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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 28, 2003

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

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 $391,649,235 as of June 29, 2003.

As of March 1, 2004, the number of shares of the registrant’s Common Stock outstanding was 78,269,088.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this annual report, to the extent not set forth in this annual report, is incorporated by reference from the registrant’s definitive proxy statement relating to the registrant’s annual meeting of stockholders to be held on June 10, 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 annual report relates.

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drugstore.com, inc.

FORM 10-K

For the Fiscal Year Ended December 28, 2003

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PART I

This annual report on Form 10-K and the documents incorporated into this annual report by reference contain forward-looking statements based on our expectations, estimates and projections as of the date of this filing. Actual results may differ materially from those expressed in forward-looking statements. See the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Special Note Regarding Forward-Looking Statements” in Part I, Item 7 of this annual report.

Overview

drugstore.com, inc. is a better way to shop for health & beauty and a leading online provider of health, beauty, wellness, personal care, vision and pharmacy solutions. Located on the Internet at www.drugstore.com, the drugstore.com^™ Web store sells health, beauty, wellness, personal care, sexual well-being and pharmacy products. We also sell prestige beauty products through our Web site located at www.beauty.com, which is also accessible through the drugstore.com Web site. As of April 28, 2003, we expanded our offering to include customized nutritional supplement programs sold through our wholly owned subsidiary, Custom Nutrition Services, Inc., or CNS, through Web sites located at www.DrWeilVitaminAdvisor.com, www.zoneprofiler.com and www.pritikin@home.com. In addition, as of December 8, 2003, we began selling contact lenses and other vision products through our wholly owned subsidiary International Vision Direct Corp., or Vision Direct^™, through Web sites located at www.visiondirect.com, www.lensmart.com and www.lensquest.com. As of March 1, 2004, our customer base was approximately five million customers worldwide.

We operate primarily in the United States and Canada, but our products are available to consumers worldwide. We were incorporated in April 1998, commercially launched our Web site at www.drugstore.com on February 24, 1999, and completed our initial public offering in July 1999. Our business has evolved over time into new product offerings and solutions and, after the acquisition of Vision Direct, we now operate and manage our business in four segments: over-the-counter, or OTC (also referred to as non-pharmaceutical), mail-order pharmacy, local pick-up pharmacy, and vision. In fiscal year 2003, OTC accounted for 44% of our consolidated revenues, mail-order pharmacy 20%, local pick-up pharmacy 35% and vision 1%. Additional information regarding our business segments can be found in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of this annual report and in Note 12 of our consolidated financial statements included in Part IV, Item 15 of this annual report.

As used in this annual report, “drugstore.com,” “we,” “our” and similar terms refer to drugstore.com, inc. and its subsidiaries, unless the context indicates otherwise.

Our Market Opportunity

Overall spending on health and wellness products, beauty aids and prescription drugs in the United States exceeded $273 billion in 2003, according to the National Association of Chain Drug Stores. Within this group, prescription drugs is the largest and fastest growing category, representing nearly $180 billion in sales in 2003. This segment is expected to grow by 11 to 12% annually through 2005. Mail-order pharmacy continues to be one of the fastest-growing segments of the pharmacy industry, as companies and individuals embrace mail-order pharmacies in an attempt to control escalating prescription drug costs. The ophthalmic pharmaceutical segment is growing rapidly as well. Spending in this segment is currently at $5.4 billion and growing by 9% per year. Over 35 million people in the United States wear contact lenses.

The Internet is an important channel for consumers to purchase products and services. The number of Web users in the United States and worldwide has increased significantly since the launch of our Web site in 1999, to over 476 million users at the end of December 2003. Retail e-commerce sales in the United States exceeded $55 billion in 2003 (up 26% from 2002) and are anticipated to grow 19% a year over the next five years, to

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nearly $230 billion by 2008. We believe that the Internet is an ideal medium for selling health, beauty, wellness, personal care, vision and pharmacy products, many of which are lightweight and easy to ship and require replenishment. In addition, consumers seeking these products frequently desire privacy with respect to their purchase. Our business model also offers the convenience of making purchases from the comfort of home or office. The combination of Internet usage trends and the size and Internet compatibility of our product categories create what we believe is a significant opportunity both domestically and abroad.

The drugstore.com Solution

Our business strategy is to offer our customers a superior shopping experience over other solutions in our market category. We attract and retain our customers by emphasizing the following key attributes of our store:

Convenience.    Our user-friendly online store may be reached from wherever the shopper has Internet access, such as the shopper’s home or office. Further advantages offered by our online stores include:

Selection.    We believe that we offer the largest selection of drugstore products available on the Internet. We do not have the shelf display space limitations that bricks-and-mortar stores do. 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. For example, we offer customized nutritional supplement programs recommended by Dr. Andrew Weil in addition to the broad selection of products offered through our nutritional and wellness store, and we are the only online retailer that offers nutrition and wellness products from General Nutrition Companies, Inc., or GNC. Our customers are able to buy drugstore products, prestige brands, salon hair care, and other specialty items with a single check-out.

Information.    We provide a broad array of interactive tools and information on our Web sites to help consumers to make informed purchasing decisions. This information is generated in-house, by third-party expert sources, and through our customer review feature, by customers themselves. Consumers can either access the

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information directly through a number of content features on our Web sites, or get free help from our customer care representatives and experts by contacting them by e-mail or by telephone at 1-800-DRUGSTORE, or 1-800-VISIONDIRECT for assistance with vision products. Our information services include:

Communication.    We can communicate with customers on a regular basis through the convenience of e-mail. We offer the following means of communication with our store:

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Value.    Through the combination of shopping convenience, product selection, information, communication, competitive pricing, and promotional programs, we believe we offer our customers superior value over the typical retail solution. We believe we can save our customers time and money. For more information regarding our merchandising, pricing and marketing strategies, see the section entitled “How We Merchandise and Market” below.

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 the drugstore.com Web store 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 a public place.

Business Segments

We offer products in four business segments: OTC, mail-order pharmacy, local pick-up pharmacy and vision. We sell products both through a multi-store format under the drugstore.com store umbrella and, for certain products, through separate subsidiary Web sites. We adjust and update our store offering and content throughout the year in response to market trends, consumer demand and vendor introduction and advertisement of new products.

OTC

We offer over 18,000 non-prescription health, beauty, wellness, personal care and sexual well-being products. Our primary OTC stores on the drugstore.com Web site include medicine cabinet, beauty and spa, nutrition and wellness, personal care, household, and sexual well-being, in addition to a variety of specialty stores such as Dr. Weil Recommends, GNC Live Well and the Natural Store. In addition, we sell prestige beauty products and customized nutritional supplements through our subsidiary Web sites.

Medicine Cabinet.    The medicine cabinet category includes OTC remedies, such as digestion aids, diabetes supplies, cough, cold, allergy and pain relief medications, first aid products, medical devices for home healthcare and other health-related products. Representative brands in our medicine cabinet category include Prilosec, 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. The beauty category can be broadly classified into two subcategories: prestige beauty products, which consumers generally find in department stores, beauty specialty stores or spas and salons, and mass-market beauty products. Representative brands in our prestige beauty product category include LORAC, Sue Devitt Studios, Calvin Klein, and tarte, in addition to anti-aging products such as Basic Research’s StriVectin. Representative brands in our mass-market beauty product category include philosophy, Neutrogena, Olay, Revlon and L’Oreal.

Nutrition and Wellness.    The nutrition and wellness category includes nutritional foods and supplements, exercise, diet and weight loss products, massage and relaxation products, and sports nutrition products.

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Representative brands in our wellness product category include Nature Made, Twinlab, Natrol, Nature’s Way, Atkins, EAS, Gaiam, HoMedics and DreamTime. We are also the exclusive online retailer of GNC Live Well products.

Personal Care.    The personal care category includes products related to hair, body and shaving, oral hygiene, baby and feminine needs. Representative brands carried in our personal care product category include Gillette, Colgate, Johnson & Johnson, Rogaine and Pampers.

Household.    The household category offers a wide selection of household products, including healthy and aromatherapeutic cleaning products and other cleaning solutions, small household appliances and healthy home products, such as air and water purification systems. Representative brands include Caldrea, Method, Seventh Generation, OxiClean, Shark, Tanita, BlueAir and SlantFin.

Sexual Well-Being.    The sexual well-being category offers 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. We provide a wide range of adult consumer shopping choices, from novelty to relationship building products to individual pleasure and relaxation products. Representative brands include Kama Sutra, Astroglide, Lover’s Choice, Shunga and Vibratex. In January 2003, we acquired the domain name sexualwellbeing.com to more effectively market the products in this category.

Dr. Weil Recommends.    The Dr. Weil Recommends store provides consumers with information, resources, and a selection of health and wellness products personally recommended by Dr. Andrew Weil. In addition to purchasing health and wellness products, customers can take the Vitamin Advisor questionnaire to obtain a personalized recommendation for vitamin supplements based on Dr. Weil’s research and sign up for daily or weekly e-mail newsletters from Dr. Weil.

Natural Store.    The natural store category features a broad selection of natural products, including those products without artificial coloring or flavoring, synthetic fragrance or other unnecessary chemicals and/or products from companies with environmentally-conscious and cruelty-free policies. The Natural Store features many of the top natural brands on the market, including Burt’s Bees, Tom’s of Maine, Zia Natural Skincare, 7th Generation, New Chapter, Boiron and Clif Bar.

