Quarterly Report

You should read the following discussion and analysis 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 December 31, 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 December 31, 2006. You should not rely on a forward-looking statement as representing our views as of any date other than the date on which we made the statement. We expressly disclaim any intent or obligation 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 1, 2007, we reported consolidated total net sales of $109.8 million, which reflected a $5.7 million, or 5%, increase over the three-month period ended April 2, 2006. Our net sales growth was driven by a 10% year-over-year increase in our total order volume, to 1.5 million orders, partially offset by a year-over-year decrease in average net sales per order to $74 compared to $77. Our revenues benefited from strong growth in our OTC segment, which grew by 15% over the first quarter of 2006. Our revenues also benefited from year-over-year growth of 9% in our local pick-up pharmacy segment and 8% in our vision segment. These increases were partially offset by a year-over-year decrease in our mail-order pharmacy segment of 26%.

Expenses . Our operating expenses, including cost of goods sold, decreased as a percentage of net sales to 104% in the three-month period ended April 1, 2007, from 106% in the three-month period ended April 2, 2006. The decrease resulted primarily from a decrease in our overall cost of goods sold 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 that we undertook to improve OTC profitability. In addition, marketing expenses declined as a percentage of net sales to 7% as a result of the conclusion of our brand campaign in the first quarter of 2006, partially offset by increased marketing expenses resulting from increased order volume.

Net Loss; Cash Position . Our net loss for the three-month period ended April 1, 2007 decreased by 29%, or $1.5 million, to $3.8 million, compared to $5.3 million for the three-month period ended April 2, 2006. We ended the first quarter of 2007 with $38.2 million in cash, cash equivalents and marketable securities, compared to $40.6 million at December 31, 2006, and $41.9 million at April 2, 2006. This balance reflects the use in the first quarter of 2007 of $505,000 to fund operating activities, $2.2 million for capital expenditures, and $700,000 to repay debt obligations, offset by proceeds of $663,000 from the exercise of employee stock options and purchases under our employee stock purchase plan and $300,000 of borrowings under our line of credit.

Significant Accounting Judgments

The preparation of financial statements in conformity with U.S. generally accepted accounting principles, or 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 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 December 31, 2006. Although we believe that our estimates, assumptions and judgments are reasonable, they are based on 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.

We record revenues from sales of OTC (other than Weil-related CNS sales, as described below), mail-order pharmacy, and vision products net of promotional discounts, cancellations, rebates, and returns allowances. We recognize revenue when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been

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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. We estimate return allowances, which reduce product sales by our estimate of expected product returns, based on our historical experience. Historically, product returns and differences between our estimates and actual returns have not been significant.

We recognize revenues from sales of customized vitamins sold through our fulfillment agreement with Weil 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. We recognize non-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, and agreements with other consignment vendors, which we also record on a net basis, because we do not take title to the inventory and do not establish pricing.

We recognize 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 that Rite Aid receives and collects on our behalf, when the customer picks up the product. In these circumstances, we use 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 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 we ship the order to the customer (for mail order prescriptions) or when the customer picks up the order (for local pick-up prescriptions).

From time to time, we provide incentive offers to our customers to encourage purchases. Such offers include discounts on specific current purchases, or future rebates based on a percentage of the current purchase, as well as other offers. We treat discounts, when our customers accept them, as a reduction in the sales price of the related transaction and we present them as a net amount in net sales. We treat rebates as a reduction in the sales price based on estimated redemption rates. We estimate redemption rates using our historical experience for similar offers. Historically, our redemption rates have not differed materially from our estimates, which we adjust 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 we record 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 test for impairment of goodwill at the beginning of the fourth quarter and whenever indicators of impairment occur. The first phase of the test screens for impairment. If we determine impairment, the second phase measures the amount of impairment by comparing the fair value of the applicable reporting unit to its carrying value. We determine fair value using either a discounted cash flow methodology or methodology based on comparable market prices.

