Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 26, 2004

or

For the transition period from              to             

Commission File Number 000-26137

drugstore.com, inc.

(Exact name of registrant as specified in its charter)

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

(Address of principal executive offices including zip code)

(425) 372-3200

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨ .

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

As of October 29, 2004, the registrant had 80,720,214 shares of common stock outstanding.

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DRUGSTORE.COM, INC.

FORM 10-Q

For the three- and nine-months ended September 26, 2004

INDEX

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PART I—FINANCIAL INFORMATION

 
Item 1. Financial Statements

 
DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of the Business

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

All customer orders are processed through our Web stores or via telephone through our toll-free telephone numbers, 1-800-DRUGSTORE and 1-800-VISIONDIRECT. We operate two distribution centers, one approximately 290,000 square foot facility that provides fulfillment capabilities for all of our pharmaceutical and non-pharmaceutical orders delivered by mail, and another approximately 17,000 square foot facility that fulfills our vision orders delivered by mail. Under the terms of an agreement with Rite Aid Corporation (“Rite Aid”), customers are also able to order existing drugstore.com ^™ and Rite Aid refill prescriptions for pickup at any Rite Aid store.

2. Basis of Presentation

The accompanying condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States (“GAAP”) and the rules and regulations of the Securities and Exchange Commission (the “SEC”). These condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the SEC for interim financial reporting. These condensed consolidated financial statements are unaudited and, in our opinion, include all adjustments, consisting of normal recurring adjustments and accruals, necessary for a fair presentation of the condensed consolidated balance sheets, statements of operating results, and statements of cash flows for the periods presented. Operating results for the periods presented are not necessarily indicative of the results that may be expected for the fiscal year ending January 2, 2005 or any other interim period due to seasonal and other factors. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted in accordance with the rules and regulations of the SEC. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our annual report on Form 10-K for the fiscal year ended December 28, 2003.

Principles of Consolidation

The condensed consolidated financial statements include the accounts of drugstore.com, inc. and our subsidiaries. All material intercompany transactions and balances have been eliminated.

Use of Estimates

The preparation of financial statements in conformity with GAAP 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 condensed consolidated financial statements and accompanying notes. Estimates are used for, among other things, inventory valuation, depreciable lives, sales returns, customer discount programs, receivables valuation, valuation of goodwill and other intangible assets, and contingencies. Actual results could differ materially from those estimates.

Employee Stock Purchase Plan

During the nine months ended September 26, 2004, employees enrolled in our employee stock purchase plan purchased our common stock on two purchase dates. An aggregate of 85,569 shares were purchased, with total proceeds to us of approximately $297,000.

Comprehensive Loss

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

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Reclassifications

Certain prior period amounts have been reclassified to conform to the current period presentation, with no effect on our financial position, cash flows or net income.

3. Goodwill

The following table summarizes the changes in goodwill, by business segment, at September 26, 2004 and December 28, 2003:

Goodwill in our over-the-counter (“OTC”) segment includes the goodwill related to the acquisitions of CNS and Beauty.com, Inc. Goodwill in our vision segment represents the goodwill related to the acquisition of Vision Direct.

During the three- and nine-month periods ended September 26, 2004, we recorded estimated impairment charges of $23.2 million to goodwill, as described below, and $3.3 million to other intangible assets (see Note 4). During the three- and nine-month periods ended September 28, 2003, we recorded no impairment charges.

As part of our quarterly review of financial results for the third quarter of fiscal 2004, we noted indicators that the carrying value of goodwill and other intangible assets related to the acquisition of Vision Direct might not be recoverable, which resulted in an impairment review. We performed the impairment review because of lower-than-expected sales growth partially attributable to challenges addressing February 2004 federal legislation and August 2004 Federal Trade Commission regulations relating to contact lens prescription access and verification and an increasingly competitive contact lens marketplace. We evaluated the recoverability of goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets.

Under the first step of the goodwill impairment analysis, we determined the fair value of the vision segment using a combination of the income approach, which estimates the fair value based on the future discounted cash flows, and the market approach, which estimates the fair value based on comparable market prices. Based on the first step analysis, we determined that the carrying amount of our vision segment was in excess of its fair value. Therefore, we were required to perform the second-step analysis on the vision segment to determine the amount of the impairment loss, if any. As of the time of filing of this quarterly report, we have not completed the second step analysis due to the complexities involved in determining the implied fair value of the goodwill of the vision segment. However, we have determined that an impairment loss is probable and could be reasonably estimated. Therefore, as permitted by SFAS 142, we recorded for the third quarter of fiscal 2004 an estimated impairment charge of $23.2 million to reduce the carrying value of goodwill.

The actual impairment charges may be higher or lower than the estimated charges we have recorded. During the fourth quarter of fiscal 2004, we will complete the second-step analysis of the impairment review and record any resulting increase or decrease in the impairment charges.