Nutritional Products.    Our GNC Live Well 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 until July 2005. We also provide personalized nutrition services to consumers in the form of an online assessment of an individual’s specific nutritional supplement needs, and deliver the personalized vitamins, minerals, herbs, and supplements in pharmaceutical-grade, daily dose packages (CustomPaks^™). In addition to providing CustomPaks for consumers purchasing vitamin supplements through our Dr. Weil Recommends store, our subsidiary CNS is the exclusive online distributor of CustomPaks for Dr. Andrew Weil at www.DrWeil.com, Dr. Barry Sears at www.zonediet.com, and The Pritikin Longevity Center at www.Pritikin.com.

Mail-Order Pharmacy and Local Pick-up Pharmacy

We divide the pharmacy product category into two business segments: mail-order pharmacy and local pick-up pharmacy. Our mail-order pharmacy segment covers the prescription drugs and supplies delivered to customers through our mail order facility, and our local pick-up pharmacy business segment covers the prescriptions picked up by customers at Rite Aid stores. 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 through our mail order facility may be mailed to the customer or picked up by the customer at any one of the approximately 3,400 Rite Aid stores nationwide. Although most prescriptions are ordered through the drugstore.com Web site, we also accept orders to fill prescriptions by telephone at 1-800-DRUGSTORE.

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Product Offering.    We are a full-service pharmacy stocking over 4,800 prescription drugs. Our pharmacy product offering consists primarily of prescription medications for chronic illnesses and needs, such as high blood pressure, diabetes, osteoporosis, depression, hair loss and birth control.

The pharmacy services at the drugstore.com online pharmacy are provided by experienced professionals using sophisticated 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 United States. We have also received VIPPS certification from the National Association of Boards of Pharmacy, or NABP, a coalition of state pharmacy boards. The voluntary VIPPS program sets standards for Internet pharmacies and informs the public of those online pharmacies that are fully licensed and in compliance with state pharmacy laws and the NABP’s pharmacy practice standards.

Filling Prescriptions.    We accept prescriptions only 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 for online purchases could be too long to meet the customer’s needs. Because there are increased risks associated with the dispensing of opiates, depressants, stimulants and other controlled substances classified as Schedule II pharmaceuticals, such as fraud, illegal resale and special storage, shipping and handling requirements, we dispense Schedule II pharmaceuticals only to patients who use pharmacy benefit managers, or PBMs, for which we act as the mail-order pharmacy provider. Like traditional retail and mail service pharmacies, we accept, verify and cross-check prescriptions.

Services.    We seek to provide a high level of responsiveness and customer support. In addition to our Ask Your Pharmacist feature, drug price index, our extensive drug information database, specialized customer care features, and refill reminders, our pharmacy services include:

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Generic Insider.    We notify customers if a branded drug becomes available in generic form or if a prescription drug becomes available in a non-prescription form available over the counter.

Insurance/PBM relationships.    We serve both cash-paying pharmacy customers and customers with insurance coverage. Through our relationships with insurance companies, PBMs, and Rite Aid Corporation, or Rite Aid, we are able to obtain insurance reimbursement coverage for many insured prescriptions filled through the drugstore.com pharmacy. For example, 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. We participate in the retail pharmacy networks of many PBMs, including Advance PCS, Aetna US Healthcare, Inc., Caremark Inc. and Express Scripts, Inc. In addition, we act as a mail-order pharmacy service provider for a number of PBMs, under which we dispense medications in supplies of 90 days or more. These PBMs provide their clients with prepaid mailing envelopes addressed to the drugstore.com pharmacy, to make it easy and convenient to send prescriptions to us.

We also expect to participate in prescription drug discount card programs to be established under the new federal Medicare legislation. This prescription discount card legislation, which goes into effect in June 2004, provides for the development and administration of discount card programs offering discounts off the retail price of prescription drugs reimbursed by Medicare. PBMs, insurance companies and others are currently applying to the federal government for approval to offer a prescription drug discount card program. We expect to participate in the networks of PBMs that are approved to offer a discount card program, and two PBMs that have applied have asked us to participate as their drug discount card vendor of choice.

Payment.    Customers may pay for their prescriptions 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 2003, approximately 95% of the prescriptions in our local pick-up pharmacy segment and approximately 25% of the prescriptions in our mail-order pharmacy segment were paid for by insurance plans, with the balance reflecting prescriptions filled for customers who paid for the prescriptions directly. We accept checks for payment by customers who use PBMs for which we act as the mail-order pharmacy provider.

Vision

We sell prescription contact lenses and other vision products through our subsidiary Vision Direct, through Web sites located at www.visiondirect.com, www.lensmart.com, and www.lensquest.com, as well as by telephone at 1-800-VISIONDIRECT.

Product Offering.    We provide our customers with a broad assortment of contact lenses, including popular brands manufactured by Johnson & Johnson, Ciba Vision, Bausch and Lomb, OSI/American Hydron and CooperVision. We also sell reading glasses and contact lens cases. We believe that we offer these products at a substantial price savings over eye care practitioners, national optical chains and many online competitors.

Prescription Verification.    We adhere to the prescription verification guidelines defined in the U.S. federal Fairness to Contact Lens Consumers Act, which became effective in February 2004. In accordance with this law, we ask the patient’s eye care professional to verify the prescription before we ship an order, and allow eight

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business hours for the eye care professional to reply to our verification request. If the eye care professional indicates that the prescription is invalid, we cancel the order and notify the customer. If the eye care professional approves the prescription or does not respond to our verification request within eight business hours, we ship the order to the customer. If, at any time after we ship an order, the eye care practitioner notifies us that the prescription is invalid, we will notify the customer of this result and the reason the prescription is invalid.

Services.    We offer a convenient process for customers to reorder from their accounts and automatic shipments based on a customer’s delivery preferences.

How We Merchandise and Market

Merchandising

We believe that the breadth and depth of our product selection, together with the flexibility and convenience of our online store and the range of useful shopping services we provide, enables us to pursue a strong merchandising strategy.

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Marketing

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 capabilities of the Internet as a means to encourage traffic to, and repeat purchases from, our Web sites. 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 e-mail. We also extend our market presence through our associates program, which enables associated Web sites to make our products and services available to their audiences through a link to our Web site.

In addition to our general marketing and promotion strategies, we utilize business segment-specific marketing programs and initiatives:

OTC.    We currently offer three anchor customer loyalty programs: Everyday Free Shipping, drugstore.com dollars^™ and Diamond Deals^™.

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

Pharmacy.    We have a strategic relationship with Rite Aid to promote our Web site. For example, Rite Aid has agreed to include the drugstore.com online store and pharmacy in a significant portion of Rite Aid’s own weekly circular advertisements, as well as on shopping bags, prescription vial caps, in-store signs and permanent links from its Web site. In addition, we receive advertising benefits through our various PBM relationships.

Vision.    Our Vision Rewards program provides customers with discounts on future orders based on their past purchases. This credit is maintained in the customer’s account and applied automatically to the customer’s next purchase.

Pricing

Our goal is to offer our customers the largest assortment of health, beauty, wellness, vision and pharmacy products with value pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can pass along the savings to our customers in the form of lower prices and exclusive deals. We also strive to make additional cost savings opportunities known to our customers when they become available. For example, in our pharmacy store we proactively highlight lower-cost generic drug alternatives where both the customer and drugstore.com save on the price of the drug as compared to higher-priced brand name solutions. We also encourage our pharmacy customers to buy 90-day supplies of medication rather than 30-day supplies, when possible, by providing quantity price breaks as incentives. This strategy allows our customers to take

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advantage of price savings and enables us to realize fulfillment cost savings and achieve higher customer retention rates. Vision Direct offers a low price guarantee on all brands of contact lenses. In addition, we increase customer retention rates through our customer loyalty programs, such as drugstore.com Dollars, Diamond Deals and Vision Rewards, which provide lower prices for repeat customers. We believe our overall pricing strategy increases average net sales per order and leads to further operating efficiencies.

Our Target Customer

We target busy, working females between the ages of 30 and 54, many of whom are married with young children. This target customer makes the majority of her household’s buying decisions, uses online shopping as a means of maximizing the use of her time, browses multiple categories and finds online shopping a convenient, relaxing and rewarding experience. We also cater to a secondary target market of men over the age of 45 who use online shopping as a means of maximizing the use of their time and who tend to use more prescription medications as they age.

How We Serve our Customers

Order Fulfillment

All of our OTC orders and our pharmacy orders that are delivered by mail are processed from primary distribution center in New Jersey. Orders for products in our vision segment, including contact lenses, reading glasses and lens cases, are processed from our distribution center in Ferndale, Washington.

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 on our Web site that enables our customers 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.

When we fill a prescription at our pharmacy for mail-order delivery from 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. When a customer orders a prescription from us to be picked up at a Rite Aid store, we utilize Rite Aid as a fulfillment partner. Upon receiving and validating a customer’s order for products to be picked up, we submit order information to Rite Aid for processing and purchase the inventory from Rite Aid, which fills the order and makes it available for pick-up by the customer. Under our agreement with Rite Aid, Rite Aid adjudicates and collects insurance reimbursement payments on our behalf.

Non-prescription orders over $49 qualify for free standard shipping under our Everyday Free Shipping program. For orders under $49, we generally charge our customers a shipping charge that covers a portion of our expense of shipping. We offer a variety of shipping options, including next-day delivery for orders received during the business week. We ship anywhere in the United States that is served by United Parcel Service or the U.S. Postal Service. Vision Direct ships contact lenses and other vision products worldwide, primarily to the United States and Canada. Orders for which customers requested expedited shipping 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 the drug utilization reviews described above. Customers who order a refill of an existing Rite Aid or drugstore.com prescription can choose to pick up the refill at any Rite Aid store or have it delivered using one of our delivery options.

