Quarterly Report

The following discussion and analysis should be read in conjunction with the financial statements and accompanying notes included elsewhere in this quarterly report and in our annual report on Form 10-K for the fiscal year ended January 1, 2006.

Special Note Regarding Forward-Looking Statements

This quarterly report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All statements made in this quarterly report other than statements of historical fact, including statements regarding our future financial and operational performance, sources of liquidity and future liquidity needs, are forward-looking. Words such as “targets,” “expects,” “believes,” “anticipates,” “intends,” “may,” “will,” “plan,” “forecast,” “continue,” “remain,” “would,” “should,” and similar expressions, are intended to identify forward-looking statements. Forward-looking statements are based on current expectations, and are not guarantees of future performance and involve assumptions, risks, and uncertainties. Actual performance may differ materially from those contained or implied in such forward-looking statements. Risks and uncertainties that could lead to such differences could include, among other things: effects of changes in the economy, changes in consumer spending, fluctuations in the stock market, changes affecting the Internet, online retailing and advertising, difficulties establishing our brand and building a critical mass of customers, the unpredictability of future revenues and expenses and potential fluctuations in revenues and operating results, risks related to business combinations and strategic alliances, possible tax liabilities relating to the collection of sales tax, consumer trends, the level of competition, seasonality, the timing and success of expansion efforts, changes in senior management, risks related to systems interruptions, possible governmental regulation and the ability to manage a growing business. These factors described in this paragraph and other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are discussed in the sections entitled “Risk Factors ” in Part II, Item 1A of this quarterly report and Part I, Item 1A of our annual report on Form 10-K for the fiscal year ended January 1, 2006. A forward-looking statement should not be relied upon as representing our views as of any date other than the date on which we made the statement. We do not intend to update any forward-looking statement after the date on which we make it.

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision and pharmacy products. We believe that we offer a better way for consumers to shop for these products through our web stores, including those located on the Internet at www.drugstore.com, www.beauty.com, www.visiondirect.com, www.lensmart.com and www.lensquest.com .

Business Segments; Growth Strategies. We operate our business in four business segments: over-the-counter, or OTC, mail-order pharmacy, local pick-up pharmacy, and vision.

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Revenues . We generate revenue primarily from product sales and shipping fees. For the three-month period ended April 2, 2006, we reported consolidated total net sales of $104.1 million, which reflected a $4.5 million, or 5%, increase over the three-month period ended April 3, 2005. Our net sales growth was driven by a 4% year-over-year increase in our total order volume, to over 1.3 million orders, and our average net sales per order remained consistent at $77. Our revenues benefited from strong growth in our OTC segment, which grew by 10% over the first quarter of 2005; our core OTC net sales and order volume (excluding wholesale and CNS) grew by 21% and 23%, respectively. Our net sales in our vision segment increased year-over-year by $455,000, or 4%, and our net sales in our mail-order pharmacy segment increased by $347,000, or 2%. These increases were partially offset by a year-over-year decrease in local pick-up pharmacy net sales of $763,000, or 3%.

Expenses . Our operating expenses, including cost of goods sold, increased slightly as a percentage of net sales to 106% in the three-month period ended April 2, 2006, from 105% in the three-month period ended April 3, 2005. The increase resulted from an increase in marketing expenses, primarily from our brand campaign costs of $1.8 million, or 2% of net sales, incurred in the first quarter of 2006, and increased technology costs. Despite the increase in operating expenses, our cost of goods sold decreased as a percentage of net sales year-over-year, reflecting both a favorable shift in our product mix and significant improvement in OTC margins due to the success of operating initiatives undertaken to improve OTC profitability. In addition, our fulfillment and general and administrative costs declined year-over-year. During the first quarter of 2006, we adopted the provisions of Financial Accounting Standards Board Statement No. 123 (revised 2004), Share-Based Payment , or FAS 123R, which requires the recognition of the fair value of stock-based compensation. Under the fair value recognition provisions of FAS 123R, stock-based compensation cost is estimated at the grant date based on the fair value of the awards expected to vest and recognized as expense ratably over the requisite service period of the award. As a result of the adoption of FAS 123R, we recognized $855,000, or 1% of net sales, of additional stock-based compensation in the first quarter of 2006, compared to the first quarter of 2005.

