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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 27, 2004

or

For the transition period from              to             

Commission File Number 000-26137

drugstore.com, inc.

(Exact name of registrant as specified in its charter)

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

(Address of principal executive offices including zip code)

(425) 372-3200

(Registrant’s telephone number, including area code)

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

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

As of July 30, 2004, the registrant had 79,768,389 shares of common stock outstanding.

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DRUGSTORE.COM, INC.

FORM 10-Q

For the three and six months ended June 27, 2004

INDEX

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PART I—FINANCIAL INFORMATION

Item 1.    Financial Statements

DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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DRUGSTORE.COM, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1.    Description of the Business

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

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

2.    Basis of Presentation

The accompanying unaudited condensed, consolidated, financial statements have been prepared in conformity with accounting principles generally accepted in the United States for interim financial information and with the regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed, or omitted, pursuant to the rules and regulations of the Securities and Exchange Commission. In our opinion, these financial statements include all adjustments, consisting only of normal and recurring adjustments, necessary for the fair presentation of our financial condition and results of operation for the interim periods presented. In addition, the accompanying balance sheet data at December 28, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements, and accompanying notes, included in our annual report on Form 10-K for the fiscal year ended December 28, 2003. Our results of operations for any interim period are not necessarily indicative of the results of operations for any other interim period or for a full fiscal year.

Reclassifications

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

Comprehensive loss

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

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3.    Intangible Assets

The intangible assets balances as of June 27, 2004 and December 28, 2003 were as follows:

4.    Goodwill

The following table summarizes the changes in goodwill, by business segment, at June 27, 2004 and December 28, 2003:

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

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5.    Net Loss Per Share

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

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

Outstanding stock options and warrants to acquire 15,702,931 and 16,232,720 common shares, respectively, as of June 27, 2004 and June 29, 2003, were excluded from the computation of diluted net loss per share, as their effect would have been antidilutive. If we had reported net income, the calculation of per share amounts would have included the dilutive effect of these common stock equivalents using the treasury stock method. In June, 2000, we issued 500,000 warrants to purchase common stock, at $7.76 a share, to a subsidiary of CIGNA Corporation as part of a joint marketing agreement. The warrants and the joint marketing agreement will terminate in June, 2005.

6.    Strategic Agreements

Rite Aid

In July 1999, we consummated a series of agreements with Rite Aid and General Nutrition Corporation (GNC) to issue 12,282,599 shares of our Series E preferred stock in exchange for an aggregate of $10 million in cash and other consideration, including access to insurance coverage, advertising commitments and a vendor agreement with an estimated fair value of $233.9 million. The $233.9 million non-cash portion of the consideration from the Rite Aid and GNC agreements was allocated to the following components based on a valuation obtained from an independent valuation expert (in millions):

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

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As part of the transactions with Rite Aid and GNC, we also entered into a 10-year agreement with GNC under which we have the right to be the exclusive online provider of GNC-branded products until July 2005. We have agreed that, as long as we have the exclusive right to distribute GNC’s products over the Internet, we will not promote any other retail health food store or operate a physical retail health food store. When the exclusivity provisions of the agreement terminate, we will have the nonexclusive right to sell these products for the remaining term of the agreement.

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

Amazon.com

Effective September 19, 2003, we entered into a new e-commerce agreement with Amazon.com, Inc. Under this agreement, we are a nonexclusive wholesaler and fulfillment provider for certain OTC products sold through the “Health & Personal Care” store on the Amazon.com Web site. We ship the Amazon.com orders we fulfill in Amazon.com-branded boxes, from our distribution facility, in exchange for a fulfillment fee and an agreed-upon product price. This agreement replaced our prior marketing agreement with Amazon.com. The initial term of this agreement ends in April 2007. The fees and product revenue generated by our agreement with Amazon.com, which are recorded as gross revenue in our OTC segment, totaled $3.9 million and $5.9 million for the three and six months ended June 27, 2004, respectively.

