technology and Chief Operating Officer from May 1999 to November 1999, as Vice President, Technology and Operations and Chief Information Officer from March 1999 to May 1999, and as Vice President, Technology and Chief Information Officer from August 1998 to March 1999. Prior to joining drugstore.com, Mr. Raman served as Chief Information Officer and Vice President of Nations Rent.

Robert A. Barton has served as Vice President of Finance and Chief Financial Officer of drugstore.com since January 2001. He has been with drugstore.com since September of 1998, serving in various senior financial management and operational roles, including Vice President and General Manager of Pharmacy from June 2000 to January 2001. Prior to joining drugstore.com, Mr. Barton was the Director of Business Planning and also managed various accounting and analysis groups for AT&T Wireless Services from August 1995 to September 1998, and served as an auditor with Deloitte & Touche LLP from February 1989 to August 1995.

Mary Allison has served as Vice President, Merchandising of drugstore.com since November 2001. Prior to joining drugstore.com, Ms. Allison was a General Manager of Garden Botanika from September 2000 to November 2001. From September 1998 to July 2000, Ms. Allison was Vice President of Sales for TURN OFF the TV.

Christopher G. Hauser has served as Vice President, Operations of drugstore.com since July 1999. Prior to joining drugstore.com, Mr. Hauser served as Senior Vice President, Information Technologies and Operations for Multiple Zones International.

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Niti Badarinath has served as Vice President, Marketing of drugstore.com since November 2002. Prior to joining the Company, Mr. Badarinath served as Senior Vice President, Strategy and Marketing of AmeriCredit Corporation from July 1999 to May 2002. From June 1998 to July 1999, Mr. Badarinath served as Vice President of GartnerGroup.

Sridhar Iyer has served as Vice President, Technology and Chief Information Officer of drugstore.com since September 2002. He has been with drugstore.com since October 1998, serving in various senior technology roles including Vice President, Information Technology from July 2002 to September 2002, Senior Director, Technology from January 2002 to July 2002, and Director of Technology from October 1998 to January 2002. Prior to joining drugstore.com, inc., Mr. Iyer spent six years at Wal-Mart Stores Inc. as a Strategy Manager within their Information Systems Division.

Alesia L. Pinney has served as Vice President, General Counsel and Secretary of drugstore.com since October 2000. From January 1999 to October 2000, she served as Assistant Secretary and Associate General Counsel of drugstore.com. Prior to joining drugstore.com, Ms. Pinney was a lawyer with Perkins Coie LLP, a limited liability partnership.

The following table sets forth information with respect to our board of directors as of December 29, 2002:

(a)    Mr. Byers resigned from his Director position subsequent to year end.

Factors That May Affect Our Business

An investment in our securities involves certain risks. In evaluating drugstore.com and our business, investors should give careful consideration to the factors listed below. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occurs, our business, financial condition or operating results could be materially adversely affected. In such case, the trading price of our common stock could decline.

We Have A Limited Operating History in a New and Rapidly Evolving Market

Because drugstore.com was founded in April 1998 and we only began selling products in February 1999, we have a limited operating history on which investors can evaluate our business strategy. We may encounter certain risks and difficulties frequently encountered by companies with limited operating histories as well as risks due to our participation in a new and rapidly evolving industry. These challenges include our:

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Consumers of Health, Beauty, Wellness, and Pharmacy Products May Not Accept Our Solution, Which Would Harm Our Revenues and Prevent Us From Becoming Profitable

If we do not attract and retain a high volume of online customers to our store at a reasonable cost, we will not be able to increase our revenues or achieve profitability. We may not be able to convert a large number of customers from traditional shopping methods to online shopping for health, beauty, wellness, and pharmacy products. Specific factors that could prevent widespread customer acceptance include:

We Have Incurred Losses Since Inception and May Continue to Incur Losses into the Foreseeable Future

We have incurred net losses of $650.0 million from inception through December 29, 2002. To date, we have not become profitable. We only began selling products in February 1999 and cannot be certain that we will obtain enough customer traffic or a high enough volume of purchases to generate sufficient revenues to achieve profitability. We may continue to incur operating and net losses for the foreseeable future.

Our Marketing Efforts May Not Be Effective At Attracting and Retaining Customers

Due to our limited operating history and competitive nature of the market for drugstore products, if we do not establish our brand, and increase awareness about us, we may lose the opportunity to build a critical mass of

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customers. Promoting and positioning our brand will depend largely on the success of our marketing efforts and our ability to provide consistent, high quality customer experiences. To promote our brand, we have incurred and expect to continue to incur substantial expense in our marketing efforts to both attract and retain customers. Due to resource limitations, these promotional activities may not be effective at building our customer base to the extent necessary. Our revenues may not increase and we may incur additional losses. Even if our efforts are successful at attracting customers, we may need to incur additional expense to retain a critical mass of customers, which may decrease our operating margins. In addition, adverse publicity about our strategic partners could damage our brand and negatively affect customer acceptance of our site.

We Face Significant Competition from Both Traditional and Online Retailers

The market segments in which we compete are rapidly evolving and intensely competitive, and we have many competitors in different industries, including both the retail and e-commerce services industries. These competitors include (1) various online stores that sell pharmaceutical and over-the-counter drugs, as well as health, beauty and wellness items; (2) mail order pharmacies; (3) existing bricks and mortar drugstores; and (4) specialty retailers and major department stores. We also compete with hospitals, HMOs and mail order prescription drug providers, all of which are or may begin offering products and services over the Internet. Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we have. They may be able to secure merchandise from vendors on more favorable terms and may be able to adopt more aggressive pricing policies. Competitors in both the retail and e-commerce services industries also may be able to devote more resources to technology development and marketing than us.

Competition in the e-commerce channel may intensify. Other companies in the retail and e-commerce service industries may enter into business combinations or alliances that strengthen their competitive positions and would prevent them from also entering into relationships with drugstore.com. Our inability to partner with a major PBM or HMO could be a major competitive disadvantage to us. As various Internet market segments obtain large, loyal customer bases, participants in those segments may expand into the market segment in which we operate. In addition, new and expanded Web technologies may further intensify the competitive nature of online retail and allow our competitors to easily duplicate many of the products, services and content offered on our site.

The nature of the Internet as an electronic marketplace facilitates competitive entry and comparison shopping and renders it inherently more competitive than conventional retailing formats. This increased competition may reduce our ability to grow and thus, reduce our sales, operating profits, or both.

In addition, we may also begin to face competition from online pharmacies outside the United States. Legislation allowing for importation of prescription drugs by individuals for personal use was 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 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.

We May Experience Significant Fluctuations in Our Operating Results and Rate of Growth

Due to our limited operating history, our evolving business model and the unpredictability of our industry, we may not be able to accurately forecast our rate of growth. Historical trends and quarter-to-quarter comparisons of our operating results are not a good indicator of our future performance. It is likely that in some future quarter our operating results may be below the expectations of public market analysts and investors. In this event, the price of our common stock may fall.