Net Loss; Cash Position . Our net loss for the three-month period ended April 2, 2006 increased by 6%, or $299,000, to $5.3 million, compared to $5.0 million for the three-month period ended April 3, 2005. We ended the first quarter of 2006 with $41.9 million in cash, cash equivalents and marketable securities, compared to $46.5 million at January 1, 2006 and $57.5 million at April 3, 2005. This balance reflects the use in the first quarter of 2006 of $2.9 million to fund operating activities, $1.4 million for capital expenditures, and $585,000 to repay debt obligations, offset by proceeds received of $251,000 from the exercise of employee stock options and purchases under our employee stock purchase plan.

Significant Accounting Judgments

The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 Securities and Exchange Commission, or SEC, has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s

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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 I of our annual report on Form 10-K for the fiscal year ended January 1, 2006. 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

We recognize revenues in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition.

Revenues from sales of OTC (other than Weil-related CNS sales, as described below), mail-order pharmacy, and vision products are recorded net of promotional discounts, cancellations, rebates and returns allowances. Revenue is recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the selling price or fee earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. We generally require payment by credit card at the point of sale. Return allowances, which reduce product sales by our estimate of expected product returns, are estimated using historical experience. Historically, product returns, and differences between our estimates and actual returns, have not been significant.

Revenues from sales of customized vitamins sold through our fulfillment agreement with Weil are recognized when products are shipped and title passes to the customer. In accordance with 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 generated by the Weil agreement in our OTC segment on a net basis, because we act as an agent, based on the fact that we earn a fixed dollar amount per customer transaction regardless of the amount billed to the customer and we do not bear general inventory risk associated with these sales. Non-Weil customized vitamin sales are recognized on a gross basis, net of promotional discounts, cancellations, rebates and returns allowances. (Before we entered into the new fulfillment agreement with Weil on December 31, 2005, we also recognized Weil customized vitamin sales on a gross basis, net of promotional discounts, cancellations, rebates and returns allowances.) Net sales in our OTC segment also include consignment service fees earned under our agreement with General Nutrition Corporation, or GNC, which are also recorded on a net basis, because we do not take title to the inventory and do not establish pricing.

Revenues from sales of OTC products ordered through the Amazon.com website and fulfilled by drugstore.com were recognized when we shipped the products from our distribution center. In accordance with EITF 99-19, we recorded fulfillment fees and revenues generated by the Amazon.com agreement in our OTC segment on a gross basis, because we believe we acted as a principal, based on the fact that we bore general inventory risk associated with these sales. Effective November 9, 2005, we terminated our agreement with Amazon.com. Neither party has any material obligations following termination.

Revenues from sales of prescription products ordered online or by telephone through the drugstore.com web store or the RiteAid.com web store (which is powered by the drugstore.com web store) for pick-up at a Rite Aid store, including co-payments received and collected on our behalf by Rite Aid, are recognized when the customer picks up the product. In these circumstances, we utilize Rite Aid as our fulfillment partner. In accordance with 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 inventory risk and credit and collection risk associated with these sales.

For insured prescriptions in both our local pick-up and mail-order segments, the co-payment and the insurance reimbursement (which together make up the amount due to drugstore.com) constitute the full value of the prescription drug sale, and we receive this entire amount as cash. We therefore recognize the entire amount as revenue when the order is shipped to the customer (for mail order prescriptions) or picked up by the customer (for local pick-up prescriptions).

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

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Inventories

We value our inventories at the lower of cost (using the weighted-average cost method) or the current estimated market value. We regularly review inventory quantities on hand and adjust our inventories 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 websites, 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 could understate or overstate the provision required for excess and obsolete inventory. Historically, inventory reserves have not differed materially from our estimates.

Goodwill and Other Intangible Assets

In accordance with Statement of Financial Accounting Standards No. 142, Accounting for Goodwill and Other Intangibles , or FAS 142, 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 occur. The first phase of the test screens for impairment. If impairment is determined, the second phase measures the amount of impairment by comparing the fair value of the applicable reporting unit to its carrying value. Fair value is determined using either a discounted cash flow methodology or methodology based on comparable market prices.

We review our indefinite-lived intangible assets, other than goodwill, for impairment when indicators of impairment occur and annually at the beginning of the fourth quarter. We compare the carrying value of the asset to its estimated fair value and record an impairment charge when the carrying value of the asset exceeds the estimated fair value.