In August 1998, we entered into a technology license and advertising agreement with Amazon.com, under which we have the right to license substantially all of Amazon.com’s technology for use in our business and to receive certain technological and advertising support from Amazon.com, and Amazon.com has the right to license substantially all of our technology for use in its business. Neither party may use the other’s technology to compete against the other. Currently, neither party has licensed any technology from the other under this agreement. If we were to be acquired by a competitor of Amazon.com and Amazon.com did not vote in favor of the transaction, we would lose our rights to use Amazon.com’s technology, if we are then using any. This agreement also restricts us from promoting on our Web site any company, other than drugstore.com, that sells products or services competitive with those that Amazon.com offers or is preparing to produce or market.

7.    Stock Options

The following table summarizes activity under our 1998 Stock Plan:

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

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

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Under APB 25, no compensation expense is recognized when the exercise price of our employee stock options equals the fair value of the underlying stock on the date of grant. Deferred stock-based compensation is recorded for those situations where the exercise price of an option was lower than the fair value for financial reporting purposes of the underlying common stock. For the three-months ended June 27, 2004 and June 29, 2003, we recorded aggregate deferred stock-based compensation of $172,000 and $0, respectively. For the six months ended June 27, 2004 and June 29, 2003, we recorded aggregate deferred stock-based compensation of $396,000 and $0, respectively. This deferred stock-based compensation is being amortized over the vesting period of the underlying options using the multiple-option approach. For the three-month periods ended June 27, 2004 and June 29, 2003, we recognized amortization of stock-based compensation of $207,000 and $119,000, respectively. In those same periods, we reversed $4,000 and $5,000, respectively, of deferred stock-based compensation as a result of employee terminations. For the six-month periods ended June 27, 2004 and June 29, 2003, we recognized amortization of stock-based compensation of $559,000 and $275,000, respectively. In those same periods, we reversed $407,000 and $25,000, respectively, of deferred stock-based compensation as a result of employee terminations.

If the stock-based compensation for our 1998 Stock Plan had been determined based on the fair value method, as promulgated by SFAS 123, our net loss would have been adjusted to the following pro forma amounts for the three- and six-month periods ended June 27, 2004 and June 29, 2003:

The initial impact on pro forma net loss may not be representative of compensation expense in future years when the effect of amortization of multiple awards would be reflected in pro forma earnings.

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

8.    Commitments and Contingencies

Legal Proceedings.

Class Action Laddering Litigation. On and after July 6, 2001, eight shareholder class action lawsuits were filed in the United States District Court for the Southern District of New York naming drugstore.com, inc. as a defendant, along with the underwriters and certain of our present and former officers and directors (the Individual Defendants), in connection with our July 27, 1999 initial public offering and March 15, 2000 secondary offering (together, the Offerings). The complaints against drugstore.com have been consolidated into a single action and a Consolidated Amended Complaint, which is now the operative complaint, was filed on April 19, 2002. The suit purports to be a class action filed on behalf of purchasers of our common stock during the period July 28, 1999 to December 6, 2000.