We review our indefinite-lived intangible assets 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

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be impaired, we perform an evaluation of recoverability. We determine whether impairment exists 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

We account for our stock-based awards under the provisions of FAS 123R, 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. We calculate the fair value of our stock options granted to employees using the Black-Scholes option pricing model using the single-option 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. We base our computation of expected volatility 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. We compute expected life 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 rates quoted for the closest 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 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. We apply an estimated forfeiture rate of approximately 35% to non-management and management employee subgroups, based on the weighted average termination behavior of those subgroups. we apply a forfeiture rate of 0% to our chief executive officer, board members, and non-employees. If our estimated forfeiture rate changes, we retrospectively increase or decrease stock-based compensation in the period of change. Any such revisions to the estimates we use to calculate the fair value of our stock-based awards could have a material impact on our results of operations and financial position. See Note 5 of our consolidated financial statements, Stock-Based Compensation , included in Part I, Item 1 of this quarterly report.

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.

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Net sales include gross revenues from sales of product and related shipping fees, net of discounts and provision for sales returns, and other allowances. Net sales also include consignment service fees earned from our arrangement with GNC and other consignment vendors, under which we do not take title to the inventory and cannot establish pricing. We record on an et basis consignment service fees, which constitute approximately 1% of total net sales in each period presented. We bill orders to the customer’s credit card or, in the case of prescriptions covered by insurance, we bill the co-payment to the customer’s credit card and the remainder of the prescription price to insurance. We record sales of pharmaceutical products covered by insurance as the sum of the amounts received from the customer and the third party.

The year-over-year increase in total net sales for the first quarter resulted from a 10% increase in order volume, primarily driven by growth in our OTC segment. Revenues from repeat customers increased to 82% of net sales in the first quarter of 2007, compared to 81% in the first quarter of 2006. The year-over-year decrease in average net sales per order for the first quarter resulted from a higher mix of OTC orders, which have lower average net sales per order. Compared to the first quarter of 2006, net sales in our OTC segment increased by $7.3 million, or 15%, net sales in our local pick-up pharmacy segment increased by $2.3 million, or 9%, and net sales in our vision segment increased by $962,000, or 8%, all of which was partially offset by a decrease in net sales in our mail-order pharmacy segment of $4.8 million, or 26%.

The year-over-year increase in et sales in our OTC segment for the first quarter of 2007 resulted from an increase in order volume. The number of orders in our OTC segment grew by 15% to 1.0 million in the first quarter of 2007, compared to 870,000 in the first quarter of 2006, 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 and orders generated through our fulfillment agreement with Weil. 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 resulting primarily from website improvements implemented in 2006.

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The year-over-year decrease in net sales in our mail-order pharmacy segment for the first quarter of 2007 resulted from a decrease in order volume, offset by an increase in the average net sales per order. The number of orders in this segment decreased by 29% to 84,000 in the first quarter of 2007, compared to 118,000 in the first quarter of 2006, 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. Included in net sales of our mail-order pharmacy segment in the three-month period ended April 1, 2007 were wholesale orders to one party totaling $614,000, which increased our average net sales per order by $7 in the first quarter of 2007. In addition, the year-over-year increase in average net sales per order in this segment resulted from an increase of approximately 8% in the average price per prescription due to higher pharmaceutical costs, partially offset by a decrease in the average number of prescriptions per order.

The year-over-year increase in net sales in our local pick-up pharmacy segment for the first quarter of 2007 resulted from an increase in the number of orders in this segment in the first quarter of 2007 to 251,000, compared to 217,000 in the first quarter of 2006. 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 increase in sales was partially offset by a $7 year-over-year decrease in average net sales per order resulting from a 6% decrease in the average number of prescriptions per order.

Vision Net Sales

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The year-over-year increase in net sales in our vision segment for the first quarter of 2007 resulted from the increase in the average net sales per order, partially offset by a slight decrease in order volume. The increase in the average net sales per order was 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. The number of orders in this segment decreased slightly to 141,000 in the first quarter of 2007, compared to 145,000 in the first quarter of 2006, as a result of a decrease in orders from new customers.

Customer Data

Approximately 338,000 new customers placed orders during the first quarter of 2007, increasing our total customer base to approximately 8.8 million customers since inception. Orders from repeat customers as a percentage of total orders increased to 77% during the first quarter of 2007, compared to 75% during the first quarter of 2006, as a result of an increase in our trailing 12-month active customer base. Active customer base includes those customers who have purchased at least once within the last 12 months. Both the active customer base (a trailing 12-month number) and average annual spend per active customer exclude net sales and orders generated by our CNS fulfillment relationship with Weil, and reflect only the activity of customers making purchases through the web sites of drugstore.com and its subsidiaries. The increase in orders from repeat customers as a percentage of total orders in the first quarter of 2007 primarily resulted from improved customer retention and increased order frequency as a result of our initiatives implemented during 2006.