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Our revenue and operating profit growth depends on the continued growth of demand for the products offered by us, and our business is affected by general economic and business conditions. A softening of demand, whether caused by changes in consumer preferences or a weakening of the U.S. economy, may result in decreased revenue or growth. Threatened or actual terrorist attacks or armed hostilities create economic and consumer uncertainty that could adversely affect our revenue or growth. Such attacks and security concerns could create delays in and increase the cost of product shipments to and from us, which may decrease demand. Revenue growth may not be sustainable and our company-wide percentage growth rate may decrease in the future. Our revenues and operating results are expected to vary significantly from quarter to quarter due to a number of factors, including:

In addition, our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are fixed in the short term. As a result, a delay in generating or recognizing revenue for any reason could result in substantial additional operating losses. Due to the limited operating history of our Web store, we may have difficulty forecasting revenue from customers or overall anticipated revenue trends.

A portion of our revenues may also be seasonal in nature, especially with respect to the sale of certain health and beauty products that depend to some extent on seasonal product changes and seasonal purchasing patterns.

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Consumer “fads” and other changes in consumer trends may cause shifts in purchasing patterns, resulting in significant fluctuations in our operating results from one quarter to the next. In addition, both seasonal fluctuations in Internet usage and traditional retail seasonality are likely to affect our business. Internet usage generally slows during the summer months, and retail sales usually increase in the fourth calendar quarter of each year.

If We Are Unable to Obtain Insurance Reimbursement Coverage for Our Customers, Our Ability to Sell Pharmacy Products Online Could Decrease, Which Would Harm Our Revenues

To obtain reimbursement on behalf of our customers for the prescription products that they purchase on our Web site, we must maintain relationships with insurance companies and PBMs, either directly or through our relationship with Rite Aid. Currently we rely primarily on Rite Aid’s relationships with insurance companies and PBMs and the extension of these relationships to cover prescriptions processed by us. Sales billed through Rite Aid’s relationships currently represent a significant percentage of our pharmacy sales. We have also entered into direct relationships with PBMs and insurers, including Advanced PCS and WellPoint. If we are unable to maintain and leverage our direct relationships, and to the extent Rite Aid is unable to maintain its relationships or if these relationships do not extend to cover the prescriptions we process, our ability to obtain reimbursement coverage for our customers would be reduced. This would reduce the number of customers that fill prescriptions through our Web site, which would reduce our revenues.

Our ability to enter into direct relationships with insurance companies and PBMs or retain our existing relationships for an extended period of time is uncertain for the following reasons:

Many of our agreements with insurance companies and PBMs are short-term, may be terminated with less than 30 days’ prior notice and are subject to amendment by such insurance companies and PBMs. Our contract with Advanced PCS is a 10-year agreement that could terminate earlier if our agreement with Rite Aid is terminated. Our contract with WellPoint is a 5-year agreement that could terminate earlier if we experience a change of control. In addition, we must process each insurance application individually, which may raise the costs of processing prescription orders and delay our order processing time. Customers may not embrace our online insurance coverage procedure.

We Are Dependent on a Limited Number of Distribution Partners

We are obligated to purchase all of our pharmaceutical products from Rite Aid unless we are able to obtain better overall terms from another vendor. Our business could be significantly disrupted if Rite Aid was to breach its contract or suffer adverse developments that affect its ability to supply products to us. If for any reason Rite Aid is unable or unwilling to supply products to us in sufficient quantities and in a timely manner, we may not be able to secure alternative fulfillment partners on acceptable terms in a timely manner, or at all. For a discussion of certain potentially adverse developments at Rite Aid, see “Our Relationship with Rite Aid Involves Many Risks and May Restrict Our Ability to Promote, Contract With or Operate Traditional Retail Stores.”

We also rely on third-party carriers for shipments to and from distribution facilities and to customers. We are therefore subject to the risks, including security concerns, employee strikes and inclement weather, associated

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with our carriers’ ability to provide product fulfillment and delivery services to meet our distribution and shipping needs. Failure to deliver products to our customers in a timely and accurate manner would harm our reputation, the drugstore.com brand and our results of operations.

We Have Significant Inventory Risk

We are exposed to significant inventory risks as a result of new product launches, rapid changes in product cycles, changes in consumer tastes with respect to our products and seasonality. In order to be successful, we must accurately predict these trends and avoid overstocking or under-stocking products. Demand for products, however, can change significantly between the time inventory is ordered and the date of sale. In addition, when we begin selling a new product, it is particularly difficult to forecast product demand accurately. A failure to optimize inventory will harm our shipping margins by requiring us to make split shipments due to backordered items. The acquisition of certain types of inventory, or inventory from certain sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection and significant inventory levels of certain products, and we may be unable to sell products in sufficient quantities or during the relevant selling seasons. Our ability to receive inbound inventory efficiently or ship completed orders to customers may be negatively affected by a number of factors, including dependence on a limited number of shipping companies, inclement weather, fire, flood, power loss, earthquakes, labor disputes, acts of war or terrorism or acts of God. Any one of the inventory risk factors set forth above may adversely affect our operating results.

We Need to Optimize Management of Our Distribution Center

If we do not successfully operate our distribution and fulfillment center, it could significantly limit our ability to meet customer demand. Because it is difficult to predict sales volume, we may not manage our facilities in an optimal way, which may result in excess or insufficient inventory, warehousing, fulfillment and distribution capacity. In addition, if we do not effectively control product damage and shrinkage through effective security measures and inventory management practices, it could adversely impact our operating margins. Margins may also be affected if we are unable to obtain products on favorable terms.

Under our agreement with GNC, we maintain their inventory in our distribution center, thereby increasing the complexity of tracking inventory in and operating our distribution center. Our failure to properly handle such inventory would result in unexpected costs and other harm to our business and reputation.

We believe that our distribution center will provide us with sufficient distribution capacity for the foreseeable future. However, if we need to increase our distribution capacity sooner than anticipated, such expansion would require additional financing that may not be available to us on favorable terms when required, or at all.

In addition, any event that impacts our distribution center’s ability to process orders, whether by an act of man or God, will halt our ability to process orders and service our mail order customer and will adversely affect our operating results.

Any Errors in the Filling or Packaging of the Prescription Drugs We Dispense May Expose Us to Liability and Negative Publicity

Pharmacy errors relating to prescriptions, dosage and other aspects of the medication dispensing process can produce liability for us that our insurance may not cover. Because we distribute pharmaceutical products directly to the consumer, we are the most visible participant in the medication distribution chain and therefore have more exposure to liability claims.

Our pharmacists are required by law to offer counseling, without additional charge, to our customers about medication, dosage, delivery systems, common side effects and other information deemed significant by the

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pharmacists. Our pharmacists may have a duty to warn customers regarding any potential adverse effects of a prescription drug if the warning could reduce or negate such effects. This counseling is in part accomplished through e-mail and inserts included with the prescription, which may increase the risk of miscommunication because the customer is not personally present or may not have provided all relevant information. We also post product information on our Web site. Providing information on pharmaceutical and other products creates the potential for claims to be made against us for negligence, personal injury, wrongful death, product liability, malpractice, invasion of privacy or other legal theories based on our product or service offerings. Our general liability, product liability and professional liability insurance may not cover potential claims of this type or may not be adequate to protect us from all liability that may be imposed.

