##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-K

(Mark one)



|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------

For the fiscal year ended January 2, 2011

or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period
from                     to

Commission File Number: 0-26137

drugstore.com, inc.

(Exact Name of Registrant as Specified in its
Charter)



|                                                               |  |                                                     
|-------------------------------------------------------------- |  | ----------------------------------------------------
|Delaware                                                       |  | 04-3416255                                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)                
|                                                               | 
|411 108thAvenue NE, Suite 1400 Bellevue, Washington 98004      |  | (425) 372-3200                                      
|(Address of Principal Executive Offices)                       |  | (Registrants telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:



|                                          |  |                                               
|----------------------------------------- |  | ----------------------------------------------
|Title of Each Class                       |  | Name of Each Market on Which Listed           
|Common Stock, par value $0.0001 per share |  | NASDAQ Stock Market LLC (NASDAQ Global Market)

Securities registered pursuant
to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities
Act.    Yes   ̈    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the
Act.    Yes   ̈    No  x

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 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such
files).    Yes   ̈    No   ̈

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will
not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in part III of this Form 10-K or any amendment to this Form
10-K.  x

Indicate by check mark whether the registrant is a large
accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the
Exchange Act. (Check one):



|                           |  |                             
|-------------------------- |  | ----------------------------
|Large Accelerated filer   ̈ |  | Accelerated filer  x        
|Non-accelerated filer   ̈   |  | Smaller reporting company   ̈

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).    Yes   ̈    No  x

The aggregate market value of common stock held by non-affiliates of the registrant was $309,790,479 as of July 4, 2010, the last
business day of the registrants most recently completed second fiscal quarter.

As of March 4, 2011, the number of
shares of the registrants common stock outstanding was 105,911,293.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this annual report, to the extent not set forth in this annual report, is
incorporated by reference from the registrants definitive proxy statement relating to the registrants annual meeting of stockholders to be held on June 9, 2011, which definitive proxy statement will be filed with the Securities and
Exchange Commission within 120 days after the end of the fiscal year to which this annual report relates.









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DRUGSTORE.COM, INC.

ANNUAL REPORT ON FORM 10-K

For the Fiscal Year Ended January 2, 2011

Table of Contents



|           |  |                                                                                                               |      |      |    | 
|---------- |  | ------------------------------------------------------------------------------------------------------------- | ---- | ---- | -- | 
|           |  |                                                                                                               |      | Page |   
|           |  | PART I                                                                                                        |      |      |    | 
|           |  |                                                                                                              
|ITEM 1.    |  | BUSINESS                                                                                                      |      |      | 1  | 
|           |  |                                                                                                              
|ITEM 1A.   |  | RISK FACTORS                                                                                                  |      |      | 7  | 
|           |  |                                                                                                              
|ITEM 1B.   |  | UNRESOLVED STAFF COMMENTS                                                                                     |      |      | 24 | 
|           |  |                                                                                                              
|ITEM 2.    |  | PROPERTIES                                                                                                    |      |      | 24 | 
|           |  |                                                                                                              
|ITEM 3.    |  | LEGAL PROCEEDINGS                                                                                             |      |      | 25 | 
|           |  |                                                                                                              
|ITEM 4.    |  | RESERVED                                                                                                      |      |      | 25 | 
|           |  |                                                                                                              
|           |  | PART II                                                                                                       |      |      |    | 
|           |  |                                                                                                              
|ITEM 5.    |  | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES |      |      | 26 | 
|           |  |                                                                                                              
|ITEM 6.    |  | SELECTED FINANCIAL DATA                                                                                       |      |      | 28 | 
|           |  |                                                                                                              
|ITEM 7.    |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS                         |      |      | 29 | 
|           |  |                                                                                                              
|ITEM 7A.   |  | QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK                                                     |      |      | 48 | 
|           |  |                                                                                                              
|ITEM 8.    |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                   |      |      | 48 | 
|           |  |                                                                                                              
|ITEM 9.    |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE                          |      |      | 48 | 
|           |  |                                                                                                              
|ITEM 9A.   |  | CONTROLS AND PROCEDURES                                                                                       |      |      | 48 | 
|           |  |                                                                                                              
|ITEM 9B.   |  | OTHER INFORMATION                                                                                             |      |      | 51 | 
|           |  |                                                                                                              
|           |  | PART III                                                                                                      |      |      |    | 
|           |  |                                                                                                              
|ITEM 10.   |  | DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE                                                       |      |      | 53 | 
|           |  |                                                                                                              
|ITEM 11.   |  | EXECUTIVE COMPENSATION                                                                                        |      |      | 53 | 
|           |  |                                                                                                              
|ITEM 12.   |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS                |      |      | 53 | 
|           |  |                                                                                                              
|ITEM 13.   |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE                                     |      |      | 53 | 
|           |  |                                                                                                              
|ITEM 14.   |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                        |      |      | 53 | 
|           |  |                                                                                                              
|           |  | PART IV                                                                                                       |      |      |    | 
|           |  |                                                                                                              
|ITEM 15.   |  | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                    |      |      | 54 | 
|           | 
|SIGNATURES |  |                                                                                                               | F-35 |     