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4. Other Intangible Assets

The other intangible assets balances as of September 26, 2004 and December 28, 2003 were as follows:

5. Net Loss Per Share

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

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

Outstanding stock options and warrants to acquire 13,460,470 common shares as of September 26, 2004 and 15,591,995 common shares as of September 28, 2003 were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive. If we had reported net income, the calculation of per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method. Included in the stock options and warrants outstanding as of September 26, 2004 and September 28, 2003 is a warrant to purchase 500,000 shares of common stock that was issued in June 2000 to a subsidiary of CIGNA Corporation, at $7.76 per share, as part of a joint marketing agreement. The warrant and the joint marketing agreement will terminate in June 2005.

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6. Strategic Agreements

Rite Aid and General Nutrition Corporation

In July 1999, we consummated a series of agreements with Rite Aid and General Nutrition Corporation (“GNC”) to issue 12,282,599 shares of our Series E preferred stock in exchange for an aggregate of $10.0 million in cash and other consideration, including access to insurance coverage, advertising commitments and a vendor agreement with an estimated fair value of $233.9 million. The $233.9 million noncash portion of the consideration from the Rite Aid and GNC agreements was allocated to the following components based on a valuation obtained from an independent valuation expert (in millions):

Under our 10-year agreement with Rite Aid, customers are able to order refills of their existing Rite Aid or drugstore.com prescriptions using our Web site, and may choose to receive that prescription using our mail-order delivery service or pick up their prescription at any of Rite Aid’s approximately 3,400 stores nationwide. In addition to offering multi-channel delivery options, Rite Aid and drugstore.com agreed to promote each other’s services both online and offline. We also received the benefit of many of Rite Aid’s insurance and pharmacy benefit manager relationships and are able to buy prescription products through Rite Aid, taking advantage of its buying power. We also sell Rite Aid private label OTC products on the drugstore.com Web site.

We also entered into a 10-year agreement with GNC under which we have the right to be the exclusive online provider of GNC-branded products 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.

The access to insurance coverage and the vendor agreement were written off in 2002, and the advertising commitments have been classified within prepaid marketing expenses. The remaining prepaid marketing asset is being amortized on a straight-line basis over its contractual life of 10 years.

Amazon.com

In August 1998, we entered into a technology license and advertising agreement with Amazon.com, Inc. 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.

Effective September 19, 2003, we entered into an e-commerce agreement with Amazon.com. Under this agreement, which was amended in June 2004, 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, in exchange for a fulfillment fee and an agreed-upon product price. This agreement replaced our prior marketing agreement with Amazon.com. The initial term of this agreement ends in April 2007. The fees and product revenue generated by our agreement with Amazon.com, which are recorded as gross revenue in our OTC segment, totaled $3.6 million and $9.5 million, respectively, for the three- and nine-month periods ended September 26, 2004 and $0 for the three- and nine-month periods ended September 28, 2003.

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7. Stock-Based Compensation

The following table summarizes activity under our 1998 Stock Plan:

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

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

Under APB 25, no compensation expense is recognized when the exercise price of our employee stock options equals the fair value of the underlying stock on the date of grant. Deferred stock-based compensation is recorded when the exercise price of an option is lower than the fair value for financial reporting purposes of the underlying common stock. For the three-month periods ended September 26, 2004 and September 28, 2003, we recorded aggregate deferred stock-based compensation of $76,000 and $186,000. For the nine-month periods ended September 26, 2004 and September 28, 2003, we recorded aggregate deferred stock-based compensation of $76,000 and $461,000. This deferred stock-based compensation is being amortized over the vesting period of the underlying options using the multiple-option approach. For the three-month periods ended September 26, 2004 and September 28, 2003, we recognized amortization of stock-based compensation of $56,000 and $1.5 million, which includes the impact of modification of certain option grants for terminated employees. In those same periods, we reversed $0 and $27,000, respectively, of deferred stock-based compensation as a result of employee terminations. For the nine-month periods ended September 26, 2004 and September 28, 2003, we recognized amortization of stock-based compensation of $615,000 and $1.7 million, which includes the impact of modification of certain option grants for terminated employees. In those same periods, we reversed $407,000 and $49,000, respectively, of deferred stock-based compensation as a result of employee terminations.