Pharmacy errors by either drugstore.com or our competitors may also produce significant adverse publicity either for us or for the entire online pharmacy industry. Because of the significant amount of press coverage on Internet retailing and online pharmacies, we believe that we will be subject to a higher level of media scrutiny than other pharmacy product channels. The amount of negative publicity that we or the online pharmacy industry receive as a result of pharmacy or prescription processing errors could be disproportionate in relation to the negative publicity received by other pharmacies making similar mistakes. We have no control over the pharmacy practices of our competitors, and we cannot ensure that our pharmacists or our prescription processing will be able to operate without error. We believe customer acceptance of our online shopping experience is based in large part on consumer trust, and negative publicity could erode such trust or prevent it from growing. This could result in an immediate reduction in the amount of orders we receive and adversely affect our revenue growth.

We Have Grown Very Rapidly, and We Need to Manage Changing and Expanding Operations

We have rapidly and significantly expanded our operations and anticipate that we will continue to expand. This growth has placed, and our anticipated future operations will continue to place, a significant strain on our management systems and resources. We will not be able to implement our business strategy in a rapidly evolving market without an effective planning and management process. We will not be able to increase gross margins unless we continue to improve our transaction-processing, operational, financial and managerial controls and reporting systems and procedures, to expand, train and manage our work force and to manage multiple relationships with third parties. Many of our senior management have no prior senior management experience at public companies, and our executive officers have limited management experience in the healthcare or retail drugstore industry.

Expanding the Breadth and Depth of Our Product and Service Offerings Is Expensive and Difficult, and We May Receive No Benefit From Our Expansion

We intend to expand the breadth and depth of our product and service offerings by promoting new or complementary products or sales formats. We cannot be certain that these new offerings will generate sufficient revenues for the costs involved. Expansion of our offerings in this manner could require significant additional expenditures and could strain our management, financial and operational resources. For example, we may need to incur significant marketing expenses, develop relationships with new fulfillment partners or manufacturers or comply with new regulations. We cannot be certain that we will be able to expand our product and service offerings in a cost-effective or timely manner. Furthermore, any new product or service offering or sales format that is not favorably received by consumers could damage the reputation of our brand. The lack of market acceptance of such efforts or our inability to generate satisfactory revenues from such expanded offerings to offset their cost could harm our business. Finally, our agreement with Amazon.com contains prohibitions that limit our ability to partner with other companies to sell products and services in markets that are competitive with those offered by Amazon.com, although we are able to sell products and services in these markets ourselves.

Our Relationship With Amazon.com May Restrict Some of Our Activities

Our relationship with Amazon.com may restrict our activities and is subject to change. We entered into a technology license and advertising agreement in August 1998 with Amazon.com. In addition, in June 2002, we

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entered into an Agreement with Amazon.com to integrate various shopping features of our Web sites and create a persistent drugstore.com shopping presence on the Amazon.com Web site. Amazon.com is currently our largest stockholder and Jeffrey P. Bezos, Amazon.com’s chairman of the board, president and chief executive officer, is a member of our board of directors.

Pursuant to these agreements, we are restricted from promoting on our Web site any company that sells products or services competitive with those that Amazon.com offers or is preparing to produce or market. If we were acquired by a competitor of Amazon.com and Amazon.com did not vote in favor of the transaction, we would lose our rights to advertise on Amazon.com’s Web site and to use Amazon.com’s technology (if we are then using any). The agreement we entered into in June 2002 contains provisions restricting the percentage of total revenues we can obtain from the sale on our Web site of products or services other than health, beauty, wellness, and pharmaceutical products. We may not assign this agreement without Amazon.com’s consent.

In addition, due to Amazon.com’s significant ownership of our common stock, it will be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions.

Our Relationship with Rite Aid Involves Many Risks and May Restrict Our Ability to Promote, Contract With, or Operate Traditional Retail Stores

In June 1999, we entered into a series of agreements with Rite Aid. These agreements involve many aspects of our businesses and the operation of our respective Web sites, the fulfillment of orders and the extension of Rite Aid’s insurance relationships to cover prescriptions processed by us. This type of arrangement is complex and requires a great deal of effort to operate successfully. As a result, there are many risks related to these arrangements, including some that we may not have foreseen. It is difficult to assess the likelihood of occurrence of these risks, including the lack of success of the overall arrangement to meet the parties’ objectives. In the event that we do not realize the intended benefits of these relationships, we will have expended a great deal of time and effort that could have been directed to more beneficial activities. In addition, customer perceptions and our business may be adversely impacted if these relationships are not successful.

While Rite Aid has committed to promoting drugstore.com in its stores and in its advertising, we do not control the choice of ads in which we are featured, and this form of advertising may not result in additional drugstore.com customers. While the Rite Aid relationship substantially broadens our ability to provide prescription medications to consumers with insurance reimbursement plans, it may not allow all of our potential customers to purchase these medications from drugstore.com and receive insurance reimbursement, which could adversely affect consumer perceptions and our revenues. We have agreed not to promote any other traditional chain drugstore or operate one ourselves. We have also agreed not to contract with another traditional retail store to fill pharmacy product orders we receive unless a Rite Aid store is not conveniently located nearby. These restrictions could limit our flexibility and ability to grow our business if our relationship with Rite Aid does not develop successfully.

Rite Aid has received significant negative publicity regarding its financial situation the restatement of its earnings in 2000 and the related SEC proceedings against Rite Aid, which were settled in 2002. Our relationship with Rite Aid is important to us, particularly in our pharmacy fulfillment operations and in our ability to offer insurance reimbursement coverage to our customers. Further negative publicity regarding Rite Aid could negatively affect the drugstore.com brand and our stock price.

Our relationship with PCS was established at the same time as, and in connection with, our relationship with Rite Aid. Rite Aid sold PCS Healthcare Systems to Advanced Paradigm. Advance Paradigm, which has changed its name to AdvancePCS, may not demonstrate the same level of commitment to our relationship with PCS Healthcare Systems as Rite Aid.

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We Are Dependent on Our Strategic Relationships to Help Promote Our Web Site and Expand Our Product Offerings; If We Fail to Maintain or Enhance These Relationships, Our Development Could Be Hindered

We believe that our strategic relationships with Rite Aid, as well as with Amazon.com, Internet portals and third-party distributors are critical to attract customers, facilitate broad market acceptance of our products and the drugstore.com brand and enhance our sales and marketing capabilities. If we are unable to develop or maintain key relationships, our ability to attract customers would suffer and our business would be adversely affected. In addition, we are subject to many risks beyond our control that influence the success or failure of our strategic partners. Our business could be harmed if any of our strategic partners were to experience financial or operational difficulties or if other corporate developments adversely affect their performance under our agreements.