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

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via e-mail or telephone. 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, for customers who choose not to transmit their credit card information over the Internet, 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 maintain customer care centers in our Bellevue, Washington headquarters and, for vision support, in Halifax, Nova Scotia, Canada. We operate toll-free telephone numbers, 1-800-DRUGSTORE and 1-800-VISIONDIRECT, through which customers can place orders and receive information.

We generally refund to customers all or a portion of the selling price, including related shipping fees if applicable, if a customer is not satisfied with the product purchased or the quality of customer service provided. Sales returns have not been significant to date.

Technology

We have implemented a broad array of services and systems for site management, product searching, customer interaction, transaction processing and order fulfillment functions, including, among other things:

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 our 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, Inc. under which we have mutually agreed to license to each other 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. This agreement is described below in the section entitled “Key Strategic Relationships—Amazon.com.”

Our core merchandise catalog, customer interaction, order collection, fulfillment and back-end systems are proprietary to drugstore.com but are available for use by Amazon.com under our technology license and advertising agreement with Amazon.com. The drugstore.com software platform and architecture are integrated with an Oracle database system. The systems are designed to provide real-time connectivity to the distribution center systems for both pharmacy and OTC 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 by Cable & Wireless (formerly Exodus Inc.) in Tukwila, Washington, which provides communication lines from multiple providers, as well as 24-hour monitoring and engineering support. Cable & Wireless has its own generators and multiple backup systems in Tukwila.

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Vision Direct uses a combination of internally developed and third-party software systems. We will integrate Vision Direct’s services and systems into drugstore.com’s services and systems during 2004.

Purchasing

OTC.    We purchase our non-pharmaceutical inventory directly from various manufacturers and distributors.

Pharmacy.    Under our agreement with Rite Aid, we are required to purchase all of our brand-name pharmaceutical products directly from McKesson Corporation through Rite Aid, unless we are able to obtain better overall terms from another vendor. We purchase our generic drugs directly from Rite Aid. Our arrangement with Rite Aid enables us to take advantage of volume discounts and credit terms obtained through Rite Aid, and therefore decreases our cost on pharmaceutical products. To date we have not been able to obtain better overall terms from any other supplier and we currently expect that McKesson and Rite Aid will continue to be our suppliers of pharmaceutical products. This purchase requirement will continue for the term of our relationship with Rite Aid.

When our customers order prescriptions through the drugstore.com Web store for pick-up at a Rite Aid store, we use Rite Aid as a fulfillment partner.

Vision.    We purchase our contact lens and vision products inventory directly from various manufacturers and other distributors. For example, we have entered into a direct buying partnership with Vistakon, a division of Johnson & Johnson Vision Care, Inc., to purchase Vistakon’s Acuvue brand of products.

Key Strategic Relationships

Rite Aid

In June 1999, we entered into a strategic relationship with Rite Aid. Through this relationship, we have access to Rite Aid customers through the RiteAid.com Web site, which is powered by the drugstore.com Web site. All pharmacy orders processed through the drugstore.com Web site or the RiteAid.com Web site can either be 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 of Rite Aid’s approximately 3,400 stores nationwide. In addition to providing for multi-channel delivery options, we and Rite Aid agreed to promote each other’s services both online and in other promotional materials. We also benefit from access to many of Rite Aid’s relationships with insurance and PBMs, which provides us with opportunities to meet the needs of more customers because of the availability of insurance coverage to those customers. Currently, we purchase all of our pharmaceutical inventory through Rite Aid, leveraging its volume requirements to obtain favorable pricing and credit terms. We also sell over 200 Rite Aid brand private label OTC products throughout our Web store. As a result of this agreement, Rite Aid is one of our largest suppliers.

As part of our relationship, drugstore.com agreed to certain exclusivity provisions that limit our ability to promote, or affiliate with, any other physical retail drugstore or to operate as a traditional physical drugstore, and Rite Aid agreed not to offer or sell products or services on the Internet other than through our Web site. In addition, our agreement requires us to purchase all of our pharmaceutical products through Rite Aid unless we are able to obtain better overall terms from another vendor. The agreement also 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. We currently use these systems to process pharmaceutical orders through our primary distribution center.

Our agreement with Rite Aid ends in 2009. In connection with this ten-year agreement, Rite Aid received 9,334,746 shares of our common stock. Rite Aid was one of our largest stockholders until 2002, when Rite Aid liquidated its holdings in our common stock.

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GNC

In June 1999, we entered into a 10-year agreement with GNC under which 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, until July 2005. We have agreed that, 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. When the exclusivity provisions of the agreement terminate, we will have the nonexclusive right to sell these products for the remaining term of the agreement. As part of this relationship, we have created the GNC Live Well Store within the drugstore.com Web site, which 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 we retain as revenues. We have also agreed with GNC to co-promote each other’s products and services in both traditional and online marketing efforts, including GNC’s placement of a link to our Web site on the GNC Web site. In connection with this relationship, GNC received 2,947,853 shares of our common stock. GNC liquidated its holdings in 2002.

Amazon.com

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

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

Amazon.com is our largest stockholder, owning 16.8% of our outstanding stock as of December 28, 2003. Jeffrey P. Bezos, Amazon.com’s chairman of the board, president and chief executive officer, is currently serving as Amazon’s designee on our board of directors.

Competition

The market for health, beauty, wellness, vision and pharmacy products is intensely competitive and highly fragmented. We face intense competition in each of our business segments, as described below. In addition, we compete with Internet portals and online service providers that feature shopping services, such as America Online, MSN and Yahoo!, and with other online or mail-order retailers that offer products within one or more of our business segments.

Pharmacy.    In our mail-order pharmacy and local pick-up pharmacy segments, we compete with chain drugstores, including those with an online presence, such as Walgreens and CVS; pharmacy benefit managers, such as Medco Health Solutions, Inc.; and hospitals, health maintenance organizations, or HMOs, and mail-order prescription drug providers, many of which are or may begin offering products and services over the Internet. In addition, we face competition from other online pharmacies. Some of these pharmacies are foreign Internet pharmacies that can sell drugs at a lower price because of government subsidies. In addition, many online

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pharmacies, often referred to as “rogue” pharmacies, sell counterfeit drugs or drugs diverted from proper channels. Foreign online pharmacies and rogue online pharmacies can often sell drugs to American residents at a lower price because they do not comply with U.S. pharmacy regulations, are not subject to U.S. regulatory oversight, or both.

OTC.    Our competitors in the OTC segment 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; and, with respect to upscale health, prestige beauty and spa products, specialty retailers and major department stores, such as Nordstrom, Macy’s, Sephora and Bloomingdale’s.

Vision.    Our competitors in the vision segment include online providers of contact lenses, such as 1-800-CONTACTS, national optical chains, such as Lenscrafters and Pearle Vision, eye care professionals and mass-market retailers such as Walmart and Costco that provide prescription vision services.

We believe that there are a number of competitive factors in our market, including brand awareness and preference, company credibility, product selection and availability, convenience, price, privacy, actual or perceived value, Web site features, functionality and performance, ease of purchasing, customer service, quality and quantity of information supporting purchase decisions (such as product information and reviews), and reliability and speed of order shipment.

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 to customers, without additional charge, 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 the drugstore.com pharmacy 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 are also subject to the Health Insurance Portability and Accountability Act of 1996, which provides standards and requirements to control the flow of health information throughout the health care system and to protect the privacy of personal health records. We also sell dietary supplements, medical devices, cosmetics, foods, drug products (prescription, OTC and homeopathic) and other consumer products that are subject to regulation by the Food and Drug Administration, or FDA, the Federal Trade Commission, or FTC, the Consumer Product Safety Commission, and state regulatory authorities, as the case may be. In addition to regulating the claims made for specific types of products, the FDA and the FTC may also attempt to regulate the format and content 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 federal, state and foreign regulations. Regulatory requirements to which our business is subject may also expand over time. For example, 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. The regulations applicable to our business often require subjective interpretation, and we cannot be certain that our attempts to comply with applicable 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 licenses or registrations, seizure of our inventory or monetary fines that could adversely affect our business, financial condition or operating results.

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We believe we are in compliance with existing federal and state requirements for pharmacy licensing and registration, with laws relating to dispensing of prescription drugs, security, record keeping and reporting of pharmacy sales, and with other applicable laws. The NABP has developed the Verified Internet Pharmacy Practice Sites, or VIPPS^®, program, which certifies that an online pharmacy is in compliance with the licensing and inspection requirements of its state and each state to which it dispenses pharmaceuticals, and other stringent criteria established by NABP to ensure good pharmacy practice. We have received VIPPS program certification.

The inclusion of outpatient prescription drugs as a Medicare benefit has been the subject of numerous bills in the U.S. Congress. One major new initiative that could substantially affect our business is the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, or DIMA, which adds a prescription drug benefit to the federal Medicare program. Under the DIMA, a new prescription drug discount card program will begin in 2004. The scope and volume of this program are yet to be seen, but discount card sponsors may seek to exert downward pressure on payments to pharmacies to reduce costs, which could adversely affect our profitability and harm our business. In 2006, a full prescription drug benefit will take effect for Medicare beneficiaries. This will likely result in a substantial increase in the number of seniors with prescription drug coverage, and may also reduce the number of customers who self-pay for their prescription drugs, which may adversely impact our drug prices and dispensing fees. Moreover, the DIMA calls for significant changes to the formulas the Medicare program uses to calculate its payments for prescription drugs, as well as introduction of managed care elements and changes to the administration of the drug benefit. When fully implemented, these changes could exert downward pressure on prescription drug prices and payments by the government, even as the number of seniors who utilize the Medicare benefits to pay for prescription drugs increases. This could adversely impact our drug prices and dispensing fees, and ultimately could reduce our profit margins. 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, our business could be materially adversely affected.