In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets , or FAS 144, we review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment occurs. When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. The determination of whether impairment exists is based on any excess of the carrying value over the expected future cash flows, as estimated through undiscounted cash flows, excluding interest charges. We measure any resulting impairment charge based on the difference between the carrying value of the asset and its fair value, as estimated through expected future discounted cash flows, discounted at a rate of return for an alternate investment.

If our estimates of revenue growth or future cash flows prove to be inaccurate, we may have a future impairment of goodwill, other intangible assets or long-lived assets.

Stock-Based Compensation

Effective January 2, 2006, we adopted the fair value recognition provisions of FAS 123R using the modified-prospective-transition method, which requires measurement of compensation cost for all stock-based awards at fair value on the date of grant and recognition of compensation over the service period for awards expected to vest. Under the modified-prospective-transition method, compensation cost recognized includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 2, 2006, which is based on the grant date fair value estimated in accordance with the original provisions of FAS 123, recognized over the vesting period of the underlying options using the multiple-option approach, (b) compensation cost for all share-based payments granted after January 1, 2006, which is based on the grant-date fair value estimated in accordance with the provisions of FAS 123R, recognized over the requisite service period of the award on a straight-line basis, and (c) compensation cost for shares issued under the 1999 ESPP, which is based on the fair value estimated in accordance with the provisions of FAS 123R and is not considered material to our overall financial statements. In accordance with the modified-prospective-transition method, results for the three months ended April 3, 2005 have not been restated to reflect, and do not include, the impact of FAS 123R.

We calculate the fair value of our stock options granted to employees using the Black-Scholes option pricing model using the single option award approach. This fair value is then amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period. Our computation of expected volatility is based on our historical volatility, adjusted for changes in capital structure and corporate changes, information available that may indicate future volatility, and observable mean reversion tendencies of historical volatility. Our computation of expected life is determined using the simplified method outlined by the SEC Staff Accounting Bulletin No. 107, or SAB 107. Under this method, our expected term is equal to the sum of the weighted average vesting term plus the original contractual term divided by two, which results in a six-year expected term. We base the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent remaining term. Where the expected term of our stock-based awards do not correspond with the terms for which interest rates are quoted, we average the periods to determine the rate from the available term maturities. A dividend yield of 0% is considered appropriate as we have not issued and do not anticipate issuing any dividends in the near future. When estimating forfeitures, we consider historical voluntary termination

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behavior in addition to analyzing actual option forfeitures. In conjunction with this analysis, we identified distinct subgroups: non-management employees, management employees, our chief executive officer, board members, and other non-employees. Our forfeiture rate is based on the weighted average termination behavior of our non-management and management employee subgroups, which is approximately 30%, and assumes a rate of 0% for our chief executive officer, board members, and non-employees. Prior to the adoption of FAS 123R, we recognized the impact of forfeitures when they occurred.

Legal Proceedings

We are currently involved in various claims and legal proceedings. Periodically, we review the status of each significant matter and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to our pending claims and legal proceedings and may revise our estimates. Any such revisions in the estimates of the potential liabilities could have a material impact on our future results of operations and financial position. For a description of our material legal proceedings, see Note 7 of our consolidated financial statements, Commitments and Contingencies , included in Part I, Item 1 of this quarterly report.

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 service fees earned from our arrangement with GNC, 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 approximately 1% of total net sales in each period presented. Included in net sales in 2005 are fulfillment fees and product revenue from our wholesale OTC fulfillment agreement with Amazon.com, which was terminated in November 2005. Also included in net sales in 2005 and 2006 are sales of customized nutritional supplements sold through CNS, which effective December 31, 2005, are now primarily recorded on a net basis under our fulfillment agreement with Weil. Orders are billed to the customer’s credit card or, in the case of prescriptions covered by insurance, the co-payment is billed to the customer’s credit card and the remainder of the prescription price is billed to insurance. Sales of pharmaceutical products covered by insurance are recorded as the sum of the amounts received from the customer and the third party. Sales made to Amazon.com under our wholesale OTC fulfillment agreement were billed directly to Amazon.com and recorded at the gross amount received from Amazon.com.