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|ITEM 1. | BUSINESS
|------- | --------

This Annual
Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements based on expectations, estimates, and projections as of the date of this filing. Actual results may differ materially from those expressed in
forward-looking statements. See item 1A of Part IRisk Factors.

drugstore.com, inc. was incorporated in
April 1998 in the state of Delaware. We launched our web store at www.drugstore.com in February 1999 and completed our initial public offering in July 1999. Our common stock is listed on the NASDAQ Global Market under the symbol
DSCM. Our principal corporate offices are located in Bellevue, Washington. As used in this annual report, drugstore.com, we, our, and similar terms refer to drugstore.com, inc. and its subsidiaries,
unless the context indicates otherwise.

Business Strategy

Our business strategy is to offer our customers a wide selection of products at competitive prices and to provide a superior online shopping experience.

Convenience. Our online stores are available to consumers 24 hours a day, seven days a week. All of our products are also
available for purchase by phone. We offer additional convenience to our customers through easy-to-use websites, robust search technology, and a variety of features such as: Your List, a personal shopping list of the customers previous
purchases that allows for quick and easy re-ordering, even without browsing the site; Auto Delivery, which enables customers to set up automatic shipments of frequently ordered products; the ability to schedule e-mail reminders about
previously purchased products that are scheduled to run out or are on sale; and an automated flexible spending account, or FSA, manager that keeps track of FSA-eligible purchases and provides customers with downloadable receipts to submit to their
FSA administrator.

Selection. We are able to offer a significantly broader assortment of products, with greater depth
in each product category, because we do not have the shelf display space limitations of brick-and-mortar stores. With a single check-out, our customers are able to buy health, beauty and personal care products, prestige beauty brands, salon hair
care, natural products, and other specialty items. In addition, we offer contact lenses and customized nutritional supplement programs through our subsidiary websites.

Information. We provide a broad array of interactive tools and information on our websites to help consumers make informed purchasing decisions. Our information services include detailed product
information pages; personalized product recommendations; customer reviews and other editorial content; the eMedAlert program, which alerts customers to safety issues such as FDA and product manufacturer recalls; and extensive health- and
pharmacy-related information, including a drug information database, a drug price index, information on generic drug alternatives, a drug interaction checker; and Ask Your Pharmacist, which is a database of over 800 frequently-asked questions
provided by pharmacists. Our customer care representatives are available to provide personal guidance and answer customers questions by phone, e-mail, and in some instances, instant chat while shopping our sites.

Privacy. When shopping at a brick-and-mortar drugstore, many consumers may feel embarrassed or uncomfortable about buying items or
asking questions that may reveal personally sensitive aspects of their health or lifestyle to pharmacists, store personnel, or other shoppers. Our customers avoid these problems by shopping from the privacy of their home or office.

Value. Our goal is to offer shoppers a broad assortment of health, beauty, clinical skincare, and vision products with competitive
pricing. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can pass along the savings to our customers in the form of lower prices and exclusive deals. We also seek to inform customers of additional
cost-saving opportunities when they become available. For example, on our vision sites, we inform our customers of available rebates and volume purchase discounts.



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Business Segments

In 2010, our over-the counter or OTC segment accounted for 84% of our net sales and our vision segment accounted for 16% of our net sales. See Note 13 of our consolidated financial statements included in
Part IV, Item 15 of this annual report. On July 30, 2010, we closed the sale of our mail-order pharmacy assets to BioScrip Pharmacy Services, Inc. (BioScrip) and entered into an agreement whereby BioScrip provides pharmacy services to
drugstore.com customers. Customers are able to continue to order and refill their prescriptions through the drugstore.com website, which are fulfilled by Bioscrip. All operations of our mail-order pharmacy segment have been presented as discontinued
operations for all periods presented.