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 five years. If enacted, this legislation could adversely affect our business because consumers may increasingly use foreign-based online prescription drug Web sites instead of U.S.-based online pharmacies to fill their prescription needs. The FDA and a U.S. federal court have recently taken action against those who support or facilitate the illegal re-importation of prescription drugs, and the U.S. Department of Health and Human Services and the NABP have publicly condemned the practice. It is too soon to tell, however, what impact, if any, initiatives against illegal re-importation may have on our business.

Intellectual Property

We regard our intellectual property as critical to our future success and we rely on a combination of patent, 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, strategic partners and others to limit access to and disclosure of our proprietary information. The steps we take to protect our intellectual property, however, may not prevent misappropriation of our technology or proprietary information. We have licensed in the past, and expect that we may license in the future, some of our proprietary rights to third parties. For example, Amazon.com has the right to license our technology and we have granted nonexclusive rights to our trademarks and copyrighted material in connection with advertising and affiliate relationships. While we attempt to ensure that such licensees maintain the quality of the drugstore.com brand, these licensees may take actions that could hurt the value of our proprietary rights or reputation. 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 patent, copyright, trademark and trade secret protection may not be available in such jurisdictions.

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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. These third-party technology licenses may not continue to be available to us on commercially reasonable terms. The loss of such technology could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could harm our business.

We own a number of domain names, hold one patent and have applied for seven others, have registered several trademarks, including the drugstore.com logo, and have filed applications for the registration of a number of our other trademarks, including DRUGSTORE.COM^™, and service marks in the United States and in some other countries. We may be unable to secure registrations for all of our marks. Our competitors or others may use marks similar to ours, which could impede our ability to build brand identity and lead to customer confusion, and owners of other registered trademarks or trademarks that incorporate variations of our marks could bring potential trade name or trademark infringement claims against us. Any claims or customer confusion related to our trademarks or any failure or inability to protect our trademarks, technology or other proprietary rights could substantially harm our business.

Seasonality

Our OTC business is subject to substantial seasonal variations in demand. Historically, net revenue has increased significantly in the fourth quarter of each year, primarily because the greater number of sales and increased OTC customer acquisition arising from the holiday season. We believe that this is the general pattern associated with the direct-to-consumer and retail industries. We do not believe that our mail-order pharmacy, local pick-up pharmacy or vision business segments are substantially affected by seasonality.

Employees

As of December 28, 2003, we had 530 full-time employees. None of our employees are represented by a labor union.

Executive Officers and Directors

The following tables set forth information regarding our executive officers and directors as of March 1, 2004:

Executive Officers

Peter M. Neupert has served as Chairman of the Board of drugstore.com since July 1999. Mr. Neupert also served as President and Chief Executive Officer of drugstore.com from July 1998 to April 2001. From March 1987 to July 1998, he worked for Microsoft Corporation in several positions, including Vice President of News and Publishing for Microsoft’s interactive media group. He is also a director and the chair of the compensation committee of aQuantive, Inc., and a director of one private company.

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Kal Raman (also known as Kalyanaraman Srinivasan) has served as President and Chief Executive Officer of drugstore.com since April 2001. Mr. Raman joined drugstore.com in August 1998 and served as Vice President, Technology and Chief Information Officer from August 1998 to March 1999, as Vice President, Technology and Operations and Chief Information Officer from March 1999 to May 1999, as Senior Vice President, Operations and Technology and Chief Operating Officer from May 1999 to November 1999 and as Senior Vice President and Chief Operating Officer from November 1999 to April 2001. From March 1998 to August 1998, he served as Chief Information Officer and Vice President of NationsRent West, Inc. From February 1997 to March 1998, he served as Senior Director of Information Systems of Blockbuster Inc.

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

Christopher G. Hauser has served as Vice President, Operations of drugstore.com since July 1999. Before joining drugstore.com, Mr. Hauser served as Senior Vice President, Information Technologies and Operations for Multiple Zones International, a reseller of brand-name computer products and services.

Sridhar Iyer has served as Vice President, Technology and Chief Information Officer of drugstore.com since September 2002. Mr. Iyer has served in various senior technology roles at drugstore.com since October 1998, 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. Before joining drugstore.com, he served for six years as Strategy Manager for Wal-Mart Stores Inc.’s Information Systems Division.

Jeffrey J. Kimmell has served as Vice President, Pharmacy Services of drugstore.com since February 2004 and as Vice President and General Manager of Pharmacy from February 2003 to February 2004. Mr. Kimmell served as Vice President, Customer Care for Pharmaceutical Care Network, a pharmacy benefits manager, from February 2001 to February 2003. From September 1996 to January 2001, he served as Senior Director of Operations for HealthScript Pharmacy Services, Inc., a provider of prescription services and health and medical products.

Ian D. Mummery has served as Vice President, Vision of drugstore.com since December 2003. Mr. Mummery co-founded International Vision Direct, a provider of contact lenses and vision accessories, in December 1998 and served as its President and Chief Executive Officer until its acquisition by drugstore.com in December 2003.

Louise Mummery has served as Vice President, Vision Operations of drugstore.com since December 2003. Ms. Mummery co-founded International Vision Direct, a provider of contact lenses and vision accessories, in December 1998 and served as its Chief Operations Officer until its acquisition by drugstore.com in December 2003.

Alesia L. Pinney has served as Vice President, General Counsel and Secretary of drugstore.com since October 2000. Ms. Pinney served as Assistant Secretary and Associate General Counsel of drugstore.com from January 1999 to October 2000. Before joining drugstore.com, Ms. Pinney was an attorney with the law firm Perkins Coie LLP.

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Directors

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. Other 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.

We have a limited operating history and a history of generating significant losses, and may never be profitable.

drugstore.com was founded in April 1998 and began selling products in February 1999, and therefore has a limited operating history on which investors can evaluate our business strategy. We have incurred net losses of $669.0 million from inception through December 28, 2003. To date, we have not become profitable, and we may never achieve profitability. We expect to continue to incur operating and net losses for at least the next year, and possibly longer.

As an early stage company with a limited operating history, we face risks and challenges in accurate financial planning and forecasting. We have limited historical data and uncertainties because of our relatively limited time period in which to implement and evaluate our business strategies, when compared to older companies with longer operating histories. Our limited operating history and the rapidly evolving nature of our business may make it difficult for investors and securities analysts to evaluate our business, strategy and prospects.

Consumers of health, beauty, wellness, vision and pharmacy products may not accept our online solution, which would harm our revenues and prevent us from becoming profitable.

If we do not attract and retain a higher volume of online customers to our store at a reasonable cost, we will not be able to increase our revenues or achieve profitability. Our success depends on our ability to convert a large number of customers from traditional shopping methods to online shopping for health, beauty, wellness, personal care, sexual well-being, vision and pharmacy products. Specific factors that could prevent widespread customer acceptance of our online solution include:

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Our marketing efforts may not be effective at attracting and retaining customers at a reasonable cost.

If we do not establish our brand and increase awareness of our solution, we may not build a critical mass of customers. Promoting and positioning our brand depends 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. Our promotional activities may not be effective at building our customer base to the extent necessary to generate sufficient revenue. In addition, an inability to acquire customers at a reasonable cost would increase our operating costs and prevent us from becoming profitable.

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 chain drugstores, mass-market retailers, warehouse clubs, specialty retailers, major department stores, health care providers, mail-order pharmacies, national optical chains, eye care professionals, Internet portals and online service providers that feature shopping services and various online stores that sell prescription and OTC drugs and health, beauty, vision and wellness items. 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.

Other companies in the retail and e-commerce service industries may enter into business combinations or alliances that would strengthen their competitive positions and prevent them, their affiliated companies or their strategic partners from also entering into relationships with drugstore.com. An inability to enter into relationships with major PBMs or HMOs 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 Internet facilitates competitive entry and comparison shopping and renders it inherently more competitive than conventional retailing formats. We expect competition in the e-commerce channel to

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intensify, and this increased competition may reduce our ability to grow and thus, reduce our revenue, operating profits, or both.

In addition, we face competition from online pharmacies outside the United States. Although prescription drug re-importation is currently illegal, a number of American consumers seek to fill their prescriptions through Canadian and other foreign online pharmacies. Legislation allowing for re-importation of prescription drugs by individuals for personal use was introduced into the U.S. Congress each year for at least the past five years. If consumers increasingly use foreign-based online prescription drug Web sites instead of U.S.-based online pharmacies to fill their prescription needs, our business and operating results would be adversely affected. The FDA has taken limited action, and has indicated that it may continue to seek action, against those who support or facilitate the illegal re-importation of prescription drugs, but it is too soon to determine what impact, if any, these actions may have on us.

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. We believe that historical trends and quarter-to-quarter comparisons of our operating results are not necessarily meaningful and should not be relied on as an indicator of our future performance. It is likely that in some future quarter our operating results will be below the expectations of securities analysts and investors. In this event, the price of our common stock may fall substantially.