Total net sales increased in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, as a result of a 4% increase in order volume, primarily driven by growth in our OTC segment. Revenues from repeat customers increased to 81% of net sales in the first quarter of 2006, compared to 77% in the first quarter of 2005. Average net revenue per order remained consistent at $77 in both quarters. Compared to the first quarter of 2005, net sales in our OTC segment increased by $4.5 million, or 10%, net sales in our vision segment increased by $455,000, or 4%, and net sales in our mail-order pharmacy segment increased by $347,000, or 2%. Net sales in our local pick-up pharmacy segment decreased by $763,000, or 3%.

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Our net sales in the OTC segment increased by $4.5 million to $49.0 million in the three-month period ended April 2, 2006, compared to $44.5 million in the three-month period ended April 3, 2005, as a result of increases in order volume. Excluding CNS net sales of $683,000 in the first quarter of 2006 and $2.0 million in the first quarter of 2005, and wholesale OTC net sales and fulfillment fees of $2.5 million in the first quarter of 2005, our core OTC net sales increased by 21% year-over-year to $48.3 million. The number of orders in our OTC segment grew by 10% to 870,000 in the first quarter of 2006, compared to 792,000 in the first quarter of 2005, and the average net sales per order remained consistent at $56 in both periods. The number of customer orders includes new and repeat orders made through the drugstore.com website and the websites of our subsidiaries, orders generated through our fulfillment agreement with Weil, and orders generated through our wholesale OTC fulfillment agreement with Amazon.com. The increase in order volume was driven by our increasing active customer base and our continued efforts to improve customer retention and conversion. During the first quarter of 2006, we also performed a review of the pricing and profitability of each OTC product unit, or SKU, which did not result in material price changes in our OTC products individually, but in the aggregate is expected to favorably impact our gross margin.

Our net sales in the mail-order pharmacy segment increased $347,000 to $18.3 million in three-month period ended April 2, 2006, compared to $18.0 million in the three-month period ended April 3, 2005, as a result of year-over-year increases in the average net sales per order. The average net sales per order in this segment increased year-over-year as a result of an increase of approximately 5% in the average price per prescription resulting from higher pharmaceutical costs, and selling a larger proportion of higher-priced brand-name drugs. The number of orders in this segment decreased by 7% to 118,000 in the first quarter of 2006, compared to 127,000 in the first quarter of 2005, as a result of our decision not to participate in the low-margin Medicare Part D prescription drug benefit program offered by the U.S. government.

Local Pick-up Pharmacy Net Sales

Our net sales in the local pick-up pharmacy segment decreased by $763,000 to $24.2 million in the three-month period ended April 2, 2006, compared to $25.0 million in the three-month period ended April 3, 2005. This decrease in net sales reflects a 7% decrease in the number of orders in this segment, to 217,000 compared to 234,000 in the first quarter of 2005. Orders in this segment are driven by Rite Aid through its marketing media, including Rite Aid store receipts, weekly Rite Aid advertising circulars and e-mail refill reminders. The decrease in net sales was partially offset by a $5 year-over-year increase in average net sales per order resulting from increases in the average price per prescription paid by the customer.

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Our net sales in the vision segment increased $455,000 to $12.6 million in the three-month period ended April 2, 2006, compared to $12.1 million in the three-month period ended April 3, 2005, as a result of an increase in the average net sales per order, driven primarily from selling a greater proportion of higher-priced, newer-technology contact lenses, and to a lesser extent, an increase in the average number of items per order and price increases for certain SKUs (none of which were material). The number of orders in this segment decreased slightly to 145,000 in the first quarter of 2006, compared to 148,000 in the first quarter of 2005, as a result of a decrease in orders from new customers.

Customer Data.

Approximately 326,000 new customers placed orders during the three-month period ended April 2, 2006, increasing our total customer base to approximately 7.5 million customers since inception. Orders from repeat customers as a percentage of total orders increased to 74% in the first quarter of 2006, compared to 70% in the first quarter of 2005, as a result of an increase in our trailing 12-month active customer base. The year-over-year increase in orders from repeat customers as a percentage of total orders primarily resulted from improved customer retention and increased order frequency, and to a lesser extent, the inclusion of 84,000 wholesale OTC orders in 2005 compared to no orders in 2006. OTC wholesale orders and Weil-related orders (after December 31, 2005) are included in the number of total orders but are considered neither repeat nor new orders for calculating repeat orders as a percentage of total orders.