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 and payment discount terms are netted against cost of sales.

Total cost of sales increased in absolute dollars in the three-month period ended April 1, 2007, compared to the three-month period ended April 2, 2006, as a result of growth in order volume and net sales. Total gross margin percentage increased year-over-year, primarily as a result of a larger proportion of net sales in our OTC segment, which is our highest-margin segment, lower net shipping costs that we absorbed, and our operational initiatives.

We include in net sale our revenues from shipping charges to customers, which were $3.8 million and $3.4 million in the three-month periods ended April 1, 2007, and April 2, 2006. We include in cost of sales outbound shipping costs, which were $5.8 million and $5.5 million in the three-month periods ended April 1, 2007 and April 2, 2006. As part of our profitability initiatives, in 2006, 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, added a weight-based shipping surcharge for orders over 20 pounds, and secured a lower contractual rate from one of our shipping carriers. We expect to continue to subsidize a portion of customers’ shipping costs for the foreseeable future, through certain free shipping options, as a strategy to attract and retain customers.

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The year-over-year increase in cost of sales in our OTC segment in absolute dollars for the first quarter of 2007 resulted from increased order volume and net sales. The year-over-year increase in gross margin percentage for the first quarter of 2007 was primarily as a result of lower per-order net shipping costs, resulting from changes in our shipping policies and securing lower contractual rates from our primary shipping carrier.

Mail-Order Pharmacy Cost of Sales and Gross Margin

The year-over-year decrease in cost of sales in our mail-order pharmacy segment in absolute dollars for the first quarter of 2007 resulted from a decrease in order volume and net sales. The year-over-year increase in gross margin percentage in this segment for the first quarter of 2007 resulted from improved margins from exiting unprofitable partnerships with certain PBMs and our review of pricing and profitability of pharmaceutical products.

Local Pick-up Pharmacy Cost of Sales and Gross Margin

The year-over-year increase in cost of sales in our local pick-up pharmacy segment in absolute dollars in the first quarter of 2007 resulted from an increase in order volume and net sales.

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The year-over-year increase in cost of sales in our vision segment both in absolute dollars and in terms of gross margin percentage for the first quarter of 2007 was primarily as a result of a shift in product mix to sales of higher cost, newer technology contact lenses and lower per order net shipping costs, offset by increased promotional activity and a slight decline in order volume.

Fulfillment and Order Processing Expenses

Fulfillment and order processing expenses include 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 are variable based on sales volume.

Fulfillment and order processing expenses for the three-month period ended April 1, 2007 included $8.2 million of variable costs and $2.8 million of fixed costs, compared to $7.6 million of variable costs and $2.6 million of fixed costs for the three-month period ended April 2, 2006. Variable fulfillment and order processing expenses increased year-over-year primarily as a result of increases in order volume and per order labor costs in our OTC segment, partially offset by a decrease in order volume in our mail-order pharmacy segment. Fixed fulfillment and order processing expenses increased year-over-year primarily as a result of increase of $79,000 in operational costs, including work related to the capacity assessment of our primary distribution center, $70,000 in depreciation, and $54,000 in stock-based compensation expense. Fulfillment and order processing expenses as a percentage of net sales increased in the first quarter of 2007, compared to the first quarter of 2006, as a result of increases in both fixed and variable fulfillment costs.

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Marketing and sales expenses include advertising expenses, promotional expenditures, and payroll and related expenses for personnel engaged in marketing and merchandising activities. Advertising expenses include our obligations under various advertising contracts. Advertising and promotional costs were $5.5 million and $6.7 million the first quarters of 2007 and 2006, respectively.

The year-over-year decrease in marketing and sales expenses both in absolute dollars and as a percentage of net sales for the first quarter of 2007 was primarily due to $1.8 million in final costs related to our brand advertising campaign that we incurred in the first quarter of 2006, partially offset by increases in advertising and promotional costs of $890,000 and increases in personnel costs and stock-based compensation expense of $315,000.

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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, utilities, and website content and design expenses.