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. Revenue growth may not be sustainable and our company-wide percentage growth rate may decrease in the future. Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors, including:

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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 our limited operating history, we may have difficulty forecasting revenue from customers or overall anticipated revenue trends.

A portion of our revenues are also 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, such as diet products, cold and flu medications and products with holiday-specific varieties. 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, traditional retail seasonality affects our OTC business, resulting in higher revenues in the fourth quarter of each year as compared to other quarters.

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. Sales billed through insurance companies and PBMs having a relationship with Rite Aid currently represent a significant percentage of our pharmacy sales. We have also entered into direct relationships with PBMs and insurers, including Advance PCS, Ameriscript, Inc., Envision Pharmaceutical Services, The Inteq Group, Inc. and US Script Inc. If we are unable to establish, 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.

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. In addition, we must process each customer’s insurance application individually, which may raise the costs of processing prescription orders and delay the customer’s initial prescription order. 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 through Rite Aid unless we are able to obtain better overall terms from another vendor. Our business could be significantly disrupted if Rite Aid were 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.

We also rely on a limited number of 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

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weather, associated 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, our business and our results of operations.

We have significant inventory risk.

We must maintain sufficient inventory levels to operate our business successfully and meet our customers’ expectations that we will have the products they order in stock. However, we must also guard against the risk of accumulating excess inventory. We are exposed to significant inventory risks as a result of uncertainty of success of 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, which we may be unable to do, and avoid over-stocking or under-stocking products. In addition, demand for products can change significantly between the time product inventory is ordered and the time it is available for sale. When we begin selling a new product, it is particularly difficult to forecast product demand accurately. A failure to optimize inventory would increase our expenses if we have too much inventory and would harm our shipping margins by requiring us to make split shipments for backordered items if we had insufficient inventory of the ordered products. Failure to have inventory in stock when a customer seeks it could cause us to lose that customer. The acquisition of some types of inventory, or inventory from some of our sources, may require significant lead-time and prepayment, and such inventory may not be returnable. We carry a broad selection of products and significant inventory levels of a substantial number of these products, and we may be unable to sell this inventory in sufficient quantities or during the relevant selling seasons. The occurrence of one or more of these inventory risks may adversely affect our business and operating results.

We must timely and effectively obtain shipments of product from our vendors and deliver merchandise to our customers.

We cannot control all of the various factors that might affect our timely and effective procurement of supplies of product from our vendors and delivery of merchandise to our customers. All products that we purchase must be shipped to our distribution centers in Swedesboro, New Jersey and Ferndale, Washington by third-party freight carriers. We also rely on third-party carriers to deliver merchandise from our distribution centers to our customers. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather and increased fuel costs, associated with such carriers’ ability to provide delivery services to meet our inbound and outbound shipping needs. Failure to procure and deliver merchandise, either to us or to our customers, in a timely and effective manner could damage our reputation and adversely affect our business and operating results. In addition, any increase in fulfillment costs and expenses could adversely affect our business and operating results.

All of our fulfillment operations and inventory are located in our distribution facilities, and any significant disruption of these centers’ operations would hurt our ability to make timely delivery of our products.

We conduct all of our fulfillment operations from our distribution facilities in New Jersey and Washington. Our primary distribution center in New Jersey houses all of our product inventory, except for our vision products, which are housed at our facility in Ferndale, Washington. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable event at either of these facilities, and in particular our primary distribution center in New Jersey, would cause interruptions or delays in our business and loss of inventory and could render us unable to process or fulfill customer orders in a timely manner, or at all. Further, we have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that a fire, natural disaster or other catastrophic event were to destroy a significant part of our either of these facilities, and in particular our New Jersey facility, or interrupt our operations for any extended period of time, our business, financial condition and operating results would be harmed.

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If we are unable to optimize management of our distribution centers, we may be unable to meet customer demand.

Our ability to meet customer demand may be significantly limited if we do not successfully operate our distribution and fulfillment centers. 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 or distribution capacity. In addition, failure to effectively control product damage and shrinkage through effective security measures and inventory management practices could adversely impact our operating margins. Our margins may also be affected if we are unable to obtain products from manufacturers and wholesalers on favorable terms. In addition, 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.

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

Any errors in filling or packaging the prescription drugs or contact lenses we dispense may expose us to liability and negative publicity.

Errors relating to prescriptions, dosage and other aspects of the medication and contact lens dispensing process may produce liability for us that our insurance may not cover. Because we distribute pharmaceutical products and contact lenses directly to the consumer, we are one of the most visible participants in the distribution chain and therefore have increased 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 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-mails to our customers 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 us with all relevant information. Although we also post product information on our Web site, customers may not read this information. 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 liabilities that may be imposed if any such claims were to be successful.

Errors by either us or our competitors may also produce significant adverse publicity either for us or for the entire online pharmacy and vision industry. Because of the significant amount of press coverage on Internet retailing and online pharmacies, we believe that we are subject to a higher level of media scrutiny than other pharmacy product channels. The amount of negative publicity that we or the online pharmacy or vision industries receive as a result of pharmacy or prescription processing errors could be disproportionate in relation to the negative publicity received by other pharmacies or eye care professionals 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 and harm our business and operating results.

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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. Before joining us, many of our senior management had no prior senior management experience at public companies, and our executive officers have limited management experience in the healthcare or retail drugstore industry. If we are unable to continue to improve our transaction-processing, operational, financial and managerial controls and reporting systems and procedures, to expand, train and manage our work force, we will be unable to increase gross margins and achieve profitability.

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. 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 may be unable to expand our product and service offerings or sales formats in a cost-effective or timely manner, and any new offerings or formats may not generate satisfactory revenues to offset the costs involved. Furthermore, any new product or service offering or sales format that is not favorably received by consumers could damage the reputation of our brand. A lack of market acceptance of such efforts or our inability to generate sufficient revenues to offset the cost of expanded offerings could harm our business. In addition, our agreement with Amazon.com contains prohibitions that limit our ability to sell products and services in markets that are competitive with some of those offered by Amazon.com. This restriction could limit our flexibility and ability to expand our product and service offerings.

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 respective 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 substantial effort and attention to operate successfully. As a result, there are many risks related to our relationship with Rite Aid, including some that we may not have foreseen. It is difficult to assess the likelihood of occurrence of these risks, including the risk that the overall arrangement will not meet the parties’ objectives. In the event that we do not realize the intended benefits of this relationship, 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 this relationship is 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 our relationship with Rite Aid 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 proceed successfully.

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Our relationship with Amazon.com may restrict some of our activities.

Our relationship with Amazon.com may restrict our activities. We entered into a technology license and advertising agreement with Amazon.com in August 1998 and an e-commerce agreement in September 2003. Under the latter agreement, we are a nonexclusive wholesaler and fulfillment provider for certain products sold by Amazon.com on its Web site. 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 use Amazon.com’s technology, if we were then using any. We may not assign the technology license and advertising agreement without Amazon.com’s consent. The potential loss of these rights could inhibit offers to acquire us.

In addition, Amazon.com beneficially owns approximately 16.8% of our outstanding stock, and Jeffrey P. Bezos, Amazon.com’s chairman of the board, president and chief executive officer, is serving as Amazon.com’s designee on our board of directors. 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. Because Amazon.com owns a significant percentage of our capital stock, furthermore, competitors of Amazon.com or other potential acquirers could decide not to merge with or acquire us. In addition, in the case of a potential acquisition of drugstore.com by another party, Amazon.com’s substantial equity stake in drugstore.com could prevent the tax-free treatment of an acquisition, making drugstore.com a less attractive acquisition candidate.

If we fail to maintain or enhance our strategic relationships to help promote our Web site and expand our product offerings, our development could be hindered.

We believe that our strategic relationships with Rite Aid, 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 accounted for 55% of our total sales in fiscal year 2003. 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, 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 often place downward pressures on profitability from sales of prescription drugs. In addition, 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.

The addition of the Medicare prescription drug benefit under the DIMA could affect our profitability. Under the new prescription drug discount card program, which will begin in 2004, discount card sponsors may seek to exert downward pressure on payments to pharmacies to reduce costs. The prescription drug benefit for Medicare beneficiaries, which will take effect in 2006, will likely increase the number of seniors with prescription drug coverage and possibly reduce the number of customers who self-pay for their prescription drugs. Moreover, the DIMA calls for significant changes to the formulas Medicare program uses to calculate its payments for prescription drugs, as well as introduction of managed care elements and changes to the administration of the drug benefit. When fully implemented, these changes could exert downward pressure on prescription drug prices

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and payments by the government, even as the number of seniors who utilize the Medicare benefits to pay for prescription drugs increases. All of these factors could adversely impact our drug prices and dispensing fees, and ultimately could reduce our profit margins.

In addition, 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 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 additional federal and state regulations that may adversely impact our prescription drug sales.

Our growth strategy depends in part on our ability to acquire complementary or strategic businesses. Any such acquisitions could result in dilution, operating difficulties, difficulties in integrating acquired businesses and other harmful consequences.

We intend to acquire, and have acquired, complementary or strategic businesses, technologies, services and/or products as part of our strategy to increase our net sales and customer base. For example, in 2003 we acquired CNS and Vision Direct and we are currently integrating both of them into our business. The process of integrating CNS, Vision Direct and any other acquired business, technology, service or product into our business and operations may result in unforeseen operating difficulties and expenditures. Integration of an acquired company, including each of CNS and Vision Direct, also requires significant management resources that would otherwise be available for operation, ongoing development and expansion of our business. To the extent we miscalculate our ability to integrate and properly manage acquired business, we may have difficulty in achieving our operating and strategic objectives. In addition, we may not realize the anticipated benefits of any acquisition or we may depend on the continued service of acquired personnel who could choose to leave.