Cost of Sales

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving and expired inventory, outbound and inbound shipping costs, and expenses related to promotional inventory included in shipments to customers. Payments that we receive from vendors in connection with volume purchase or rebate allowances are netted against cost of sales.

Total cost of sales increased in absolute dollars in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, as a result of growth in order volume and net sales. Cost of sales as a percentage of net sales decreased year-over-year primarily as a result of lower net shipping costs absorbed by us, a larger proportion of net sales in our OTC segment, which is our highest-margin segment, and improved margins resulting from our operational initiatives, including the review of pricing and profitability of our OTC SKUs.

Our revenues from shipping charges to customers are included in net sales and were $3.4 million in the first quarter of 2006, compared to $2.7 million in the first quarter of 2005. Outbound shipping costs are included in cost of sales and were $5.5 million in the first quarter of 2006, compared to $5.6 million in the first quarter of 2005. As part of our profitability initiatives, we continue to make pricing adjustments to our shipping policies to reduce our shipping costs. Most recently, we eliminated free 3-day shipping on orders of $99 or more, added shipping surcharges for shipments to Alaska, Hawaii, U.S. Territories, and APO/FPO military addresses, increased the upgrade charge for 3-day shipping for customers who qualify for free ground shipping, added a weight-based shipping surcharge for orders over 20 pounds, and signed a new contract with one of our shipping carriers that we anticipate will provide lower rates. We expect to continue to subsidize a portion of customers’ shipping costs for the foreseeable future, through free shipping options, as a strategy to attract and retain customers.

OTC Cost of Sales

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Cost of sales in our OTC segment increased in absolute dollars in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, as a result of increased order volume. Cost of sales as a percentage of net sales in this segment decreased in the first quarter of 2006, compared to the first quarter of 2005, primarily as a result of lower per-order net shipping costs resulting from changes in our shipping policies, and to a lesser extent, improved margins from our operational initiatives, including the review of pricing and profitability of each of our OTC SKUs. As a result of these initiatives, our core OTC gross profit dollars (excluding wholesale OTC and CNS) increased $3.1 million, or 29%, to $13.6 million in the first quarter of 2006, compared to $10.5 million in the first quarter of 2005.

Mail-Order Pharmacy Cost of Sales

Cost of sales in our mail-order pharmacy segment increased in absolute dollars but remained flat as a percentage of net sales in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, as a result of increased per-order product costs and selling a higher proportion of higher-cost, lower-margin brand-name drugs.

Local Pick-up Pharmacy Cost of Sales

Cost of sales in our local pick-up pharmacy segment decreased in absolute dollars in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, as a result of a 7% decrease in order volume. Cost of sales as a percentage of net sales in this segment increased in 2006, compared to 2005, as a result of increased per-order product costs and declining margins resulting from lower contractual reimbursement rates from insurance plans.

Cost of sales in our vision segment increased both in absolute dollars and as a percentage of net sales in the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, primarily as a result of a shift in product mix to sales of higher cost, newer technology contact lenses and increased promotional activity, offset by a slight decline in order volume.

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Fulfillment and order processing expenses include expenses related to 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), distribution center equipment and packaging supplies, per-unit fulfillment fees charged by Rite Aid for prescriptions ordered through the drugstore.com website and picked up at a Rite Aid store, credit card processing fees, and bad debt expenses. These expenses also include rent and depreciation related to equipment and fixtures in our distribution center and call center facilities. Variable fulfillment costs represent the incremental (variable) costs of fulfilling, processing and delivering the order that we believe are variable based on sales volume.

Fulfillment and order processing expenses for the three-month period ended April 2, 2006 were comprised of $7.6 million of variable costs and $2.6 million of fixed costs, compared to $7.6 million of variable costs and $2.7 million of fixed costs for the three-month period ended April 3, 2005. Variable fulfillment and order processing expenses remained flat year-over-year despite a 4% increase in order volume, as increased costs from the greater order volume were offset by lower per-order labor costs. Fixed fulfillment and order processing expenses also remained flat year-over-year primarily as a result of a decrease in depreciation expense of $548,000 for assets fully depreciated during 2005, offset by stock-based compensation expense of $221,000 resulting from the adoption of FAS 123R, and increased personnel costs of $281,000. Fulfillment and order processing expenses as a percentage of net sales declined in the first quarter of 2006, compared to the first quarter of 2005, as greater order volumes resulted in improved utilization of our primary distribution center.