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In general, the complaint alleges that the prospectuses through which we conducted the Offerings were materially false and misleading for failure to disclose, among other things, that (i) the underwriters of the Offerings allegedly had solicited and received excessive and undisclosed commissions from certain investors in exchange for which the underwriters allocated to those investors material portions of the restricted number of shares issued in connection with the Offerings and (ii) the underwriters allegedly entered into agreements with customers whereby the underwriters agreed to allocate drugstore.com shares to customers in the Offerings in exchange for which customers agreed to purchase additional drugstore.com shares in the after-market at predetermined prices. The complaint asserts violations of various sections of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. The action seeks damages in an unspecified amount and other relief. The action is being coordinated with approximately 300 other nearly identical actions filed against other companies. On July 15, 2002, we moved to dismiss all claims against us and the Individual Defendants. On October 9, 2002, the Court dismissed the Individual Defendants from the case without prejudice based on stipulations of dismissal filed by the plaintiffs and the Individual Defendants. On February 19, 2003, the Court denied the motion to dismiss the complaint against drugstore.com. drugstore.com has approved a settlement agreement and related agreements, which set forth the terms of a settlement between drugstore.com, the plaintiff class and the vast majority of the other approximately 300 issuer defendants. Among other provisions, the settlement agreement provides for a release of drugstore.com and the Individual Defendants for the conduct alleged in the action to be wrongful. We would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims we may have against our underwriters. It is anticipated that any potential financial obligation of drugstore.com to plaintiffs pursuant to the terms of the settlement agreement and related agreements will be covered by existing insurance. Therefore, we do not expect that the settlement will involve any payment by drugstore.com. The settlement agreement has not yet been executed. The agreement will be subject to approval by the court, which approval cannot be assured. We can give no assurances as to whether or when a settlement will occur or be finalized. Because our liability, if any, cannot be reasonably estimated, no amounts have been accrued for this matter. The ultimate outcome of this matter could have a material adverse affect on our results of operations.

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

On January 14, 2004, we filed motions for a more definite statement of count one (breach of contract) and to dismiss count two of the complaint (defamation). On January 29, 2004, AC Lens filed an amended complaint alleging breach of contract with greater specificity and removing the defamation claim. Consequently, we withdrew our motions. On February 27, 2004, we filed an answer to the amended complaint and asserted a counterclaim for breach of contract. AC Lens replied to the counterclaim on March 3, 2004. The parties are now engaged in discovery. At this time, we are unable to predict the outcome of this litigation. No amounts have been accrued for this matter, as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our financial position and results of operations.

Vision Direct – 1-800 Contacts Litigation.    On October 9, 2002, plaintiff 1-800 Contacts, Inc. filed a complaint in the United States District Court for the Southern District of New York (the District Court) against defendants WhenU.com, Inc. and Vision Direct, Inc. (VDI), a subsidiary of International Vision Direct Corp. The complaint alleged copyright and trademark violations based on defendants’ use of “pop-up” advertising over 1-800 Contacts’ Web site, a “cyber squatting” claim against VDI based on its registration of the domain name www.www1800Contacts.com (the Domain Name) and unspecified damages. 1-800 Contacts also moved for a preliminary and permanent injunction against both defendants to stop their use of pop-up advertisements and compel VDI to relinquish its registration of the Domain Name. Both defendants answered the complaint and VDI denied the substantive allegations of the complaint. The defendants also opposed the motion for a preliminary injunction.

On December 22, 2003, the District Court granted 1-800 Contacts’ motion for a preliminary injunction, notwithstanding the fact that VDI had voluntarily ceased the use of pop-up advertisements before the commencement of the action and relinquished its registration of the Domain Name. Both defendants filed timely notices of appeal from the District Court’s order to the United States Court of Appeals for the Second Circuit, which have been fully briefed. The Second Circuit heard oral arguments on April 5, 2004 and is now considering the appeals. On June 24, 2004, we settled the action by 1-800 Contacts against VDI without any material financial obligation to us or VDI. Because we were not the only defendants in this matter, the Second Circuit is still considering certain issues on appeal.

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

On February 5, 2004, the District Court granted Vision Direct’s request to adjourn a status conference scheduled for February 6, 2004, pending resolution of the appeals in the 1-800 Contacts litigation discussed above. The appeal in the 1-800 Contacts litigation is currently under submission to the U.S. Court of Appeals for the Second Circuit. At this time, we are unable to predict the outcome of this litigation. No amounts have been accrued for this matter, as our liability, if any, cannot be reasonably estimated. The ultimate outcome of this matter could have a material adverse affect on our financial position and results of operations.