The year-over-year increase in technology and content expenses both in absolute dollars and as a percentage of net sales for the first quarter of 2007 resulted primarily from increased depreciation expense of $370,000, resulting from the acquisition of software and computer equipment related to enhancements to our IT infrastructure in 2006, an increase in maintenance costs related to acquired software tools and other operational costs of $265,000, and to a lesser extent, a 6% increase in personnel costs and stock-based compensation expense.

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

The year-over-year increase in general and administrative expenses both in absolute dollars and as a percentage of net sales for the first quarter of 2007 resulted primarily from an increase in stock-based compensation of $498,000, as a result of increased option grants and option fair values, increased personnel costs of $369,000, including $190,000 of costs related to the departure of our chief financial officer and the search for his replacement, partially offset by declines in professional fees, insurance costs, and other administrative costs of $446,000.

Amortization of Intangible Assets

Amortization of intangible assets includes the amortization expense associated with assets acquired in connection with our acquisitions of CNS and Acumins, Inc., 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 year-over-year decrease in amortization expense for the first quarter of 2007 resulted from certain intangible assets being fully amortized in 2006.

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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. The year-over-year increase in net interest income for the first quarter of 2007 was a result of higher average interest rates.

Income Taxes

There was no provision or benefit for income taxes for the three-month periods ended April 1, 2007 and April 2, 2006 due to our ongoing operating losses.

Off-Balance Sheet Transactions

We have not entered into any off-balance sheet transactions.

Liquidity and Capital Resources

We have incurred net losses of $754.1 million since inception. We believe that we will continue to incur net losses for at least the next year, and possibly longer. From our inception through April 1, 2007, we have financed our operations primarily through the sale of equity securities, including common and preferred stock, yielding net cash proceeds of $417.0 million.

Discussion of Cash Flows

The following table provides information regarding our cash flows for the three-month periods ended April 1, 2007 and April 2, 2006.

Net cash used in operating activities for the three-month period ended April 1, 2007 primarily reflects a net loss of $3.8 million and the use of $2.0 million in cash for operating assets and liabilities, partially offset by non-cash activities of $5.3 million. Net cash used in operating activities for the three-month period ended April 2, 2006 primarily reflects a net loss of $5.3 million and the use of $1.8 million in cash for operating assets and liabilities, partially offset by $4.3 million of non-cash activities. The year-over-year decrease in net cash used in operating activities was primarily as a result of a $1.5 million decrease in our net loss and a $1.1 million increase in non-cash activities, primarily from increased stock-based compensation and depreciation.

Net cash used in investing activities for the three-month period ended April 1, 2007 is primarily attributable to the purchase of marketable securities and the acquisition of fixed assets, offset by the sales and maturities of marketable securities. Net cash provided by investing activities for the three-month period ended April 2, 2006 is primarily attributable to sales and maturities of marketable securities, offset by purchases of marketable securities and the acquisition of fixed assets. The year-over-year increase in net cash used in investing activities was primarily as a result of decreased sales and maturities of marketable securities, partially offset by a decrease in purchases of marketable securities.

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Net cash provided by financing activities for the three-month period ended April 1, 2007 was attributable to proceeds received from exercises of employee stock options and purchases under our employee stock purchase plan and borrowings under our revolving bank line of credit, partially offset by the repayment of debt obligations. Net cash used in financing activities for the three-month period ended April 2, 2006 was attributable to payments on our debt obligations, partially offset by proceeds received from exercises of employee stock options and purchases under our employee stock purchase plan.

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.

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 December 31, 2006.

In April 2007, 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 $10.0 million, which accrue interest at the prime rate. The revolving line of credit matures in March 2008. 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. As of April 1, 2007, borrowings under the existing line of credit totaled $1.3 million, of which $1.0 million was converted into a term loan under the amended and restated loan and security agreement. The term loan will be paid in thirty six monthly installments and accrues interest at the prime rate plus .50%.

As of April 1, 2007, we did not have any future material noncancelable commitments to purchase goods or services.

We believe that our cash and marketable securities on hand plus our sources of cash will be sufficient to fund our operations and anticipated capital expenditures. 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 decide to build a new distribution center or pursue business or technology acquisitions) or if our expectations regarding our operations and anticipated capital expenditures change. We have assessed 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 2007, we are targeting net sales in the range of $108.0 million to $110.0 million and a net loss in the range of $3.0 million to $4.0 million.