We may be unable to identify suitable acquisition opportunities and to negotiate and complete acquisitions on favorable terms, or at all. In addition, any future acquisitions may require substantial capital resources and we may need to obtain additional capital or financing, from time to time, to fund these activities. This could result in potentially dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could harm our business, financial condition and results of operation. Sufficient capital or financing may not be available to us on satisfactory terms, or at all.

Our computer and communications systems are vulnerable to system interruption, damage or security breaches, which could harm our operations and reputation could be harmed.

Our ability to receive and fulfill orders successfully is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. We experience periodic system interruptions that make our Web sites inaccessible to our customers and prevent us from efficiently fulfilling orders or providing services to third parties. To minimize future 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. To the extent we are unable to do so, systems interruptions may reduce customer satisfaction and thus affect our sales.

Our systems and operations, and those of our suppliers, are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, failure in the Internet backbone 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, service delays and loss of critical data and could prevent us from accepting and fulfilling customer orders. Any significant interruption in the availability or functionality of our Web sites or customer processing, distribution or communications systems, for any reason, could seriously harm our business, financial condition and operating results. While we do have backup systems for certain

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aspects of our operations, we do not have fully redundant backup 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 distribution 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 substantial 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. For example, entities engaging in the practice of pharmacy are subject to federal and state regulatory and licensing requirements and the U.S. FDA regulates advertising and promotion of, among other things, prescription drugs, OTC products and medical devices. We are also subject to extensive regulation relating to confidentiality, storage, and release of patient records. As we expand our product and service offerings and more non-pharmaceutical products become subject to FDA and other regulation, more of our products and services will likely be subject to regulation. Complying with regulations is time consuming, burdensome and expensive and could delay our introduction of new products or services. Regulations in these areas 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 business, financial condition or operating results. Legislation and regulations currently being considered at the federal and state level could affect our business, including legislation or regulations relating to the electronic access to patient records and disclosure requirements for Internet pharmacies. 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 or lead to delays as we adjust our Web sites and operations.

We are subject to increasing regulation relating to privacy and the use of personal user information. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. In addition, several states have proposed legislation that would limit the uses of personal, user information gathered online or require online services to establish privacy policies. The FTC has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposed legislation in the United States and existing laws in other countries require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages and may otherwise have material adverse effect on our business, results of operations and financial condition.

In addition, because our Web site is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results and financial condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could have a material adverse effect on our business.

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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, brand and reputation.

Our success depends in substantial part on our proprietary rights, including our technology, copyrights, trademarks, service marks, trade dress, trade secrets and similar intellectual property. We rely on a combination of patent, trademark, trade secret and copyright law and contractual restrictions to protect our proprietary rights. Despite our efforts to protect our proprietary rights, however, unauthorized parties may attempt to copy, obtain and use information that we regard as proprietary, such as our sales formats, the technology used to operate our Web site, our Web site content and our trademarks. In addition, the laws of many countries do not protect our proprietary rights to the same extent as the laws of the United States.

We have filed applications for U.S. trademark registrations for our mark “drugstore.com” and certain other trademarks and have filed applications for patents. We may be unable to secure these registrations or patents, which could negatively affect our business. 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. If we were unable to protect or preserve the value of our trademarks, patents, copyrights, trade secrets or other proprietary rights for any reason, our business would be harmed.

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 names or 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. Third parties may also assert claims against us alleging infringement, misappropriation or other violations of patent, trademark or other proprietary rights held by them, whether or not such claims have merit. 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 claims, whether they are with or without merit or are determined in our favor, could be time-consuming, result in costly litigation, divert the attention of our management, cause service upgrade delays and harm our business or operating results. Furthermore, as a result of infringement claims we may be required to enter into costly royalty or licensing agreements, which may not be unavailable on terms that are acceptable to us, or at all. If a third party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to obtain suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, our business could be adversely affected.

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. 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 names “drugstore.com,” “beauty.com,” “visiondirect.com,” and 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 our domain names 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 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.

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We may be subject to product 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. Any such product liability claim or product recall may result in adverse publicity regarding us and the products we sell, which may harm our reputation. If we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and our reputation could suffer, any of which could harm our business. Some of our vendors do not indemnify us against 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. Any imposition of product liability that is not covered by vendor indemnification or our insurance could harm our business, financial condition and operating results.

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, intellectual property infringement, 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 protect us from all liability that may be imposed. Any imposition of liability that is not covered by our insurance or is in excess of our insurance coverage could harm our business, financial condition and operating results.

Our officers, directors and certain existing stockholders control the majority of our common stock, which could discourage an acquisition of drugstore.com 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, because Amazon.com beneficially owns approximately 16.8% of our outstanding stock, 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.

We may be unable to obtain additional capital we need in the future to support our growth.

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. Any additional financing that we may need may not be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our strategic flexibility or ability to develop and grow our business may be significantly limited.

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.

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Further, the online market for drugstore products is still developing. The market is significantly less developed than the online market for books, auctions, music, software and 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 centers, the operations of any future distribution centers and other aspects of our evolving business may, however, result in sales and use tax collection obligations. One or more states may seek, either through unilateral action 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 revenue agency of the State of New Jersey, where our affiliated distribution center is located, has asserted that we owe state sales tax on certain of our prior sales to New Jersey residents from January 3, 2000 to December 29, 2002. We have not paid the amount of back sales tax that is being asserted and are currently appealing the 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, financial condition and operating results.

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 over the Internet. 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 position regarding sales and use taxes on Internet sales. If any of these initiatives addressed the Supreme Court’s constitutional concerns and resulted in a reversal of its current position, we could be required to collect sales and use taxes in states other than Washington. The imposition of various taxes upon Internet commerce by state and local governments could create significant administration burdens for us, decrease our future sales and adversely affect our cash flow and operating results.

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 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 stores, proprietary technology and transaction-processing systems to customer requirements or emerging industry standards. Failure to successfully and timely do so 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 the same federal, state and local laws generally applicable to businesses, as well as those directly applicable to companies conducting business online, including consumer protection laws, user privacy laws and regulations prohibiting unfair and deceptive trade practices. In particular, many government agencies and consumers are focused on the privacy and security of medical and pharmaceutical records. Under federal and

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state financial privacy laws and regulations, we must provide notice to our customers of our policies on sharing nonpublic information with third parties, must provide advance notice of any changes to our privacy policies and, with limited exceptions, must give consumers the right to prevent sharing of their nonpublic personal information with unaffiliated third parties. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, user privacy, fraud, quality of products and services, taxation, advertising, intellectual property rights and information security. Applicability of existing laws to the Internet relating to issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, U.S. and international laws regulate our ability to use customer information and to develop, buy and sell mailing lists. The vast majority of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act, are only beginning to be interpreted by the courts, and their applicability and reach are therefore uncertain. These restrictions imposed by, and costs of complying with, current and possible future laws and regulations related to our business could harm our business, operating results and financial condition.

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, including those describe in this annual report, some of which are beyond our control, and these fluctuations could result in substantial losses for investors. 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.

The trading price of our company stock is significantly lower than our initial public offering price, and 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.

Available Information

We file with and furnish to the Securities and Exchange Commission, or SEC, periodic reports, proxy and information statements and other information. We make available, free of charge, on our Web site at http://www.drugstore.com (under Corporate Information), our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC. Our SEC filings are also posted on the SEC’s Web site at http://www.sec.gov, which contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Materials that we file with the SEC are also available at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330.

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 primary distribution facility is located in Swedesboro,

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New Jersey, where we lease approximately 290,000 square feet under a lease that expires in December 2010, with options to renew for two additional five-year periods.

Vision Direct’s executive offices are located in Vancouver, British Columbia, Canada, where we lease approximately 4,000 square feet under a lease that expires in September 2008. The Vision Direct customer care center is located in Halifax, Nova Scotia, Canada, where we lease approximately 11,500 square feet under a lease that expires in March 2011. The distribution facility for Vision Direct is located in Ferndale, Washington, where we lease approximately 16,600 square feet under a lease that expires in July 2008, with an option to renew for an additional five-year period.

We believe that our facilities provide sufficient capacity to meet our demands for the foreseeable future, are being appropriately utilized and have sufficient production capacity for their present intended purposes. Management reviews our anticipated requirements for facilities and the costs and benefits associated with new facilities and, based on that review, may adjust our facilities needs.

See Note 7 of our consolidated financial statements, “Commitments and Contingencies—Legal Proceedings,” included in Part IV, Item 15 of this annual report.

No matter was submitted to a vote of our stockholders during the fourth quarter of fiscal year 2003.

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PART II

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 sales prices of our common stock, as reported by the Nasdaq National Market.

Holders

On March 1, 2004, the reported last sale price of our common stock on the Nasdaq National Market was $5.96 per share. As of March 1, 2004, there were approximately 846 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.

Recent Sales of Unregistered Securities

On December 8, 2003, in connection with our acquisition of Vision Direct, we issued to the shareholders, warrantholders and optionholders of Vision Direct, or the Vision Direct sellers, an aggregate of 6,830,601 shares of our common stock having a fair value of $45.7 million, paid the Vision Direct sellers $10 million in cash, and incurred related transaction costs. The issuance of the shares of common stock as part of the consideration for the acquisition of Vision Direct was exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, on the basis that the transaction did not involve a public offering.