State Sales Tax Claims.    In early 2002, we received an Arbitrary Assessment notice from the state of New Jersey for past sales tax due from fiscal years 2000 and 2001, based upon its best estimate of sales revenue numbers during those periods. In December 2002, we received a Revised Assessment from the State of New Jersey based on sales revenue numbers we provided. In March 2003, we filed an appeal of the Revised Assessment with the Tax Court of New Jersey, based on the fact that the State of New Jersey is pursuing its claim specifically against one of our consolidated subsidiaries that is not the retailing entity in that state. The appeal is pending and is in the pre-trial discovery phase. Due to the uncertainty of the appeal, no amounts have been recorded in the accompanying financial statements with respect to the sales tax alleged to be due. We believe that the ultimate resolution of this sales tax assessment will not have a material adverse effect on our financial position or operating results. No amounts have been accrued for this matter as our liability, if any, cannot be reasonably estimated. However, the ultimate outcome of this matter could have a material adverse affect on our financial position and results of operations.

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

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

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9.    Segment Information

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

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis should be read in conjunction with the financial statements and accompanying notes included elsewhere in this quarterly report as well as our annual report on Form-10-K for the fiscal year ended December 28, 2003.

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 other than statements of historical fact, including statements regarding industry prospects and our future financial and operational performance, made in this quarterly report are forward-looking. Words such as “expects,” “believes,” “anticipates,” “intends,” “may,” “will,” “plan,” “continue,” “forecast,” “remains,” “would,” “should,” and similar expressions, are intended to identify forward-looking statements. Forward-looking statements reflect management’s current expectations, are not guarantees of future performance and involve assumptions, risks, and uncertainties. Our actual results may differ significantly from those stated or implied in the forward-looking statements for a variety of reasons, including, among others, effects of changes in the economy, consumer spending patterns, the mix of products sold to customers, fluctuations in the stock market, changes affecting the Internet, online retailing and advertising, drugstore.com’s limited operating history, our ability to attract and retain customers, the unpredictability of future revenues and expenses and potential fluctuations in revenues and operating results, risks and benefits related to business combinations and strategic relationships, consumer trends, the level of competition, seasonality, the timing and success of expansion efforts, risks related to systems interruptions, possible governmental regulation, and the ability to manage a rapidly growing business. These and other risks and uncertainties that could cause our actual results to differ significantly from management’s expectations are described in the following discussion and in the section entitled “Business – Factors That May Affect Our Business” in Part I, Item 1 of our annual report on Form 10-K for the fiscal year ended December 28, 2003, filed with the Securities and Exchange Commission. 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 expressly disclaim any intent or obligation to update any forward-looking statement after the date on which we make it, except as we otherwise specifically state.

We operate on a retail calendar. References in the following discussion to yearly periods are to fiscal years, unless the context indicates otherwise. For example, “2003” refers to the fiscal year ended December 28, 2003.

Overview

drugstore.com, inc. is a leading online provider of health, beauty, vision and pharmacy solutions. We believe that our Web stores, including those located on the Internet at www.drugstore.com, www.beauty.com, www.visiondirect.com, and www.lensmart.com, offer a better way for consumers to shop for these products. We operate primarily in the United States and Canada, but our products are available to consumers worldwide.

Business Segments; Growth Strategies.    Following our acquisition of Vision Direct in December 2003 and in keeping with our current growth strategy in our pharmacy product category, in the fourth quarter of 2003 we organized our business into four primary business segments: mail-order pharmacy, local pick-up pharmacy, over-the-counter (OTC), and vision. The organization of our business into these four distinct segments allows our management to gain a comprehensive financial view of each of our key businesses and our business as a whole. In addition, this segmentation better allows us to align strategies in operations, marketing and customer care in order to optimize the overall customer experience, both within each segment and across all segments, and to maximize growth.