We Face Uncertainty Related to Pharmaceutical Costs and Pricing, Which Could Affect Our Revenues and Profitability

Pharmacy sales account for a significant percentage of our total sales. Sales of our pharmacy products depend in part on the availability of reimbursement from third-party payors such as government health administration authorities, private health insurers, health maintenance organizations (HMOs), PBMs and other organizations. These organizations are increasingly challenging the price and cost-effectiveness of medical products and services. The efforts of third-party payors to contain costs will place downward pressures on profitability from sales of prescription drugs. Our revenues from prescription drug sales may also be affected by health care reform initiatives of federal and state governments, including proposals designed to address Medicare, Medicaid and other government programs, prescription drug discount card programs, changes in programs providing for reimbursement for the cost of prescription drugs by third-party payors and regulatory changes related to the approval process for prescription drugs. Such initiatives could lead to the enactment of federal and state regulations that may adversely impact our prescription drug sales.

One such initiative is the Bush Administration’s proposal to introduce a Medicare prescription drug benefit. If legislation is enacted as a result of this or any related proposal, there could be an increase in the number of senior persons with prescription drug coverage with a possible reduction in customers who self-pay for their prescription drugs and this may adversely impact our drug prices and dispensing fees.

We cannot be certain that our products or services will be considered cost effective or that adequate third-party reimbursement will be available to enable us to maintain price levels sufficient to realize a profit.

Acquisitions Could Result in Dilution, Operating Difficulties and Other Harmful Consequences

If appropriate opportunities present themselves, we intend to acquire complementary or strategic businesses, technologies, services and/or products. The process of integrating an acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company may also require significant management resources that would otherwise be available for ongoing development of our business. Moreover, the anticipated benefits of any acquisition may not be realized or may depend on the continued service of acquired personnel who could choose to leave. We currently do not have any understandings, commitments or agreements with respect to any acquisitions, and no material acquisitions are currently being pursued. Future acquisitions could also result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could harm our business.

Our Systems and Operations, and Those of Our Distributors, Are Vulnerable to System Interruption, Natural Disasters and Other Unexpected Problems

We experience periodic system interruptions that make our Web sites inaccessible to the customer, prevent us from efficiently fulfilling orders or providing services to third parties, which may reduce customer

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satisfaction, and thus affect our sales. To avert system interruptions, we continually need to add software and hardware and improve our systems and network infrastructure to accommodate both increased traffic on our Web sites and increased sales volume.

Our systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, failure in the Internet backbone service providers or Internet service providers, earthquakes, acts of war or terrorism, acts of God, computer viruses, physical or electronic break-ins and similar events. Any of these events could lead to system interruptions, delays and loss of critical data and could prevent us from accepting and fulfilling customer orders. While we do have backup systems for certain aspects of our operations, we do not have fully redundant systems or a formal disaster recovery plan. Our business interruption insurance may be inadequate to compensate for all losses that may occur.

We retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and are perceived by the marketplace to be secure. A material security breach could damage our reputation or result in liability to us.

Governmental Regulation of Our Business Could Require Significant Expenditures, and Failure to Comply With Certain Regulations Could Result in Civil and Criminal Penalties

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. Regulations in this area often require subjective interpretation, and we cannot be certain that our attempts to comply with these regulations will be deemed sufficient by the appropriate regulatory agencies. Violations of any regulations could result in various civil and criminal penalties, including suspension or revocation of our licenses or registrations, seizure of our inventory or monetary fines, which could adversely affect our operations.

We are also subject to laws and regulations regarding homeopathic drugs, and we may face enforcement actions, lawsuits or claims asserting that we have not complied with these laws and regulations. As we expand our product and service offerings, more of our products and services will likely be subject to regulation by the FDA, which regulates drug advertising and promotion. Complying with FDA regulations is time consuming, burdensome and expensive and could delay our introduction of new products or services.

Legislation and regulations currently being considered at the federal and state level could affect our business, including legislation or regulations relating to confidentiality of patient records and the electronic access and storage of such records, disclosure requirements for Internet pharmacies and the inclusion of prescription drugs as a Medicare benefit. In addition, state legislatures may add or amend legislation related to the regulation of nonresident pharmacies. Compliance with new laws or regulations could increase our expenses.

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, in order to comply with the privacy standards rule, and until October 16, 2003, in order to comply with the Standardization of Transactions and Code Sets rules. The requirements in these regulations could create financial and administrative burdens for pharmacies, including online pharmacies, may restrict the manner in which we transmit and use information and may cause us to use additional resources in order to comply with the requirements of these regulations and may have an adverse effect on our results of operations. This could lead to delays as we revise our Web site and operations.

We are subject to extensive regulation relating to the confidentiality and release of patient records. Additional legislation governing distribution of medical records, confidentiality of patient records and electronic access and storage exists or has been proposed at both the state and federal level. It may be expensive to

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implement security or other measures designed to comply with any new legislation. Moreover, we may be restricted or prevented from delivering patient records electronically. This could have an adverse impact on our ability to gain and retain customers.

We Cannot Be Certain That We Will Be Able to Protect Our Intellectual Property, and We May Be Found to Infringe Proprietary Rights of Others, Which Could Harm Our Business

We rely or may in the future rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our intellectual property. These afford only limited protection. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our sales formats or to obtain and use information that we regard as proprietary, such as the technology used to operate our Web site, our Web site content and our trademarks.

We have filed applications for U.S. trademark registrations for “drugstore.com” and certain other trademarks. We may be unable to secure these registrations. It is also possible that our competitors or others will adopt service names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the term drugstore.com or our other trademark applications. Any claims or customer confusion related to our trademarks or our failure to obtain any trademark registration could negatively affect our business.

Litigation or proceedings before the U.S. Patent and Trademark Office may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets and domain name and to determine the validity and scope of the proprietary rights of others. Any litigation or adverse priority proceeding or other efforts to protect our intellectual property could result in substantial costs and diversion of resources and could seriously harm our business and operating results. Finally, we may in the future sell our products internationally, and the laws of many countries do not protect our proprietary rights to as great an extent as do the laws of the United States.

Third parties may also claim infringement by us with respect to past, current or future technologies. We expect that participants in our markets will be increasingly subject to infringement claims as the number of services and competitors in our industry segment grows. Any such claim, whether meritorious or not, could be time-consuming, result in costly litigation, cause service upgrade delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements might not be available on terms acceptable to us, or at all.

We have licensed in the past, and expect that we may license in the future, certain of our proprietary rights, such as trademarks or copyrighted material, to third parties. For example, as noted above, we have licensed our technology to Amazon.com, and we have also granted nonexclusive rights to our trademarks to certain entities in connection with advertising and affiliate relationships. While we attempt to ensure that such licensees maintain the quality of the drugstore.com product brand, we cannot ensure such licensees will not take actions that might hurt the value of our proprietary rights or reputation.

We May Not Be Able to Protect Our Domain Names In All Countries or Against All Infringers, Which Could Decrease the Value of Our Brand Name and Proprietary Rights

We currently hold the Internet domain name “drugstore.com,” as well as various other related names. Domain names generally are regulated by Internet regulatory bodies. The regulation of domain names in the United States and in foreign countries is subject to change. Regulatory bodies could establish additional top-level domains, appoint additional domain name registrars or modify the requirements for holding domain names. As a result, we may not acquire or maintain the “drugstore.com” domain name in all of the countries in which we may seek to conduct business. In addition, regulations governing domain names may not protect our trademarks and

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similar proprietary rights. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe or otherwise decrease the value of our brand name, trademarks and other proprietary rights.