If the stock-based compensation for our 1998 Stock Plan had been determined based on the fair value method, as promulgated by SFAS 123, our net loss would have been adjusted to the following amounts for the three- and nine-month periods ended September 26, 2004 and September 28, 2003:

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

On March 31, 2004, the Financial Accounting Standards Board issued an exposure draft, Share-Based Payment - An Amendment of FASB Statements No. 123 and 95 (“proposed FAS 123R”). The proposed FAS 123R addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The proposed FAS 123R would eliminate the ability to account for stock-based compensation transactions using APB 25, and generally would require instead that such transactions be accounted for using a fair-value based method. As proposed, companies would be required to recognize an expense for compensation cost related to stock-based payment arrangements, including stock options and employee stock purchase plans. The FASB expects to issue a final standard by December 31, 2004. Proposed FAS 123R currently is expected to be effective for public companies for periods beginning after June 15, 2005. We would be required to implement proposed FAS 123R no later than the fiscal quarter that begins July 4, 2005. The cumulative effect of adoption of proposed FAS 123R, if any, applied on a modified prospective basis, would be measured and recognized on July 4, 2005. We are currently evaluating option valuation methodologies and assumptions related to employee stock options. Current estimates of option values using the Black-Scholes method may not be indicative of results from valuation methodologies ultimately adopted in the final rules.

8. Commitments and Contingencies

Commitments

In February 2005, we will be moving our corporate headquarters to a new location in Bellevue, Washington. On August 16, 2004, we entered into a new operating lease for approximately 53,000 square feet for our new corporate headquarters. The new lease, which expires on July 31, 2013, commences on the later of February 1, 2005 or the date on which the new landlord tenders possession of the premises with agreed-upon tenant improvements substantially completed. Under the terms of the new lease, our new landlord assumed the operating lease for our existing office space and entered into a new sublease agreement with us for the sublease of our existing office space. We will sublease our existing office space from the new landlord until February 2005, when we plan to occupy our new office space. In connection with the new lease, we received landlord-provided incentives in the form of tenant improvements of approximately $2.3 million, which have been recorded as additions to fixed assets and other current liabilities and will be paid over the term of the lease. In addition, we received approximately $100,000 from the new landlord for amounts related to the rental rate differential arising from the difference in our existing lease rate and our new lease rate during the three months we negotiated the lease with the new landlord. In connection with our new lease arrangements, we were required to provide two standby letters of credit as security deposits. The letters of credit were issued in the amounts of approximately $500,000 in July 2004 and approximately $600,000 in October 2004. To date no portion of either letter of credit has been utilized.

Our new contractual obligations for operating leases are as follows:

Legal Proceedings

Class Action Laddering Litigation . On and after July 6, 2001, eight stockholder class action lawsuits were filed in the United States District Court for the Southern District of New York naming drugstore.com as a defendant, along with the underwriters and certain of our present and former officers and directors (the “Individual Defendants”), in connection with our July 27, 1999 initial public offering and March 15, 2000 secondary offering (together, the “Offerings”). The complaints against drugstore.com have been consolidated into a single action and a Consolidated Amended Complaint, which is now the operative complaint, was filed on April 19, 2002. The suit purports to be a class action filed on behalf of purchasers of our common stock during the period July 28, 1999 to December 6, 2000. In general, the complaint alleges that the prospectuses through which we conducted the Offerings were materially false and misleading for failure to disclose, among other things, that (i) the underwriters of the Offerings allegedly had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those

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investors material portions of the restricted number of shares issued in connection with the Offerings and (ii) the underwriters allegedly entered into agreements with customers whereby the underwriters agreed to allocate drugstore.com shares to customers in the Offerings in exchange for which customers agreed to purchase additional drugstore.com shares in the after-market at predetermined prices. The complaint asserts violations of various sections of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. The action seeks damages in an unspecified amount and other relief. The action is being coordinated with approximately 300 other nearly identical actions filed against other companies or their former officers and directors. On July 15, 2002, we moved to dismiss all claims against us and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based on stipulations of dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against drugstore.com.

We have approved a settlement agreement and related agreements, which set forth the terms of a settlement between drugstore.com, the plaintiff class and the vast majority of the other issuer defendants or, in the case of bankrupt issuers, their directors and officers. Among other provisions, the settlement agreement provides for a release of drugstore.com and the Individual Defendants for the conduct alleged in the action to be wrongful. We would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims we may have against our underwriters. The settlement agreement also provides a guaranteed recovery of $1 billion to the plaintiffs for the cases relating to all of the approximately 300 issuers. To the extent that the underwriter defendants settle all of the cases for at least $1 billion, no payment will be required under the issuers’ settlement agreement. To the extent that the underwriter defendants settle for less than $1 billion, the issuers are required to make up the difference. We have no information as to whether there are any material limitations on the expected recovery by other issuer defendants of any potential financial obligation to plaintiffs from the insurance carriers of those issuer defendants. Assuming there are no such material limitations, our maximum financial obligation to the plaintiffs pursuant to the settlement agreement is less than $3.4 million. We anticipate that any potential financial obligation of drugstore.com to the plaintiffs pursuant to the terms of the settlement agreement and related agreements will be covered by existing insurance, and we have already satisfied our deductible. We are currently not aware of any material limitations from our insurance carriers on the expected recovery of any potential financial obligation to the plaintiffs. Our carriers are solvent and we are not aware of any uncertainties as to the legal sufficiency of an insurance claim with respect to any recovery by the plaintiffs. Therefore, we do not expect that the settlement will involve any payment by drugstore.com.