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. In addition, marketing and sales expense include CNS-related royalties, which were reduced as a result of our new fulfillment agreement with Weil, of $19,000 for the first quarter of 2006 and $635,000 for the first quarter of 2005. Advertising and promotional costs in the first quarter of 2006 were $6.7 million, compared to $5.0 million in 2005.

Marketing and sales expenses increased both in absolute dollars and as a percentage of net sales for the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005. The increase was primarily due to $1.8 million in final costs related to our brand advertising campaign incurred in the first quarter of 2006, and an increase in stock-based compensation expense of $181,000 resulting from the adoption of FAS 123R.

Technology and Content Expenses

Technology and content expenses consist primarily of payroll and related expenses for personnel engaged in developing, maintaining and making routine upgrades and enhancements to our websites. Technology and content expenses also include Internet access and hosting charges, depreciation on hardware and IT structures, and website content and design expenses.

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Technology and content expenses for the three-month period ended April 2, 2006 increased both in absolute dollars and as a percentage of net sales, compared to the three-month period ended April 3, 2005. The increase resulted from increased depreciation expense of $446,000 resulting from the acquisition of software and computer equipment related to enhancements to our IT infrastructure in 2005, an increase in stock-based compensation expense of $268,000 resulting from the adoption of FAS 123R, and increased operational costs.

General and administrative expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, professional service expenses, travel expenses and other general corporate expenses.

General and administrative expenses for the three-month period ended April 2, 2006 decreased both in absolute dollars and as a percentage of net sales, compared to the three-month period ended April 3, 2005. The decrease resulted primarily from reductions in corporate insurance costs and utility costs, offset by an increase of $185,000 in stock-based compensation expense resulting from the adoption of FAS 123R, and increased professional fees. The decrease as a percentage of net sales resulted from our fixed corporate administrative costs being spread over more net sales.

Amortization of Intangible Assets

Amortization of intangible assets includes the amortization expense associated with assets acquired in connection with our acquisitions of CNS, Acumins, Inc., and Vision Direct, and assets acquired in connection with our agreements with Rite Aid and GNC, and other intangible assets, including a technology license agreement, domain names and trademarks.

The decrease in amortization expense for the three-month period ended April 2, 2006, compared to the three-month period ended April 3, 2005, resulted from certain intangible assets being fully amortized in 2005.

Interest Income and Expense

Interest income consists of earnings on our cash, cash equivalents and marketable securities, and interest expense consists primarily of interest associated with capital lease and debt obligations. Net interest income increased in the first quarter of 2006, compared to the first quarter of 2005, as a result of higher interest rates and higher weighted average cash, cash equivalents and marketable securities balance in first quarter of 2006 compared to 2005.

Income Taxes

There was no provision or benefit for income taxes for the three-month periods ended April 2, 2006 and April 3, 2005 due to our ongoing operating losses.

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Stock-Based Compensation

Effective January 2, 2006, we adopted the fair value recognition provisions of FAS 123R using the modified-prospective-transition method, which requires measurement of compensation cost for all stock-based awards at fair value on the date of grant and recognition of compensation over the service period for awards expected to vest. As a result of adopting FAS 123R on January 2, 2006, we recognized stock-based compensation totaling $1.7 million for the three months ended April 2, 2006. Our incremental stock-based compensation expense resulting from the adoption of FAS 123R totaled $1.5 million and increased our basic and diluted net loss per share by $0.02, which includes a reduction of stock-based compensation of $248,000 that would have been recognized prior to the adoption for options granted with an exercise below the market value on the date of grant. As required by FAS 123R, management made an estimate of expected forfeitures and we are recognizing compensation costs only for those equity awards expected to vest. Prior to January 2, 2006, we recognized stock-based compensation under the provisions of APB 25 and FAS 123 for options granted with exercise prices below market value on the date of grant, options and warrants issued to non-employees for services, and modifications to existing option grants. Such compensation expense totaled $848,000 for the three months ended April 3, 2005. See Note 5 in our consolidated financial statements included in Part I, Item 1 of this quarterly report.