We May Face Liability Claims if People or Property Are Harmed by the Products We Sell

Some of the products we sell may expose us to product liability claims relating to personal injury, death or property damage caused by such products and may require us to take actions such as product recalls. Some of our vendor agreements do not indemnify us from product liability. Further, our liability insurance may not be adequate to protect us from all liability that may be imposed as a result of such claims, and we cannot be certain that insurance will continue to be available to us on economically reasonable terms, or at all.

We May Face Liability for Content on Our Web Site

Because we post product information and other content on our Web site, we face potential liability for negligence, copyright, patent, trademark, defamation, indecency and other claims based on the nature and content of the materials that we post. Such claims have been brought, and sometimes successfully pressed, against Internet content distributors. In addition, we could be exposed to liability with respect to the unauthorized duplication of content or unauthorized use of other parties’ proprietary technology. Although we maintain general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. Any imposition of liability that is not covered by insurance or is in excess of insurance coverage could harm our business.

Our Officers, Directors and Certain Existing Stockholders Control the Majority of Our Common Stock, Which Could Discourage an Acquisition of Us or Make Removal of Incumbent Management More Difficult

Executive officers, directors and entities affiliated with them beneficially own more than 51% of our outstanding common stock. These stockholders, if acting together, would be able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. In addition, Amazon.com beneficially owns approximately 19%. Therefore, Amazon.com is able to significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. In addition, in the case of a potential acquisition of drugstore.com by another party, Amazon.com’s substantial equity stakes in drugstore.com could prevent the tax-free treatment of an acquisition, making drugstore.com a less attractive acquisition candidate.

We May Need Additional Capital in the Future to Support Our Growth, and It Is Unlikely Such Additional Financing Will Be Available To Us

Our available funds may not be sufficient to meet all of our long-term business development requirements, and we may seek to raise additional funds through public or private debt or equity financings in order to:

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Due to current market conditions, it is unlikely that any additional financing that we may need will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our ability to undertake any of the activities noted above may be significantly limited.

Certain Anti-takeover Provisions and Significant Equity Ownership by Amazon.com Could Preclude an Acquisition

Provisions of our certificate of incorporation, bylaws, Washington law and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. Further, because Amazon.com owns a significant percentage of our capital stock, a competitor of Amazon.com as well as other potential acquirors could decide not to merge with or acquire us. In addition, if we were acquired by an Amazon.com competitor and Amazon.com did not vote in favor of the transaction, we would lose our ability to use Amazon.com’s technology (if we were, at that time, using any). The potential loss of these rights could inhibit offers to acquire us.

We Depend on Continued Use of the Internet and Growth of the Online Drugstore Market

Consumer use of the Internet as a medium for commerce is a recent phenomenon and is subject to a high level of uncertainty. While the number of Internet users has been rising, the Internet infrastructure may not expand fast enough to meet the increased levels of demand. If use of the Internet as a medium for commerce does not continue to grow or grows at a slower rate than we anticipate, our sales would be lower than expected and our business would be harmed.

Further, the online market for drugstore products is in its infancy. The market is significantly less developed than the online market for books, auctions, music, software and numerous other consumer products. Even if use of the Internet and electronic commerce continues to increase, the rate of growth, if any, of the online drugstore market could be significantly less than the online market for other products. Our rate of revenue growth could therefore be significantly less than other online merchants.

If We Are Required To Collect Sales and Use Taxes On The Products We Sell In Additional Jurisdictions, We May Be Subject To Liability For Past Sales And Our Future Sales May Decrease

In accordance with current industry practice and our interpretation of current law, we do not currently collect sales and use taxes or other such taxes with respect to shipments of goods into states other than Washington. The operation of our affiliated distribution center, the operations of any future distribution centers and other aspects of our evolving business may, however, result in sales and use tax obligations. One or more states may seek, either through their unilateral actions or through federal legislation, to impose sales or other tax collection obligations on out-of-jurisdiction companies that engage in electronic commerce as we do. Moreover, one or more states could begin to impose sales taxes on sales of prescription products, which are not generally taxed at this time. If so, customers who order prescriptions at our Web site and pick them up at a Rite Aid store would be required to pay sales tax. For example, the State of New Jersey, where our affiliated distribution center is located, has notified us that we owe state sales tax on certain of our prior sales to New Jersey residents from January 3, 2000 to December 30, 2001 and that we should collect sales tax on a prospective basis on purchases made by New Jersey residents. We have not paid the amount of back-sales tax that we have been notified is due and are currently appealing the State of New Jersey’s assessment of back-sales tax in the Tax Court in New Jersey. If we are unsuccessful in our appeal or if one or more other states successfully asserts that we should collect sales and use or other taxes on the sale of our products, it could result in substantial tax liabilities for our past sales, decrease our ability to compete with traditional retailers, and otherwise harm our business.

Currently, decisions of the U.S. Supreme Court restrict the imposition of obligations to collect state and local sales and use taxes with respect to sales made by out-of-state sellers. However, a number of states, as well as the U.S. Congress, have been considering various initiatives that could limit or supersede the Supreme Court’s

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decisions. If any of these initiatives were successful, we could be required to collect sales and use taxes in states other than Washington.

Federal legislation limits the imposition of U.S. state and local taxes on Internet-related sales. In 1998, Congress passed the Internet Tax Freedom Act, which placed a three-year moratorium on state and local taxes on Internet access, unless such tax was already imposed prior to October 1, 1998, and on discriminatory taxes on electronic commerce. This moratorium was extended until November 1, 2003. If Congress chooses not to renew this legislation in 2003, state and local governments would be free to impose new taxes on electronically purchased goods.

The imposition of various taxes upon Internet commerce by state and local governments could create significant administration burdens for us and decrease our future sales.

If We Do Not Respond to Rapid Technological Changes, Our Services Could Become Obsolete and Our Business Would Be Seriously Harmed

As the Internet and online commerce industry evolve, we must license leading technologies useful in our business, enhance our existing services, develop new services and technology that address the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. We may not be able to successfully implement new technologies or adapt our Web store, proprietary technology and transaction-processing systems to customer requirements or emerging industry standards. If we are unable to do so, it could adversely impact our ability to build the drugstore.com brand and attract and retain customers.

Governmental Regulation of the Internet and Data Transmission Over the Internet Could Affect Our Business

We are subject to laws and regulations generally applicable to businesses, as well as those directly applicable to communications or commerce over the Internet. These laws and regulations may deal with privacy, copyrights, taxation, content and consumer protection. The European Union has also enacted its own privacy regulations. In particular, many government agencies and consumers are focused on the privacy and security of medical and pharmaceutical records. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing privacy, libel and taxation apply to Internet stores such as ours. The rapid growth and development of the market for online commerce may prompt calls for more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on companies conducting business online and in particular companies that fill prescriptions or maintain medical or pharmaceutical records. The adoption or modification of laws or regulations relating to Internet businesses could adversely affect our ability to attract and serve customers.