On August 12, 2003, in connection with our acquisition of Acumins, Inc., we issued to the shareholders of Acumins an aggregate of 100,000 shares of our common stock having a fair value of $496,000. The issuance of the shares of common stock as consideration for the acquisition of Acumins was exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, on the basis that the transaction did not involve a public offering.

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On April 28, 2003, in connection with our acquisition of CNS, we issued to the members of Concept Development LLC, or the CNS sellers, 635,593 shares of our common stock having a fair value of $2.5 million, paid the CNS sellers $1.5 million in cash and incurred related transaction costs. The issuance of the shares of common stock as part of the consideration for the acquisition of CNS was exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, on the basis that the transaction did not involve a public offering.

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The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included elsewhere in this annual 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 are forward-looking. Forward-looking statements reflect management’s current expectations and are inherently uncertain. Our actual results may differ significantly from those stated or implied in the forward-looking statements for a variety of reasons, including, among others, the rate of growth of the economy in general, the Internet and online commerce, customer spending patterns, our ability to attract and retain customers, the mix of products sold to customers, the anticipated benefits and risks of our key strategic relationships, risks of inventory management, seasonality, the future value of our common stock, the anticipated size or trends of the market segments in which we compete and the anticipated competition in those markets, potential government regulation, and our future capital requirements and the ability to meet those capital needs. These and other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are described in the following discussion and in the section entitled “Business—Factors That May Affect Our Business” in Part I, Item 1 of this annual report. Forward-looking statements are made on the basis of management’s views and assumptions as of the time the statements are made and we undertake no obligation to update these statements. There can be no assurance that our expectations will necessarily come to pass.

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

Overview

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

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

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Revenues.    We generate revenue primarily from product sales and shipping fees. In 2003, we reported consolidated total net sales of $245.7 million, which reflected a $51.8 million, or 27%, increase over 2002. Improved performance in our OTC business segment, in which net sales grew by $28.9 million, or 36%, in 2003 contributed substantially to our growth in total net sales for the year. Of this OTC growth, $23.7 million was organic growth, which we believe was aided by our ongoing customer loyalty programs, Everyday Free Shipping, drugstore.com Dollars and Diamond Deals, and $5.2 million was due to our acquisition of CNS. Growth in our local pick-up pharmacy segment also contributed significantly to our growth in total net sales. Net sales in this segment increased by $17.7 million, or 26%, in 2003 compared to 2002. Over the course of the year, we saw the growth rate of this segment decline as we began to redirect and focus our marketing dollars on our higher-margin OTC business. Finally, our mail-order pharmacy segment and our vision segment (which was created in December 2003) contributed $2.9 million and $2.3 million, respectively, to the growth in our total net sales in 2003. Assuming that we are able to successfully implement our growth strategies, successfully integrate Vision Direct and CNS into our business and manage our expenses, among other things, we anticipate total net sales in 2004 in the range of $360 million to $390 million, up $114 million to $144 million from 2003. We expect our 2004 growth to benefit from a full year’s net sales by Vision Direct and CNS.

Expenses.    Our operating expenses, including cost of goods sold, declined as a percentage of net sales from 122% in 2002, to 108% in 2003. This decline resulted from our efforts to reduce our cost of goods as a percentage of total net sales by increasing our mix of higher-margin OTC products relative to lower-margin pharmacy products. The decline in operating expenses as a percentage of total net sales was also due to increased efficiency in our marketing spending, which resulted in a decrease of $10, or 36%, in our sales and marketing expenses per new customer acquired in 2003 compared to 2002. In addition, increased utilization of our primary distribution center reduced our fulfillment expenses to 11.8% of total net sales in 2003, down from 13.8% in 2002. We also reduced technology expenses by $3.6 million and held general and administrative and other operating expenses relatively flat in 2003.

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Net Loss; Cash Position.    The combination of our revenue growth and cost containment efforts resulted in a year-over-year decline in our net loss of 63%, or $32 million, to $18.6 million in 2003. We ended 2003 with over $43.6 million in cash and marketable securities and no debt. Uses of cash in 2003 included the expenditure of an aggregate of $11.5 million in connection with the acquisitions of Vision Direct and CNS. Assuming that we are able to implement our growth initiatives, increase sales and continue to reduce total expenses as a percentage of sales, we anticipate net losses in 2004 to decline to the range of $13.5 million to $9.5 million. Although we expect a net loss for 2004, we do not expect our cash balance to decline significantly in 2004 because we anticipate that a substantial portion of our 2004 net loss will reflect non-cash expenses, such as amortization and depreciation.

Accounting Policies and Estimates

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

Revenue Recognition

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

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

Periodically, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, which we refer to as Diamond Deals, or future rebates based upon a percentage of the current purchase, which we refer to as drugstore.com Dollars, and 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 we offer are treated as a reduction to sales price based on estimated redemption rates. Redemption rates are estimated using our historical experience for similar offers. Historically, our redemption rates, which are adjusted quarterly, have not differed materially from our estimates.

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

Goodwill

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

Acquisitions

International Vision Direct Corp.

On December 8, 2003, we acquired Vision Direct, a privately held Internet retailer of contact lenses. Under the terms of the acquisition agreement, we acquired Vision Direct for $56.6 million in aggregate consideration, comprised of $10 million in cash and 6,830,601 shares of common stock having an aggregate fair value of $45.7 million, and related transaction costs. The value of the common stock issued in connection with the acquisition was determined using the six-day average of the closing prices of our common stock on the two days prior to, the day of, and the three days following November 3, 2003, the date we announced the acquisition. 50% of these shares are being held in escrow for the duration of a contingency period that expires on June 30, 2004.

In accordance with the requirements of the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 141, Business Combinations, or SFAS 141, we accounted for this acquisition using the purchase method of accounting. Results of Vision Direct’s operations are included in our consolidated statement of operations beginning December 9, 2003. To date, we have incurred total acquisition costs related to Vision Direct of $56.6 million, which include the following (amounts in thousands):

We engaged a third-party appraiser to assist management in performing a valuation of intangible assets acquired in the transaction. Based on the results of this valuation, we allocated a total of $11.3 million to intangible assets, which consists of $5.6 million for Vision Direct’s trade name and trademarks, $3.5 million for an installed customer base, $1.0 million for non-compete agreements and $1.2 million for Vision Direct’s agreement with Vistakon, a division of Johnson & Johnson Vision Care, Inc. The identifiable intangible assets have been recorded with useful lives ranging from two to three years. The excess of capitalizable costs over the fair values of all identifiable assets acquired amounts to $44.7 million of goodwill as of December 28, 2003.

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Amounts included in other transaction costs include severance paid to Vision Direct employees to whom we did not offer continuing employment following the acquisition, legal, accounting and other professional fees. Further adjustments to the Vision Direct purchase price are possible based on resolution of contingencies. Any such further costs will increase the value of goodwill identified on the face of our condensed consolidated balance sheet.

The following table presents the amounts assigned to each major asset and liability category as a result of the Vision Direct acquisition, as of December 8, 2003 (amounts in thousands):

Acumins, Inc.

On August 12, 2003, we acquired all of the outstanding shares of Acumins, Inc. and all of Acumins’ existing assets and liabilities, including a patent for diagnosis and interpretation methods and apparatus for a personal nutrition program. No other assets or liabilities of significant value resulted from the acquisition. In connection with the acquisition, we issued 100,000 shares of our common stock having an aggregate fair value of $496,000. The fair value was determined using a six-day average of the closing prices of our common stock on the two days prior to, the day of, and the three days following the date of the acquisition. We have accounted for this acquisition as an addition to intangible patents, and will amortize the patent over its useful life.

Custom Nutrition Services

On April 28, 2003, we acquired Concept Development, LLC, conducting business under the name Custom Nutrition Services, a privately held company providing personalized nutrition services to consumers. Under the terms of the acquisition agreement, we acquired CNS for $4.3 million in aggregate consideration, comprised of $1.5 million in cash, 635,593 shares of our common stock having an aggregate fair value of $2.5 million (45,000 shares of which we later recovered from escrow), and related transaction costs. The value of the common stock issued in connection with the transaction was determined using the six-day average of the closing prices of our common stock on the two days prior to, the day of, and the three days following April 29, 2003, the date on which we announced the acquisition. These shares were held in escrow for the duration of a contingency period that expired in December 2003. The acquisition agreement also provides for the payment by drugstore.com of additional purchase consideration of up to $10 million, payable over three years from the date of the acquisition, based on the future attainment of specific performance targets by the CNS business. To date, no amounts have been paid to the sellers of the CNS business under this earn-out provision.

In accordance with the requirements of SFAS 141, we accounted for this acquisition using the purchase method of accounting. Results of CNS’s operations are included in our consolidated statement of operations beginning April 29, 2003. To date, we have incurred total acquisition costs related to the CNS transaction of $4.3 million, which include the following (amounts in thousands):

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We engaged a third-party appraiser to assist management in performing a valuation of intangible assets acquired in the transaction. Based on the results of this valuation, we allocated a total of $3.3 million to intangible assets, which consists of $3.2 million in contract-based intangibles and $130,000 for a technology-based intangible asset. The identifiable intangible assets have been recorded with useful lives ranging from four to five years. The excess of capitalizable costs over the fair values of all identifiable assets acquired amounts to $2.7 million of goodwill as of December 28, 2003.

