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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2006 Highlights . During late 2005 and the first half of 2006, we performed a strategic review of each of our business segments to evaluate the profitability of each customer order and partnership. As a result of this analysis, we eliminated or adjusted the price on several thousand OTC SKUs and reduced the amount of our net shipping costs by revising our shipping policies, introducing weight- and location-based surcharges for certain customer orders and negotiating lower shipping rates from our primary shipping carrier. In addition, we terminated our low-margin wholesale OTC fulfillment agreement with Amazon.com, renegotiated the terms of our Weil agreement, terminated several unprofitable agreements with third-party prescription benefit providers, and decided not to participate in the low-margin Medicare Part D prescription drug program. We are also exiting an unprofitable PBM relationship in the second half of 2006. These profitability initiatives have resulted in improved OTC gross margins, which increased by 260 basis points, to 30.1%, and total gross margins, which increased by 120 basis points, to 21.6%, for the six-month period ended July 2, 2006 as compared to the six-month period ended July 3, 2005. Our contribution margins were also positively impacted by these initiatives, increasing year-over-year to $29.5 million, or 22%, for the first six months of 2006, primarily as a result of improved OTC contribution margins, which increased year-over-year by $5.2 million, or 34%, for the first six months of 2006. Although these profitability initiatives resulted in loss of revenue (albeit revenue from unprofitable business), we continued to achieve year-over-year revenue growth, primarily in our OTC segment, with OTC net sales increasing by $8.6 million, or 10%, and core OTC net sales increasing by $15.5 million, or 20%, for the first six months of 2006 compared to the same period in 2005.

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Revenues . We generate revenue primarily from product sales and shipping fees. For the three-month period ended July 2, 2006, we reported consolidated total net sales of $102.4 million, which reflected a $5.5 million, or 6%, increase over the three-month period ended July 3, 2005. For the six-month period ended July 2, 2006, we reported consolidated net sales of $206.5 million, which reflected a $10.1 million, or 5%, increase over the six-month period ended July 3, 2005. Our net sales growth was driven by a 7% year-over-year increase in total order volume for the second quarter of 2006, to 1.3 million orders, and a 5% year-over-year increase in total order volume for the first six months of 2006, to 2.7 million orders. Our average net sales per order declined slightly to $77 for the second quarter of 2006, from $78 in the second quarter of 2005, and our average net sales per order remained consistent year-over-year at $77 for the first six months of 2006. Our revenues benefited from strong growth in our OTC segment, in which net sales grew by 10% year-over-year for the three- and six-month periods ended July 2, 2006. Core OTC net sales (excluding wholesale and CNS) grew by 18% and 20% year-over-year for the three- and six-month periods ended July 2, 2006. Net sales in our vision segment grew year-over-year by $1.1 million, or 9%, for the second quarter of 2006 and $1.5 million, or 6%, for the first six months of 2006. Net sales in our local pick-up pharmacy segment grew year-over-year by $1.4 million, or 6%, for the second quarter of 2006 and $613,000, or 1%, for the first six months of 2006. These increases were partially offset by a year-over-year decrease in mail-order pharmacy net sales of $1.0 million, or 6%, for the second quarter of 2006 and $664,000, or 2%, for the first six months of 2006.

Expenses . Our operating expenses, including cost of goods sold, decreased as a percentage of net sales to 103% for the second quarter of 2006, from 105% in the second quarter of 2005, and decreased year-over-year to 104% of net sales for the first six months of 2006, from 105% in the first six months of 2005. The decrease for the three- and six-month periods ended July 2, 2006 resulted from a decrease in our cost of goods sold as a percentage of net sales, reflecting both a favorable shift in our product mix and significant improvement in OTC margins due to the success of the profitability initiatives described above. Our marketing expenses for the second quarter of 2006 decreased as a percentage of net sales as a result of the conclusion of our brand campaign in the first quarter of 2006, but increased year-over-year for the first six months of 2006 because the brand campaign costs in the six-month period ended July 2, 2006 exceeded the costs in the same period in 2005. Our general and administrative expenses also decreased year-over-year as a percentage of net sales for the second quarter of 2006 and the first six months of 2006. These declines were partially offset by an increase in technology and content expenses as a percentage of net sales for the second quarter of 2006 and the first six months of 2006, as a result of ongoing enhancements to our IT infrastructure. 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. As a result, we recognized $1.2 million and $2.0 million, or 1% of net sales, of additional stock-based compensation under FAS 123R in the three- and six-month periods ended July 2, 2006.