Our Stock Price is Likely to Continue to Fluctuate, Which Could Result in Substantial Losses for Investors

The market price of our common stock has been and is likely to continue to be extremely volatile. Our stock price could be subject to wide fluctuations in response to a number of factors, some of which are beyond our control, and these fluctuations could result in substantial losses for investors. Factors that could cause our stock price to fluctuate include:

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The trading price of our company stock has been volatile and is significantly lower than our initial public offering price. It is unlikely that investors will be able to resell their shares of our common stock at or above the initial offering price. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We have been named in such stockholder class action suits and may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert management’s attention and resources, which could seriously harm our business and operating results. If our stock price were to fall below $1.00 for a period of time, we may not be able to maintain the standards required for continued listing on the NASDAQ National Market (NASDAQ). Delisting from the NASDAQ would prevent holders of our common stock from being able to easily buy or sell our common stock.

In addition, future volatility in our stock price could force us to increase our cash compensation to employees or grant larger stock awards than we have historically, which could hurt our operating results or reduce the percentage ownership of our existing stockholders, or both.

Subsequent Sales of Our Common Stock Could Adversely Affect Our Stock Price and Our Ability To Raise Funds in New Equity Offerings

In the past, we have granted incentive stock options to our employees to purchase shares of our common stock at $0.01 per share. Currently, approximately 2.3 million of these options are outstanding, the majority of which are also exercisable. In addition, our executive officers, directors and entities affiliated with them (insiders) hold more than 51% of our total outstanding stock, which they may, in the future, choose to sell. Future sales of substantial amounts of our common stock by our employees, insiders or other stockholders could adversely affect prevailing market price for our common stock and could materially impair our future ability to raise capital through an offering of equity securities. In addition, the perception that such sales may occur could produce the same effect.

ITEM 2.    PROPERTIES

Our principal executive offices are located in Bellevue, Washington, where we lease approximately 55,000 square feet under a lease that expires in July 2005. Our distribution facility is located in Bridgeport, New Jersey, where we lease approximately 290,000 square feet under a lease that expires in April 2005, with options to renew for two additional five-year periods.

Management believes that the facilities provide sufficient capacity to meet the demands of the foreseeable future, are being appropriately utilized and have sufficient production capacity for their present intended purposes. Management reviews its anticipated requirements for facilities and, based on that review, may adjust its facilities needs.

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ITEM 3.    LEGAL PROCEEDINGS

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 the Company as a defendant, along with the underwriters and certain of the Company’s present and former officers and directors (the “Individual Defendants”), in connection with the Company’s July 27, 1999, initial public offering and the Company’s March 15, 2000, secondary offering. The complaints against the Company 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 the Company’s common stock during the period July 28, 1999 to December 6, 2000.

The allegations in the complaint vary, but in general they allege that the prospectuses through which the Company conducted the initial public offering and the secondary offering (together, 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 they 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 aftermarket 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, the Company moved to dismiss all claims against it and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based upon 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 the Company. The Company disputes the allegations of wrongdoing against it in these complaints and intends to vigorously defend itself in these matters.

The Company maintains insurance policies that it believes will provide coverage for these claims and therefore believes that these claims will not have, individually or in the aggregate, a material adverse effect on its business prospects, financial condition or operating results. However, an unfavorable resolution in these matters could materially affect the Company’s business and future results of operation, financial position or cash flows.

In early 2002, the Company received an Arbitrary Assessment notice from the State of New Jersey for past sales tax due, based upon estimated numbers. In December 2002, the Company received a Revised Assessment based upon sales numbers provided by the Company to the State of New Jersey. In March 2003, the Company filed an appeal of the Revised Assessment with the Tax Court of New Jersey. Due to the uncertainty of the appeal, no amounts have been recorded in the accompanying financial statements. The Company believes that the ultimate resolution of this assessment for sales tax through December 29, 2002 will not have a material adverse effect on its financial position or operating results.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS

No matter was submitted to a vote of the Company’s shareholders during the fourth quarter of 2002.

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PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER  

MATTERS

Market Information

Our common stock has been quoted on the NASDAQ National Market under the symbol “DSCM” since our initial public offering on July 27, 1999. Prior to that time, there was no public market for our common stock. The following table sets forth, for the periods indicated, the high and low reported intraday sales prices per share of our common stock.

Holders

On February 28, 2003, the reported last sale price of our common stock on the Nasdaq National Market was $2.80 per share, and there were approximately 811 holders of record of our common stock, although there is a much larger number of beneficial owners.

Dividends

We have never declared or paid cash or stock dividends on our capital stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any dividends in the foreseeable future.

Equity Compensation Plan Information

drugstore.com maintains the 1998 Stock Option Plan and the 1999 Employee Stock Purchase Plan. The following table summarizes information concerning these equity based compensation plans as of December 29, 2002:

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ITEM 6.    SELECTED FINANCIAL DATA

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.

Special Note Regarding Forward-Looking Statements

This Annual Report on Form 10-K 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 Annual Report on Form 10-K are forward-looking. We use words such as anticipates, believes, expects, future, intends and similar expressions to identify forward-looking statements. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from management’s expectations. The following discussion includes forward-looking statements regarding expectations of future profitability, net sales, and cash flows from operations, all of which are inherently difficult to predict. Actual results could differ materially 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 risks and uncertainties, as well as other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations, are described in greater detail in Item 1 (see “Business—Factors That May Affect Our Business,”) which, along with the following discussion, describes some, but not all, of the factors that could cause actual results to differ significantly from management’s expectations.

Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy and completeness of the forward-looking statements. We are under no duty to update any of the forward-looking statements to conform such statements to actual results or to changes in our expectations.

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.

Strategic Agreements

Rite Aid

Rite Aid and drugstore.com continue to jointly promote Rite Aid.com, powered by drugstore.com, via weekly Rite Aid circulars, mailers and other forms of marketing activities. The purpose of the these activities is to increase consumer awareness of the benefits of ordering prescription refills online through a Rite Aid branded version of the drugstore.com Web store.

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All customer orders are processed through our Web store and can be either shipped to the customer from our distribution center or, in the case of refills of existing drugstore.com or Rite Aid prescriptions, picked up by the customer at any Rite Aid store in the United States. In 2002, 35% of our net sales were generated through our agreement with Rite Aid. If, for any reason, Rite Aid were unable to perform at its current levels, our future operating results could be materially impacted.

In accordance with our agreement with Rite Aid, we are obligated to purchase all of our pharmaceutical inventory from Rite Aid unless we are able to obtain better overall terms from another vendor. Currently, we purchase nearly all of our pharmaceutical inventory from Rite Aid, leveraging their volume requirements to obtain favorable pricing and credit terms. Thus far, we have not been able to obtain pricing on overall terms that are more favorable than those we are able to obtain through our Rite Aid relationship. If Rite Aid were unable to supply our inventory, there are other suppliers in the marketplace that could provide us with the inventory we need. If we were unable to obtain terms equivalent to the terms we are receiving through Rite Aid or if we were not able to make the transition to a new supplier in a timely manner, our operations could be adversely impacted either because we would not be able to process orders for pharmaceutical products, which would have a negative impact on the customer experience, or because our margins on pharmaceutical sales may decrease.

In addition, the agreement with Rite Aid also contains 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. We currently use these systems to process pharmaceutical orders through our distribution center. If we were no longer able to use them, it could take us a significant amount of time and effort to replace these systems and would have a material adverse impact on our business.