OTC

We stock approximately 50,000 non-prescription health, beauty, personal care, household, and other products. We also offer approximately
20,000 products through our arrangements with drop-ship vendors. We offer OTC products in a variety of categories, including:



|                             |  |                                                                                                                  
|---------------------------- |  | -----------------------------------------------------------------------------------------------------------------
|     Personal Care          |  |      Diet and Fitness                                                                                           
|     Makeup and Accessories |  |      Household                                                                                                  
|     Hair Care              |  |      Pets                                                                                                       
|     Skin Care              |  |      Baby and Mom                                                                                               
|     Mens                  |  |      Food and Snacks                                                                                            
|     Medicine and Health    |  |      FSA                                                                                                        
|     Vitamins               |  |      Sexual Well-Being                                                                                          
|     Gifts                  |  |      Toys and Games                                                                                             
|     Oral Care
     GNC    |  |      Beauty.com (prestige beauty products, also
accessible through www.beauty.com)                              
|     Green and Natural      |  |      SkinStore.com (clinical skincare and
beauty products, accessible through www.SkinStore.com and spalook.com)

Through our
newly acquired subsidiary Salu Beauty, Inc. (Salu), we offer on www.SkinStore.com and through www.spalook.com, which we operate on behalf of a third party, over 200 premium brands of clinical skincare and beauty products typically
found only in luxury spas, fine stores, and dermatologists offices. Our beauty business, combined with the acquisition of Salu, is now one of the largest online beauty retailers offering mass and prestige brands, and clinical skincare
products.

We currently operate five microsites that we offer OTC products for sale, which allow us to better target specific
customers with tailored marketing programs by offering a larger assortment of niche-specific SKUs and product content. We also offer our OTC products for sale through various marketplaces and websites including Amazon.com and Buy.com, and in the
first quarter of 2011, we launched marketplaces on ShopRunner.com, Facebook.com and eBay.com.

In addition, we have partnered
with Medco Health Services, Inc. (Medco) and Rite Aid Corporation (Rite Aid) to provide technical development and operation services, consumer health products and OTC merchandising, fulfillment capabilities and customer care for the non-prescription
drug offerings on the Medco-branded and Rite Aid-branded online stores.

We also provide personalized nutrition services to
consumers in the form of an online assessment of an individuals specific nutritional supplement needs, and deliver the personalized vitamins, minerals, herbs, and supplements in pharmaceutical-grade, daily dose packages. In addition, we act as
the exclusive fulfillment provider for customized nutritional supplements sold through www.DrWeilVitaminAdvisor.com, www.DrWeil.com, and other Dr. Weil-related websites.



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Vision

Through our subsidiary Vision Direct, we offer a broad assortment of contact lenses, in addition to reading glasses, contact lens cases,
and other contact lens supplies. We believe that we offer these products at a substantial price savings over eye care practitioners, national optical chains, and many online competitors.

In 2009, we entered into a strategic multi-year e-commerce partnership with Luxottica Group, S.p.A. (Luxottica), a global leader in the
design, manufacturing and distribution of fashion, luxury, and sport eyewear. Through this partnership, we will develop branded contact lens e-commerce sites for Luxotticas North American businesses such as LensCrafters, Pearle Vision, and
Sears Optical. In January 2011, we launched two of the Luxottica-branded sites: www.lenscrafterscontacts.com and www.pearlevisioncontacts.com.

Our contact lens business is subject to the U.S. Fairness to Contact Lens Consumers Act, or FTCLCA, and the related regulations of the Federal Trade Commission, or FTC, which establish a national uniform
standard for eye care practitioners and direct marketers with respect to the sale of contact lenses, including verification of contact lens prescriptions. In accordance with these guidelines, we ask the patients eye care professional to verify
the prescription before we ship an order and allow eight business hours for the eye care professional to reply to our verification request. If the eye care professional approves the prescription, or does not respond to our verification request
within eight business hours, we ship the order to the customer as expressly permitted by the FTCLCA.

Marketing and Promotions

Our marketing and promotion strategy is designed to build brand recognition, increase customer traffic to our store, add
new customers, build strong customer loyalty, maximize repeat purchases, and develop incremental revenue opportunities. Our online advertising campaigns are focused on search engines, frequently visited Internet portals, health- and beauty-related
websites, and direct-to-consumer e-mail marketing programs. We further extend our online market presence through our affiliate program, through which we permit certain websites to make our products and services available to their audiences through
links to our websites.

We also employ a variety of marketing programs and promotions, such as discounted and free shipping
promotions, dollar off and percentage discounts, free gifts with purchase, and the drugstore.com dollars program, a loyalty program in which customers automatically earn a five percent rebate to be used for future non-prescription purchases.

Fulfillment and Customer Care

Order Fulfillment

We process most OTC orders from our primary
distribution center in Swedesboro, New Jersey, and in January 2010, we moved the processing of all vision orders from our distribution center in Ferndale, Washington to our primary distribution center in Swedesboro, New Jersey. We also process
drop-ship orders for certain OTC products and arrange for our drop-ship vendor partners to ship these products directly from the vendors warehouse. Due to the relatively short lead time required to fill orders for our products, usually 24 to
48 hours, order backlog is not material to our business.

We ship OTC products to U.S., U.S. Territory, and APO/FPO military
addresses. In addition, through an agreement with FiftyOne, Inc., we offer international shipment of select OTC health, beauty, and wellness products to 56 countries, and expect to expand to more countries over time. Vision Direct ships contact
lenses and other vision products worldwide, primarily to the United States and Canada.