Off-Balance Sheet Transactions

We have not engaged in any off-balance sheet transactions.

Liquidity and Capital Resources

We have incurred net losses of $742.6 million since inception. We believe that we may continue to incur net losses for at least the next year, and possibly longer. From our inception through April 2, 2006, we have financed our operations primarily through the sale of equity securities, including common and preferred stock, yielding net cash proceeds of $413.9 million.

Net cash used in operating activities for the three-month periods ended April 2, 2006 and April 3, 2005 primarily reflects net losses and changes in operating assets and liabilities, partially offset by non-cash expenses. Net cash used in operating activities increased in the first quarter of 2006, compared to the first quarter of 2005, primarily as a result of increased uses of other working capital partially offset by decreased investments in inventory.

Net cash provided by investing activities for the three-month period ended April 2, 2006 was primarily attributable to the sales and maturities of marketable securities, offset by the purchase of marketable securities and the acquisition of fixed assets. Net cash used in investing activities for the three-month period ended April 3, 2005 was primarily attributable to the purchase of marketable securities and acquisition of fixed assets, offset by the sale and maturity of marketable securities.

Net cash used in financing activities for the three-month period ended April 2, 2006 was attributable to the repayment of debt obligations, offset by proceeds received from the exercises of employee stock options and purchases under our employee stock purchase plan. Net cash provided by financing activities for the three-month period ended April 3, 2005 was attributable to $26.0 million of net proceeds received from the sale of 10.0 million shares of our common stock, cash provided from exercises of employee stock options and purchases under our employee stock purchase plan, and borrowings under our revolving line of credit agreement with a bank, partially offset by payments on our debt obligations.

Until required for other purposes, our cash and cash equivalents are maintained in deposit accounts or highly liquid investments with remaining maturities of 90 days or less at the time of purchase. Our marketable securities, which include commercial paper, auction rate securities, corporate notes and government bonds, are considered short-term as they are available to fund current operations.

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Liquidity Sources, Requirements and Contractual Cash Requirements and Commitments

Our principal sources of liquidity are our cash, cash equivalents and marketable securities. Historically, our principal liquidity requirements have been to meet our working capital and capital expenditure needs.

Our primary source of cash is sales made through our websites, for which we collect cash from credit card settlements or insurance reimbursements. Our primary uses of cash are purchases of inventory, salaries, marketing expenses, and overhead and fixed costs. Any projections of our future cash needs and cash flows are subject to substantial uncertainty for the reasons discussed in the sections entitled “ Risk Factors ” in Part II, Item 1A of this quarterly report and Part I, Item 1A of our annual report on Form 10-K for the year ended January 1, 2006.

In March 2006, we entered into an amended and restated loan and security agreement with our existing bank. This agreement includes a revolving line of credit allowing for borrowings of up to $7.5 million, which accrue interest at the prime rate. The revolving line of credit has a maturity date of one year from the date of advance. The agreement allows for the conversion of up to $2.5 million of the outstanding balance into a term loan within 60 days of maturity. No amounts have been borrowed on the line of credit as of April 2, 2006.

As of April 2, 2006, we did not have any future material noncancelable commitments to purchase goods or services.

We believe that our sources of cash will be sufficient to fund our operations and anticipated capital expenditures until we begin generating positive operating cash flow. However, any projections about our future cash needs and cash flows are subject to substantial uncertainty. As a result, we may need to raise additional monies to fund our operating activities or for strategic flexibility (if, for example, we pursue business or technology acquisitions or decide to build a new distribution center or if our expectations regarding our operations and anticipated capital expenditures change). We have in the past and will continue to assess opportunities for raising additional funds by selling equity, equity-related or debt securities, obtaining additional credit facilities or obtaining other means of financing for strategic reasons or to further strengthen our financial position. We cannot be certain that additional financing will be available to us on acceptable terms when required, or at all. Furthermore, if we were to raise additional funds through the issuance of securities, such securities may have rights, preferences or privileges senior to those of the rights of our common stock and our stockholders may experience additional dilution.

Management Outlook

For the second quarter of fiscal year 2006, we are targeting net sales in the range of $101.0 million to $105.0 million and a net loss in the range of $4.3 million to $5.5 million.