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 “expects,” “believes,” “targets,” “may,” “will,” “outlook,” “continue,” “remain,” “could,” “would,” “should,” and similar expressions or any variation of such 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, vision, mail-order pharmacy, local pick-up pharmacy.

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Revenues . We generate revenue primarily from product sales and shipping fees. For the three-month period ended September 30, 2007, we reported consolidated total net sales of $107.3 million, which reflected a $6.7 million, or 7%, increase over the three-month period ended October 1, 2006. For the nine-month period ended September 30, 2007, we reported consolidated net sales of $327.5 million, which reflected a $20.3 million, or 7%, increase over the nine-month period ended October 1, 2006. Our net sales growth was driven by a 10% year-over-year increase in our total order volume for the three- and nine-month periods ended September 30, 2007, to 1.4 million orders and 4.4 million orders, respectively. Our average net sales per order declined slightly to $75 for the three- and nine-month periods ended September 30, 2007, from $77 for the three- and nine-month periods ended October 1, 2006. Our revenues benefited from strong growth in our OTC segment, in which net sales grew by 20% and 19%, respectively, year-over-year for the three- and nine-month periods ended September 30, 2007. Our revenues also benefited from year-over-year growth of 17% and 12%, respectively, for the three- and nine-month periods ended September 30, 2007 in our vision segment and 5% and 6%, respectively, in our local pick-up pharmacy segment. These increases were partially offset by a year-over-year decrease in mail-order pharmacy net sales of 33% for the third quarter of 2007 and 29% for the nine-month period ended September 30, 2007.

Expenses . Our operating expenses, including cost of goods sold, remained consistent as a percentage of net sales at 103% during the three-month period ended September 30, 2007, when compared to the three-month period ended October 1, 2006, and declined slightly to 103% of net sales for the nine-month period ended September 30, 2007, compared 104% for the nine-month period ended October 1, 2006. During the three- and nine-month periods ended September 30, 2007 our overall cost of goods sold as a percentage of net sales year-over-year decreased 170 basis points and 120 basis points, respectively, due to a favorable shift in our product mix to higher margin OTC sales, as well as improvement in pharmaceutical and vision margins. Our improved gross margins were offset by increased marketing expenses resulting from increased order volumes and search advertising costs, increased technology and content expenses as a result of ongoing enhancements to our IT infrastructure, and increased general and administrative expenses primarily due to higher stock based compensation expenses and consulting fees during the third quarter of 2007 and the nine-month period ended September 30, 2007. We also recognized $387,000 and $2.1 million of additional stock-based compensation in the three- and nine-month periods ended September 30, 2007 compared to the same periods in 2006.

Net Loss; Cash Position . Our net loss for the three-month period ended September 30, 2007 decreased by 8%, or $219,000 to $2.4 million, compared to $2.6 million for the three-month period ended October 1, 2006, and decreased by 9%, or $912,000, to $9.2 million, compared to $10.1 million for the nine-month period ended October 1, 2006. We ended the third quarter of 2007 with $37.9 million in cash, cash equivalents and marketable securities, compared to $40.6 million at December 31, 2006 and at October 1, 2006.

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This balance reflects cash generated from operating activities in the nine-month period ended September 30, 2007 of $7.0 million, proceeds received of $3.4 million 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. These increases were offset by $11.2 million for capital expenditures and asset acquisitions and $2.2 million to repay debt obligations.

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), vision, and mail-order pharmacy, 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 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 have not been significant and have not differed significantly from our estimates.

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 evaluate the criteria of EITF 99-19, in determining whether it is appropriate to record the gross amount of product sales and related costs in conjunction with our drop ship arrangements with vendors. Generally, when we are the primary party obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, we record revenue on a gross basis.

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).

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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 SFAS 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 SFAS 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. 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 SFAS 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 does 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

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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, Stockholders’ Equity , included in Part I, of 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 – Legal Proceedings , included in Part I, of Item 1 of this quarterly report.

Results of Operations

Net Sales

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 a net 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.

Total net sales increased year-over-year primarily as a result of a 16% increase in order volume for the three-month period ended September 30, 2007, and a 17% increase in order volume for the nine-month period ended September 30, 2007, in our OTC segment. Revenues from repeat customers represented 82% of net sales in the three-and nine-month periods ended September 30, 2007, compared to 84% of net sales in the third quarter of 2006 and 83% of net sales in the nine-month period ended October 1, 2006. The year-over-year decrease in average net sales per order for the three- and nine-month periods ended September 30, 2007 resulted from a higher mix of OTC orders, which have lower average net sales per order. Compared to the third quarter and the nine-month period ended October 1, 2006, net sales in our OTC segment increased by $9.0 million and $26.5 million, net sales in our vision segment increased by $2.2 million and $4.5 million, and net sales in our local pick-up pharmacy segment increased by $1.2 million and $4.8 million, respectively, all of which were partially offset by a decrease in net sales in our mail-order pharmacy segment of $5.7 million and $15.5 million, respectively.