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Revenues.    We generate revenue primarily from product sales and shipping fees. In the three and six month period ended June 27, 2004, we reported consolidated total net sales of $87.8 million, and $172.2 million respectively. Improved performance in our OTC and mail-order pharmacy business segments along with the addition of our vision segment contributed substantially to our growth in total net sales for the three- and six-months ended June 27, 2004.

Expenses.    Our operating expenses, including cost of goods sold, declined as a percentage of net sales to 105.7% and 105.6% for the three- and six-month periods ended June 27, 2004 compared to 108.1% and 109.2% for the three- and six-month periods ended June 29, 2003. This decline resulted from our efforts to drive greater sales volumes across our fixed cost infrastructure.

Net Loss; Cash Position.    Our net losses for the three-month periods ended June 27, 2004 and June 29, 2003 were $5.0 million and $4.6 million respectively. Included in the second quarter of 2004 net loss are expenses of $230,000 related to Kal Raman’s departure from drugstore.com, inc., and capitalized labor costs of approximately $540,000. Our net loss for the six-month periods ended June 27, 2004 of $9.5 million reflected a loss reduction of $657,000 from $10.2 million reported for the six months ended June 29, 2003. The loss reduction reflects the benefit of a greater sales volume relative to our fixed cost infrastructure. We ended the second quarter of 2004 with over $37.8 million in cash and marketable securities and no debt. Uses of cash in the quarter included increased capitalized labor costs related to the integration of CNS and Vision Direct, and funding ongoing operations.

Chief Executive Officer.    On June 11, 2004, drugstore.com, inc. announced the appointment of chief financial officer Robert A. Barton as the company’s acting chief executive officer, and the resignation of Kal Raman as president and chief executive officer. The company has engaged a search firm and is focused on hiring a highly qualified chief executive officer as soon as possible.

Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 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

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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, which 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 IV, Item 15 of our annual report on Form 10-K for the fiscal year ended December 28, 2003. Although we believe that our estimates, assumptions and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments or conditions. In addition, any significant unanticipated changes in any of our assumptions could have a material adverse effect on our business, financial condition and results of operations.

Revenue Recognition

Revenues from sales of products delivered to customers (net of promotional discounts, cancellations, rebates and returns allowances) are recorded when the products are shipped and title passes to the customer. Return allowances, which reduce product sales by our estimate of expected product returns, are estimated using historical experience. If our estimate of return allowances is too high, our revenues will be understated; if our estimate of these allowances is too low, our revenues will be overstated. Historically, product returns, and differences between our estimates and actual returns, have not been significant.

Revenues from sales of certain pharmaceutical products ordered through our drugstore.com Web store or by telephone for pick-up at a Rite Aid store are recognized when the customer picks up the product. In these circumstances, we utilize Rite Aid as a fulfillment partner. According to the criteria outlined in 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 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 credit risk and inventory risk associated with these sales.

Revenues from sales of OTC products ordered through the Amazon.com Web site which are fulfilled by drugstore.com are recognized when the products are shipped from our distribution center. According to the criteria outlined in EITF 99-19, we record fees and revenues generated by the Amazon.com agreement in our OTC segment on a gross basis, because we believe we act as a principal, based on the fact that we bear general inventory risk associated with these sales.

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

Inventory

We value our inventory at the lower of cost (using the weighted-average cost method) or the current estimated market value of the inventory. We regularly review inventory quantities on hand and record a reserve 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 Web sites, 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 will understate or overstate the provision required for excess and obsolete inventory. Historically, the market value of our inventory has not differed materially from our estimates.

Goodwill

In accordance with SFAS No. 142, Accounting for Goodwill and Other Intangibles, 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 exist. The first phase of the test screens for impairment and the second phase, (if necessary) performed by comparing the fair value of the applicable reporting unit to its carrying value, measures for impairment. Fair value is determined using a discounted cash flow methodology. If our estimates of revenue growth or future cash flows prove to be inaccurate, we may have a future impairment of goodwill.

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Results of Operations

Net Sales