The settlement agreement has been submitted to the Court for approval. Approval by the Court cannot be assured and we can give no assurances as to whether or when a settlement will occur or be finalized. We are unable to estimate the potential damages that might be awarded if the settlement were not approved, we were found liable and there arose a material limitation with respect to our insurance coverage. Because our liability, if any, cannot be reasonably estimated, no amounts have been accrued for this matter. An adverse outcome in this matter could have a material adverse affect on our results of operations.

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

On October 12, 2004, we entered into a settlement agreement and mutual release, dated as of October 7, 2004, with AC Lens. The terms of the settlement agreement require us to issue up to 125,330 shares of our common stock to AC Lens, with the total number of shares to be issued subject to adjustment in certain circumstances. Of these 125,330 shares, we have already issued 72,560 shares, which were registered for resale in a registration statement that became effective on October 15, 2004. The remaining shares, if any, will be issued within three trading days after the end of the twenty trading day period following the date of effectiveness of the registration statement. This settlement, which we valued at $475,000, is included in our operating results for the quarter ended September 28, 2004.

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

On February 5, 2004, the District Court granted VDI’s request to adjourn a status conference scheduled for February 6, 2004, pending resolution of the appeals in the 1-800 Contacts litigation involving VDI, which we settled without any material financial obligation to VDI or us on June 24, 2004. The appeal in the 1-800 Contacts litigation is currently under submission to the U.S. Court of Appeals for the Second Circuit. At this time, we are unable to predict the outcome of this litigation. No amounts have been accrued for this matter, as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our financial position and results of operations.

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State Sales Tax Claims. In early 2002, we received an arbitrary assessment notice from the state of New Jersey for past sales tax due from fiscal years 2000 and 2001, based upon its best estimate of sales revenue numbers during those periods. In December 2002, we received a revised assessment from the state of New Jersey for 2000 and 2001 in the amount of $221,626 in tax, plus penalties in the amount of $11,081 and interest that continues to accrue. We do not currently collect and do not believe that we are required to collect New Jersey sales tax. In March 2003, we filed an appeal of the revised assessment with the Tax Court of New Jersey, based on the fact that the state of New Jersey is pursuing its claim specifically against one of our consolidated subsidiaries that is not the retailing entity in that state. The appeal is pending and is in the pre-trial discovery phase. Due to the uncertainty of the appeal, no amounts have been recorded in the accompanying financial statements with respect to the sales tax alleged to be due. If we are unsuccessful in our appeal, the state of New Jersey may expand its assessment to include other years for which we did not collect sales tax. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. However, the ultimate outcome of this matter could result in substantial tax liabilities for our past sales and have a material adverse affect on our financial position and results of operations.

Federal Securities Action . On and after June 25, 2004, several putative class actions were filed in the United States District Court for the Western District of Washington against drugstore.com and certain of its present and former officers for alleged violations of the federal securities laws. The suits purport to have been filed on behalf of purchasers of our common stock between January 14, 2004 and June 10, 2004. The complaints generally allege that the defendants made false and misleading statements about our prospects for fiscal year 2004 and failed to disclose, among other things, (i) a negative impact on our gross margins from the integration of our acquisition of Vision Direct and from our free 3-day shipping promotion, and (ii) a negative impact on our sales growth arising from cancellations of certain expired prescriptions. On October 8, 2004, the Court issued an order consolidating the individual actions. Motions for lead plaintiff are pending. No amounts have been accrued for this matter, as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse effect on our financial position and results of operations.

Stockholder Derivative Action . On August 4, 2004, two stockholder derivative actions were filed by plaintiffs Gerald Rusk and George Zimmer in the Superior Court of the state of Washington, King County, against certain of our present and former officers and directors for alleged breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. These actions seek damages from the defendants on behalf of drugstore.com, which is a nominal defendant in the actions. The complaints allege that the defendants issued or authorized false and misleading information and that certain of the defendants sold shares of drugstore.com stock at artificially inflated prices. The allegations are based on those in the putative federal securities class action described above. The defendants intend to move to stay proceedings pending further developments in the federal securities action.

Although the stockholder derivative complaints do not seek financial relief directly against drugstore.com, the litigation could have financial consequences for us through, for example, the attorneys’ fees we incur and advances to the defendants and, if appropriate under the circumstances, indemnification of the defendants. No amounts have been accrued for this matter, as our liability, if any, cannot be reasonably estimated. An adverse outcome in this matter could have a material adverse effect on our financial position and results of operations.

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

10. Segment Information

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

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