Our agreement with Rite Aid terminates in 2009.

Amazon.com

We have continued to integrate our product search capabilities with those of Amazon.com, pursuant to our current and previous marketing agreements with them. Amazon.com customers can view drugstore.com product images and descriptions on Amazon.com’s Web site along with a personalized presentation of additional products and suggested items that may be of interest at drugstore.com’s Web site. In 2002, net sales through our agreement with Amazon represented 3% of our net sales to all customers. In addition, 12% of new customers acquired during 2002 were acquired through Amazon.com. In June 2002, the Company and Amazon.com entered into a new cost-per-new-customer marketing agreement in order to maintain the drugstore.com presence on the Amazon.com Web site through March 2003, which was subsequently amended in January 2003 to be effective through March 2004.

Critical Accounting 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 which 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. For additional information see Item 8 of Part II, “Financial Statements and Supplementary Data—Note 1—The Company and Summary of Significant Accounting Policies.” 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.

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Significant Accounting Policies

Revenue Recognition

Revenues from sales of products delivered to customers (net of promotional discounts, 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 is transferred as pursuant to our contracts with our carriers (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 would be understated; if our estimate of these allowances is too low, then our revenues would be overstated. Product returns have not been significant in the past.

Revenues from sales of certain pharmaceutical products ordered through the Company’s Web store to be picked up at a Rite Aid store are recognized when the customer picks up 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, (EITF 99-19) we record these revenues from the Rite Aid local pick-up arrangement on a gross basis, since we believe we act as a principal, based on the fact that, among other things, we bear both credit risk and inventory risk.

We also recognize revenue from our consignment arrangement with GNC. According to the criteria provided by EITF 99-19, consignment service fees from GNC are booked on a net basis upon shipment to our customer, based on the fact that we do not take title to the inventory and cannot establish pricing.

Periodically we provide incentive offers to our customers to encourage purchases. Such offers include discounts off specific current purchases, which we refer to as Diamond Deals^™, or offers for future rebates based upon a percentage of the current purchase, which we refer to as drugstore.com Dollars^™ and other similar 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 offered by drugstore.com are treated as a reduction to sales price based on estimated redemption rates. Redemption rates are estimated using our historical experience for similar offers.

Inventories

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 the difference between the cost of the inventory and the estimated market value based upon management’s assumptions about future demand for the products we offer and market conditions. We are using a variety of methods to reduce the quantity of the slow moving inventory including reducing sales prices on our Web site, negotiating returns to vendors, and liquidating inventory through third parties. If our estimates of future product demand and our assumptions about market conditions prove to be inaccurate, we may have understated or overstated the provision required for excess and obsolete inventory. Although we make every effort to ensure the accuracy of our assumptions about future demand and market conditions, any significant unanticipated changes in any of these assumptions could have a significant impact of the value of our inventory.

Results of Operations

We have incurred net losses of $650.0 million from inception to December 29, 2002. We believe that we will continue to incur net losses for at least the next year (and possibly longer). We have a limited operating history on which to base an evaluation of our business and prospects. Our prospects must be considered in light of the risks, expenses, and difficulties encountered by companies in their early stage of development, particularly companies in new and rapidly evolving markets such as e-commerce.

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In view of our four-year operating history and the rapidly evolving nature of our business, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and should not be relied upon as an indication of future performance. It is likely that in some future quarter our operating results may fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock may fall significantly.

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. We routinely offer discounts and coupons as incentives to attract and retain customers. In addition, if a customer is not satisfied with a particular product or the level of customer service we provide, we generally refund all or a portion of the sale. Allowances for refunds and sales price incentives, including discounts and coupons, are netted against the related sales price. Sales returns and allowances have not been significant to date. In the future, we may expand or increase the coupons and discounts we offer to our customers.

Net sales also include 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 all years presented.

All customer orders are processed through our Web store and can either be shipped to the customer or, in the case of prescription refills, picked up by the customer at any Rite Aid store located in the United States. Orders are either billed to the customer’s credit card or, in the case of prescriptions covered by insurance, billed to third parties. Sales of pharmaceutical products covered by third parties are recorded at the net amount to be received. Generally, we collect cash from credit card sales in two to five days from the date the order is shipped. Amounts billed to third parties are, on average, collected in approximately 30 days after the date the order is shipped; however, such timing can vary depending on the payor. Sales billed to third party insurance companies and PBMs through our relationship with Rite Aid currently represent a significant percentage of our pharmacy sales. We expect that sales billed to these third parties will continue to represent a significant percentage of our pharmacy sales for the foreseeable future.

Our net sales in the non-pharmaceutical segment were $80.3 million, $67.1 million, and $54.4 million, in 2002, 2001, and 2000, respectively. Our net sales in the pharmaceutical segment were $113.6 million, $78.2 million, and $55.6 million in 2002, 2001, and 2000, respectively. The year-over-year increase in both segments is due to higher average net sales per order, which increased to $69 in 2002 from $64 and $46 in 2001 and 2000, respectively. This increase is attributable to a higher average sales price per item, an increase in the average number of items per order, and changes in the mix of products merchandised in our Web store, including specialty and seasonal products as well as prestige beauty products. The number of orders grew to 2.8 million in 2002 from 2.3 million in 2001 and 2.2 million in 2000. New customers increased by 138,000 from 2001 to 2002, but decreased by 256,000 from 2000 to 2001, due to a refocused marketing effort during 2001 in which we targeted a somewhat different customer than those acquired in 2000. Our total customer base increased to approximately 3.2 million customers at the end of fiscal year 2002, compared to 2.4 million and 1.7 million in 2001 and 2000, respectively. The percentage of orders from repeat customers continues to increase as we more

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successfully focus our marketing efforts on acquiring high value customers that are more interested in selection, quality and convenience than discount pricing.

We are currently targeting a 20-30% increase in net sales for fiscal year 2003 from net sales in fiscal year 2002. Our actual attainment of targeted net sales will depend on a number of factors including, but not limited to, the following:

Cost of Sales

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage, damage, slow movement and expiration of inventory, as well as outbound and inbound shipping costs. Additionally, expenses related to promotional inventory included in shipments to customers are included in cost of sales. Payments that we receive from vendors in connection with joint merchandising activities, net of related costs, are netted against cost of sales in the period in which such merchandising activities take place.

Cost of sales in our non-pharmaceutical segment were $56.2 million, $51.4 million and $50.0 million in 2002, 2001 and 2000, respectively, which resulted in non-pharmaceutical cost of sales as a percent of net sales of 70.0%, 76.6% and 92.0% in 2002, 2001 and 2000, respectively. We continue to improve product margins in the non-pharmaceutical segment through a more favorable mix of product sales that include higher margin items in specialty, seasonal and prestige beauty merchandise.