Net Loss; Cash Position . Our net loss decreased by $2.1 million to $2.2 million for the second quarter of 2006, compared to $4.3 million for the second quarter of 2005, and decreased by $1.8 million to $7.5 million for the first six months of 2006, compared to $9.3 million for the first six months of 2005. We ended the second quarter of 2006 with $39.7 million in cash, cash equivalents and marketable securities, compared to $46.5 million at January 1, 2006 and $56.0 million at July 3, 2005. This balance reflects the use in the first six months of 2006 of $2.9 million to fund operating activities, $3.3 million for capital expenditures, and $1.2 million to repay debt obligations, offset by proceeds of $617,000 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 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.

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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.

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.

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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 subsequent to January 2, 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 consolidated financial statements. In accordance with the modified-prospective-transition method, results for the three- and six-month periods ended July 3, 2005 have not been restated to reflect, and do not include, the impact of FAS 123R. Prior year amounts have been reclassified to conform to the current year presentation.

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 SEC Staff Accounting Bulletin No. 107, Share-Based Payment , 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 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. An estimated forfeiture rate of approximately 30% is applied to non-management and management employee subgroups based on the weighted average termination behavior of those subgroups. A forfeiture rate of 0% is applied to 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.

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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.

Results of Operations

Net Sales

Net sales includes gross revenues from sales of product and related shipping fees, net of discounts and provision for sales returns, third-party reimbursement and other allowances. Net sales also include 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 recorded 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 year-over year as a result of a 7% increase in order volume for the three-month period ended July 2, 2006 and a 5% increase in order volume for the six-month period ended July 2, 2006, primarily driven by growth in our OTC segment. Revenues from repeat customers increased year-over-year to 82% for the three-month period ended July 2, 2006, compared to 80% for the three-month period ended July 3, 2005, and increased year-over-year to 82% for the six-month period ended July 2, 2006, compared to 79% for the six-month period ended July 3, 2005.

OTC Net Sales

Net sales in our OTC segment increased year-over-year for the three-month period ended July 2, 2006, as a result of an increase in order volume. Excluding CNS net sales of $612,000 for the second quarter of 2006 and $1.8 million for the second quarter of 2005, and wholesale OTC net sales and fulfillment fees of $1.8 million for the second quarter of 2005, our core OTC net sales increased by 18% year-over-year to $46.6 million for the three-month period ended July 2, 2006. The number of orders in our OTC segment grew year-over-year by 12% to 842,000 for the second quarter of 2006, compared to 754,000 for the second quarter of 2005. Average net sales per order for the second quarter of 2006 declined year-over-year to $56, from $57.

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Net sales in our OTC segment increased year-over-year by $8.6 million for the six-month period ended July 2, 2006, as a result of an increase in order volume. Excluding CNS net sales of $1.3 million for the six-month period ended July 2, 2006 and $3.8 million for the same period in 2005, and wholesale OTC net sales and fulfillment fees of $4.4 million for the six-month period ended July 3, 2005, our core OTC net sales increased by 20% year-over-year to $95.0 million for the six-month period ended July 2, 2006. The number of orders in our OTC segment grew year-over-year by 11% to 1.7 million for the six-month period ended July 2, 2006, compared to 1.5 million for the same period in 2005. Average net sales per order for the first six months of 2006 declined year-over-year to $56, from $57.

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 OTC order volume was driven by increased orders from both new and repeat customers as a result of our increasing active customer base and our continued efforts to improve customer retention and conversion. Our average net sales per order declined as a result of changes made to our shipping policies, and to a lesser extent, changes in product mix. During 2006, we performed a review of the pricing and profitability of each OTC SKU, which did not result in material price changes in our OTC products individually but, in the aggregate, favorably impacted our gross margin.

Net sales in our vision segment increased year-over-year in the three- and six-month periods ended July 2, 2006 as a result of an increase in average net sales per order driven primarily by 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 individually material). The number of orders in this segment decreased slightly to 138,000 in the second quarter of 2006, compared to 139,000 in the second quarter of 2005, and decreased to 283,000 in the first six months of 2006, compared to 286,000 in the first six months of 2005, as a result of decreases in orders from new customers.

Customer Data

Approximately 297,000 new customers placed orders during the second quarter of 2006, increasing our total customer base to approximately 7.8 million customers since inception. Orders from repeat customers as a percentage of total orders increased year-over-year to 76% and 75% for the three- and six-month periods ended July 2, 2006, compared to 72% and 71% for the same periods in 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 in 2006 primarily resulted from improved customer retention and increased order frequency and, to a lesser extent, the inclusion of 66,000 and 150,000 wholesale OTC orders for the three- and six-month periods ended July 3, 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.