Amounts included in other transaction costs include severance paid to CNS employees to whom we did not offer continuing employment following the acquisition, legal, accounting and other professional fees, and contract and lease buyouts relating to assets that will no longer be utilized for the operation of the business. During the quarter ended September 28, 2003, goodwill decreased by $171,000 based primarily on the favorable settlement of CNS lease liabilities. During the quarter ended December 28, 2003, we settled additional liabilities that resulted in our recovery of 45,000 shares of our common stock from the CNS escrow, which reduced goodwill by $223,000. Further adjustments to the purchase price are possible, based on the resolution of certain remaining liabilities from existing CNS contracts. Any such further costs will increase the value of goodwill that is identified on the face of our condensed consolidated balance sheet.

The following table presents the amounts assigned to each major asset and liability category as a result of the CNS acquisition, as of April 28, 2003 (amounts in thousands):

Results of Operations

Net Sales

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Net sales includes gross revenues from sales of product and related shipping fees, net of discounts and provision for sales returns, third-party reimbursement and other allowances. Net sales also include consignment services fees earned from our GNC arrangement, under which we do not take title to the inventory and cannot establish pricing. Consignment service fees are booked on a net basis and constitute less than 2% of total net sales in each year presented. Orders are billed to the customer’s credit card or, in the case of prescriptions covered by insurance, billed to third parties. Sales of pharmaceutical products covered by third parties are recorded at the net amount to be received.

Total net sales, and net sales in each segment, increased in 2003, 2002 and 2001 as a result of increased order volume and growth in average net revenue per order. The total number of orders grew year over year, as a result of new customer acquisition and increases in repeat orders from existing customers. Average net sales per order increased by 7% to $74 in 2003, from $69 in 2002 and $64 in 2001, as a result of customers purchasing an increasing number of items per order.

Our net sales in the mail-order pharmacy segment were $49.2 million in 2003, $46.2 million in 2002, and $41.8 million in 2001. The total number of orders in 2003 in this segment remained relatively flat compared to 2002 and 2001. We are transitioning our growth strategy in this segment from marketing to individuals to focusing on groups of customers as we develop more PBM fulfillment relationships. Average net sales per order increased during 2003 as a result of a greater number of customers purchasing 90-day supplies.

Our net sales in the local pick-up pharmacy segment were $85.1 million in 2003, $67.4 million in 2002, and $36.4 million in 2001. The number of orders in this segment in 2003 grew by 17% to 885,000, compared to 756,000 in 2002 and 425,000 in 2001, due to direct marketing campaigns that resulted in additional customers taking advantage of the local pick-up option at Rite Aid stores. Average net sales per order grew each year as a result of increases in the average number of prescriptions per order and the average price per prescription.

Our net sales in the OTC segment were $109.2 million in 2003, $80.3 million in 2002, and $67.1 million in 2001. The number of orders in this segment in 2003 grew by 20% to 2.0 million, compared to 1.6 million in 2002 and 1.3 million in 2001, as a result of an increase in the number of new customers acquired and a growing volume of repeat orders from our customer base. Average net sales per order increased in 2003 and 2002 as a result of an increase in the average number of items per order and an increase in the average price per item. We believe that our promotional offers, such as free shipping on non-prescription orders of $49 or more, are supporting the growth in both average number of items per order and price per item sold.

Our net sales in the vision segment for the three-week period in December 2003 were $2.3 million. We acquired Vision Direct on December 8, 2003.

Repeat orders continue to increase in both absolute dollars and as a percentage of total orders as we continued to focus our marketing efforts on acquiring high-value customers. These efforts were supported by our anchor loyalty programs of Everyday Free Shipping, drugstore.com Dollars and Diamond Deals. Our total customer base increased to approximately 4.8 million customers at the end of 2003, compared to 3.2 million in 2002 and 2.4 million in 2001. This increase was due to our continued customer acquisition efforts and to the addition of approximately 600,000 Vision Direct customers who were not already drugstore.com customers.

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Cost of Sales

Total cost of sales increased in absolute dollars in 2003, 2002 and 2001 as a result of growth in net sales and increased order volume over the same periods. Cost of sales as a percentage of net sales decreased primarily as a result of the addition of higher-margin OTC items and a higher mix of total OTC orders in relation to total mail-order pharmacy and local pick-up pharmacy orders.

Cost of sales in our mail-order pharmacy segment was $40.5 million in 2003, $38.6 million in 2002 and $36.7 million in 2001. Cost of sales in our local pick-up pharmacy segment was $77.3 million in 2003, $60.8 million in 2002 and $32.6 million in 2001. We maintain and improve our product margin in the pharmacy segments through the sale of generic pharmaceutical products, which generally saves the customer money and reduces our product costs. We emphasize to our customer the cost savings of choosing to buy generic drugs and alert our customers to the anticipated release of new generic alternatives to the brand drugs they may be currently purchasing.

Cost of sales in our OTC segment was $76.2 million in 2003, $56.2 million in 2002 and $51.4 million in 2001. We continue to improve product margins in the OTC segment through a more favorable mix of product sales that include higher-margin items in specialty, seasonal and prestige beauty merchandise and customized nutritional supplements.

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

Cost of sales in our vision segment was $1.5 million for the last three weeks of 2003. Vision Direct charges a standard shipping charge on all orders under $99, which provides a benefit to overall gross margin.

Fulfillment and Order Processing Expense

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

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related to equipment and fixtures in our distribution center and call center facilities. The impact of vision operations on overall expense in 2003 was nominal because we acquired Vision Direct in the last month of the year.

Fulfillment and order processing expenses increased in absolute dollars in 2003 as a result of larger order volumes. Fulfillment and order processing expenses as a percentage of net sales declined in 2003, 2002 and 2001 as greater volumes resulted in improved utilization of our primary distribution center.

Marketing and Sales Expense

Marketing and sales expenses include advertising and marketing expenses, promotional expenditures and payroll and related expenses for personnel engaged in marketing and merchandising activities. Advertising expenses include various advertising contracts, including the expense associated with our marketing agreement with Amazon.com (which was terminated in September 2003). We recognized $1.1 million in 2003, $9.1 million in 2002 and $19.0 million in 2001 in marketing and sales expense related to our marketing agreement with Amazon.com.

Marketing and sales expenses decreased both in absolute dollars and as a percentage of net sales in each of 2003 and 2002 as we replaced higher-cost legacy portal contracts with lower-cost pay-for-performance contracts in more economical channels, such as search engines. Decreases in 2002 also resulted from a decrease in television and radio advertising, promotional activities and agency and production costs. The decrease in marketing and sales expenses is also attributable to a decrease in employee-related expenses. Marketing and sales expense per new customer has decreased significantly to $18 in 2003 from $28 in 2002 and $50 in 2001.

Technology and Content Expense

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

Technology and content expenses decreased both in absolute dollars and as a percentage of sales in each of 2003 and 2002 primarily due to $480,000 of Web site development costs capitalized in 2003, as well as to reductions in headcount and related expenses and in depreciation expense on Web servers and other equipment. These decreases also resulted from a continued decrease in the use of consultants and contract workers, who previously performed minor upgrades, enhancements and maintenance procedures to our Web store that are increasingly being performed by our own employees.

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General and Administrative Expense

General and administrative expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, professional service expenses, travel and other general corporate expenses. General and administrative expenses remained relatively flat as a percentage of net sales in 2003 and decreased in 2002 as a result of our fixed corporate infrastructure costs being spread over more net sales.

Impairment and Restructuring Charges

No impairment or restructuring charges were incurred in 2003. The charges in 2002 related to the write-off of prepaid cable television advertising rights. The charges for 2001 included a write down of $169.9 million in intangible assets recorded in connection with the Rite Aid and GNC strategic agreements that were executed in 1999 and an $8.5 million restructuring charge relating to the cancellation of a lease for corporate office space and write-off of related leasehold improvements and equipment.

Amortization of Intangible Assets

Amortization of intangible assets includes the amortization expense associated with the following:

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 2002. In addition, at the beginning of 2002, and as a result of implementing SFAS 142, amortization expense was further reduced because the goodwill associated with the acquisition of Beauty.com is no longer being amortized.

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Stock-based Compensation

We record deferred stock-based compensation in connection with stock options granted below market value on the date of grant to our employees in all operating expense categories. The deferred stock-based compensation amounts represent the difference between the exercise price of stock option grants and the fair value of our common stock at the time of such grants. Such amounts are amortized to expense over the vesting periods of the options granted using the multiple-option approach.

In 2003, stock-based compensation included $1.3 million resulting from modification of certain stock options for terminated employees.

As of December 28, 2003, deferred stock-based compensation for stock options issued to our employees will be subsequently recognized as expense, subject to continuing employment, for each of the next four fiscal years, when amortization of deferred stock compensation will be complete on all existing grants, as follows:

Interest Income and Expense

Interest income consists of earnings on our cash, cash equivalents and marketable securities, and interest expense consists of interest associated with capital lease obligations. Net interest income decreased during both 2003 and 2002 as a result of decreases in interest rates over the course of both years as well as our decreasing cash, cash equivalents and marketable securities balances.

Cumulative Effect of Changes in Accounting Principles and Extraordinary Gain on Renegotiation of Equity Guarantee

On December 31, 2001 (the beginning of our fiscal year 2002), we adopted SFAS 142. Based on the analysis required pursuant to SFAS 142, we determined impairment of goodwill recorded in association with the acquisition of Beauty.com and recorded an $8.9 million impairment charge as a cumulative effect of change in accounting principle in the first quarter of 2002.

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