Cost of sales in our pharmaceutical segment were $99.4 million, $69.3 million and $50.7 million in 2002, 2001 and 2000, respectively, which resulted in pharmaceutical cost of sales as a percent of net pharmaceutical sales of 87.5%, 88.7% and 91.2%, in 2002, 2001 and 2000, respectively. We continue to improve product margin in the pharmaceutical segment through an increase in the sale of generic pharmaceutical products, which generally saves the customer money and reduces our product costs. The increase in the sale of generic pharmaceuticals is due to increased availability of generic alternatives as a result of patent expirations, which enables generic manufacturers to produce and compete with a previously patented drug. In addition, our consumer education program emphasizes to our customer the cost savings of choosing to buy generic drugs, and also alerts our customers to the anticipated release of new generic alternatives to the brand drugs they may be currently purchasing.

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Although we continue to offer promotional merchandise as a strategy to attract new customers, such amounts have decreased over time as a percentage of net sales. Our shipping costs continue to exceed the amount we charge customers for shipping. However, the amount by which we subsidize shipping charges decreased significantly in both 2002 and 2001. Our net shipping subsidy, or the amount by which our shipping costs exceeded shipping revenue, was $2.8 million, $3.2 million and $5.1 million, respectively, in 2002, 2001, and 2000. We expect to continue to subsidize a portion of our shipping costs for the foreseeable future as a strategy to attract and retain customers, through our Everyday Free Shipping program on orders of $49 or more, but we expect the net shipping subsidy to continue to decrease as a percentage of net sales.

We expect cost of sales to increase in absolute dollars in 2003, to the extent that our sales volume increases. Cost of sales is targeted to be approximately 80% of net sales in fiscal year 2003. However, the actual cost of sales we achieve will depend on a number of factors, including, but not limited to, the following:

Fulfillment and Order Processing

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, and payroll and related expenses for personnel engaged in customer service, purchasing, distribution, and fulfillment activities, including warehouse personnel and pharmacists engaged in prescription verification activities. These expenses also include rent and depreciation related to equipment and fixtures in our distribution center.

Fulfillment and order processing expenses decreased as a percentage of net sales year-over-year primarily as a result of a decrease in variable labor costs due to the efficiencies gained in the operation of the distribution center, the mix of mail order versus locally picked up (at Rite Aid stores) pharmaceutical sales and an increase in the volume of orders being processed.

We expect that fulfillment and order processing expenses for fiscal year 2003 will decrease as a percentage of net sales, compared to 2002.

Marketing and Sales

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Marketing and sales expenses include advertising and marketing expenses, promotional expenditures and payroll and related expenses for personnel engaged in marketing and merchandising activities. Advertising expenses include various advertising contracts, including the expense associated with our marketing agreements with Amazon.com. The Company recognized $9.1 million in 2002, $19 million in 2001 and $15.2 million in 2000 in marketing and sales expense related to these marketing agreements with Amazon.com.

Marketing and sales expenses decreased during 2002 and 2001 primarily due to the decrease in television and radio advertising, promotional activities and agency and production costs. This decrease is also attributable to a decrease in employee-related expenses and a reduction in obligations under marketing agreements, including the expiration of the Amazon.com marketing agreement during 2002. In addition, we have focused our marketing efforts on more effective and efficient marketing channels. Marketing and sales expense per new customer has decreased significantly to $28 in 2002 from $50 in 2001, and from $78 in 2000.

In fiscal year 2003, we expect marketing and sales expenses to be consistent with fiscal year 2002, as we continue to refine our marketing approach by targeting specific lifestyles and matching demographics and psychographics to our best customer profiles. Our target range for marketing and sales expense per new customer, for fiscal year 2003, is $15-$20.

Technology and Content

Technology and content expenses consist primarily of payroll and related expenses for personnel engaged in maintaining and making minor upgrades and enhancements to our Web sites and their content. Technology and content expenses also include Internet access and hosting charges, depreciation on hardware and IT structures, and our Web sites’ content and design expenses.

Technology and content expenses decreased in 2002 and 2001 primarily due to a reduction in headcount and related expenses, as well as a reduction in depreciation expense on Web servers and other equipment. These reductions are also the result of a continued decrease in the use of consultants and contract labor, who previously performed minor upgrades, enhancements and maintenance procedures to our Web store. These functions are increasingly being performed by our own employees.

Our goal is to keep technology and content expenses relatively flat in absolute dollars during fiscal year 2003, as compared to 2002.

General and Administrative

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 in both 2002 and 2001 primarily due to a reduction in personnel costs, reduced rent expense and lower depreciation expense. Our goal is to keep general and administrative expenses relatively flat in absolute dollars during fiscal year 2003, as compared to 2002.

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Impairment and Restructuring Charges

During the second quarter of 2002, we determined that it was not economically feasible for us to utilize our remaining prepaid cable television advertising rights, which were previously received and recorded in connection with a private equity placement. Consequently, $2.5 million of prepaid advertising rights were determined impaired, and written off in June of 2002.

As a result of a general economic downturn and tightening of the capital markets, we determined that, in order for us to remain a viable business, we needed to reach profitability sooner than previously planned. Accordingly, in January 2001, the Company implemented a cost reduction plan that included a reduction in headcount across all areas of the Company, as well as significant decreases in planned facility, marketing and advertising expenditures. We laid off approximately 100 employees. As a result of the layoffs, the Company decided to consolidate certain of its corporate facilities. In March 2001, the Company negotiated the cancellation of a lease for corporate office space in exchange for forfeiting a portion of the lease deposit. Accordingly, the Company recorded an $8.5 million restructuring charge, which included forfeiture of a cancelled lease deposit, the cost of exiting the leases of vacated facilities and the write-off of related leasehold improvements and equipment.

Also in 2001, we identified impairment indicators of our long-lived assets, consisting primarily of our intangible assets and long-term marketing contracts. These indicators included, but were not limited to, revisions in our long-term financial plan, our book value compared to our market capitalization, a deterioration of economic and market conditions and substantially lower expectations of projected future operating results related to certain significant intangible assets resulting from agreements with Rite Aid and GNC. Consequently, we performed an analysis of our long-lived assets. This analysis determined that an impairment may exist in certain of these assets. The fair market value of the impaired assets was determined based on the present value of estimated expected future cash flows. Accordingly, we recorded a non-cash impairment charge of approximately $169.9 million. The primary component of the impairment charge was a write-down of the intangible assets recorded in connection with the Rite Aid and GNC strategic agreements that were executed in 1999.

We will continue to review our definite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In circumstances where impairment is determined to exist, we will write down the asset to its fair market value.

Amortization of Intangible Assets

Amortization of intangible assets includes the amortization expense associated with the assets received in connection with agreements with Rite Aid and with General Nutrition Companies, Inc. (GNC), including access to insurance coverage and a vendor agreement; assets acquired in connection with the purchase of Beauty.com, including domain names; and other intangible assets, including a technology license agreement, domain names and trademarks.

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During fiscal year 2001, certain intangible assets were written down to their estimated fair values in accordance with SFAS 121, thus significantly reducing the amortization recorded during fiscal year 2002. In addition, as of the beginning of fiscal year 2002, due to the implementation of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), amortization expense was further reduced because the goodwill associated with the acquisition of Beauty.com is no longer being amortized.

We expect that amortization of intangible assets will decrease further in 2003, as compared to 2002, as most of our intangible assets were fully amortized as of December 29, 2002.

Amortization of Stock-based Compensation