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Net sales in our OTC segment increased year-over-year for the three-month period ended September 30, 2007, as a result of an increase in order volume. The number of orders in our OTC segment grew year-over-year by 16% to 966,000 for the third quarter of 2007, compared to 830,000 for the third quarter of 2006 with the average net sales per order for the third quarter of 2007 increasing year-over-year to $57 from $55. During the nine-month period ended September 30, 2007 the number of OTC orders grew year-over year by 15% to 3.0 million compared to 2.5 million in the same period of 2006, and the average net sales per order also increased to $57 from $56. The number of customer orders includes new and repeat orders made through the drugstore.com website and websites of our subsidiaries and orders generated through our fulfillment agreement with Weil. The increase in OTC order volumes in 2007 as compared to 2006 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 from our ongoing website enhancements. The slight year-over-year increase in average net sales per order for the three- and nine-month periods ended September 30, 2007 is primarily the result of increased sales of higher priced prestige beauty products.

Vision Net Sales

Net sales in our vision segment increased year-over-year in the three- and nine-month periods ended September 30, 2007 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). Net sales per order increased to $101 for the three-month period ended September 30, 2007 compared to $92 for the three-month period ended October 1, 2006 and increased to $99 for the nine-month period ended September 30, 2007 compared to $90 for the nine-month period ended October 1, 2006. The number of orders in this segment increased to 146,000 for the three-month period ended September 30, 2007, compared to 138,000 for the three-month period ended October 1, 2006, and increased to 428,000 for the nine-month period ended September 30, 2007, compared to 421,000 for the nine-month period ended October 1, 2006 as a result of increases in orders from repeat customers.

Mail-Order Pharmacy Net Sales

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Net sales in our mail-order pharmacy segment decreased year-over-year for the three- and nine-month periods ended September 30, 2007 as a result of decreases in order volume. Included in net sales of our mail-order pharmacy segment for the three- and nine-month periods ended September 30, 2007 were wholesale orders to one party of $71,000 and $1.0 million, respectively, and included in net sales for the three- and nine-month periods ended October 1, 2006 were wholesale orders to one party for $2.0 million. The wholesale orders increased our average net sales per order by $1 and $4 for the three- and nine-month periods ended September 30, 2007, respectively, and increased our net sales per order by $21 and $6 for the three- and nine-month periods ended October 1, 2006, respectively. The number of orders in this segment decreased 22% year-over-year to 76,000 for the three-month period ended September 30, 2007, compared to 98,000 for the same period in 2006, and decreased 27% year-over-year to 238,000 for the nine-month period ended September 30, 2007, compared to 324,000 for the same period in 2006, as a result of a year-over-year decrease of 49% and 53% in orders from PBMs, due to our decision to exit unprofitable partnerships, in the three- and nine-month periods ended September 30, 2007, respectively, and decreases in new and repeat orders.

Local Pick-up Pharmacy Net Sales

The increase in net sales in our local pick-up pharmacy segment for the three-month period ended September 30, 2007 reflects a 3% year-over-year increase in the number of orders in this segment, to 249,000, compared to 241,000 for the third quarter of 2006, as a result of an increase in orders from repeat customers. In addition, the segment experienced a slight increase in the average net sales per order to $106 during the three-month period ended September 30, 2007 compared to $104 for the three-month period ended October 1, 2006, primarily due to increased prices of brand name drugs as a result of a 4% average increase in prescription costs, offset slightly by a greater number of prescriptions filled with lower priced generic drugs compared to higher priced brand name drugs. The increase in net sales for the nine-month period ended September 30, 2007 reflects a 7% year-over-year increase in the number of orders in this segment, to 753,000 for the nine-month period ended September 30, 2007 compared to 703,000 for the nine-month period ended October 1, 2006, as a result of increases in orders from repeat customers . The average net sales per order remained consistent at $106 for the nine-month period ended September 30, 2007 and October 1, 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.

Customer Data

Approximately 326,000 and 1.0 million new customers placed orders during the three-and nine-month periods ended September 30, 2007, increasing our total customer base to approximately 9.5 million customers since inception. Orders from repeat customers as a percentage of total orders decreased slightly to 76% for the third quarter of 2007, compared to 77% in the same period in 2006, and remained consistent at 76% year-over-year for the nine-month period ended September 30, 2007 and October 1, 2006. Our active customer based increased 12% to 2.4 million year-over-year for the nine-months ended September 30, 2007, compared to the same period in 2006, and the average annual spend per active customer was $180. 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.

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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- and nine-month periods ended September 30, 2007, compared to the three- and nine-month periods ended October 1, 2006, as a result of growth in order volume and net sales. Total gross margin percentage increased year-over-year for the three- and nine-month periods ended September 30, 2007, primarily as a result of a larger proportion of net sales in our OTC segment, which is our highest-margin segment, as well as improved gross margins in all of our other segments.

Shipping