We use third-party fulfillment
partners in Columbus, Ohio, and Australia to process and ship Salu orders.



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Customer Care

Our customer care representatives operate from our call center in Halifax, Nova Scotia, Canada, from our headquarters in Bellevue,
Washington, and from our Sacramento, California office. Our customer care specialists are available 24 hours a day, seven days a week via e-mail or telephone to handle customer inquiries and assist customers in finding desired products. The
Help sections of our websites outline store policies and provide answers to customers frequently asked questions.

Technology

We have implemented a broad array of services and systems for site management, product searching, customer interaction,
transaction processing, and order fulfillment functions. These services and systems use a combination of our own proprietary technologies and commercially available, licensed technologies. We focus our internal development efforts on creating and
enhancing the specialized, proprietary software that is unique to our business. For example, our core merchandise catalog, customer interaction, order collection, fulfillment, and back-end systems are proprietary to drugstore.com. Our systems are
designed to provide real-time connectivity to the distribution center systems for both vision and OTC products. They include an inventory-tracking system, a real-time order tracking system, an executive information system, and an inventory
replenishment system.

We license database, operating system, and hardware components from third parties.

Competition

The market
for health, beauty, wellness, and vision products is intensely competitive and highly fragmented. Our competitors in the OTC segment include chain drugstores, mass market retailers, warehouse clubs, supermarkets, and, with respect to prestige
beauty, health, and spa products, specialty retailers and major department stores. Our competitors in the vision segment include other online providers of contact lenses, national optical chains, eye care professionals, and mass-market retailers and
warehouse clubs that provide prescription vision services. In addition, we compete with Internet portals and online service providers that feature shopping services and with other online or mail-order retailers that offer products within one or more
of our business segments.

During the recent economic conditions, we have seen and expect to see continued price competition
and elevated response rates to coupons and other promotional offers by increasingly price-conscious customers. That said, we have found that overall orders are less affected in periods of economic slowdown, due in part to our value-pricing and the
non-discretionary nature of many of our products.

We believe that the principal competitive factors in our market segments
include: brand awareness and preference, company credibility, product selection and availability, convenience, price, actual or perceived value, website features, functionality and performance, ease of purchasing, customer service, privacy, quality
and quantity of information supporting purchase decisions (such as product information and reviews), and reliability and speed of order shipment.

Intellectual Property

We regard our intellectual property as critical to
our future success; and we rely on a combination of patent, copyright, trademark, service mark, and trade secret laws, as well as contractual restrictions to establish and protect our proprietary rights in products and services. We own a number of
domain names, hold nine patents, have registered several trademarks, and have filed applications for the registration of a number of our other trademarks and service marks in the United States as well as several other countries. We have licensed in
the past, and expect to license in the future, some of our proprietary rights to third parties.



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Seasonality

Our OTC business is subject to seasonal variations in demand. Historically, the fourth quarter of each year has been our strongest OTC sales quarter, primarily because of increased online shopping and our
greater marketing efforts during the holiday season as well as increased purchases by customers using funds from flexible spending accounts. We do not believe that our vision segment is substantially affected by seasonality.

Employees

As of
January 2, 2011, we had approximately 945 full-time employees. However, employment levels fluctuate due to seasonal variations in our OTC business, and we hire independent contractors and temporary employees as needed to address demand. None of
our employees is represented by a labor union, and we consider our employee relations to be good.

Available Information

We file with, and furnish to, the Securities and Exchange Commission, or SEC, periodic reports, proxy statements, and other information.
We make these documents available, free of charge, on our website at www.investor.drugstore.com as soon as reasonably practicable after we electronically file them with, or furnish them to, the SEC.

Directors and Officers

The following tables provide information regarding our directors and officers as of the date of this annual report:

Directors



|                      |  |     |    |  |          |                                                                                  
|--------------------- |  | --- | -- |  | -------- | ---------------------------------------------------------------------------------
|Name                  |  | Age |    |  | Position
|Dawn G. Lepore        |  |     | 56 |  |          | President, Chief Executive Officer and Chairman of the Board, drugstore.com, inc.
|Richard W. Bennet III |  |     | 58 |  |          | CEO, CCA Global Partners                                                         
|Geoffrey R. Entress   |  |     | 47 |  |          | Venture Partner, Voyager Capital                                                 
|Jeffrey M. Killeen    |  |     | 57 |  |          | Chairman and CEO, GlobalSpec, Inc.                                               
|William D. Savoy      |  |     | 46 |  |          | Consultant                                                                       
|Gregory S. Stanger    |  |     | 46 |  |          | Chief Financial Officer, Chegg, Inc.                                             

Executive Officers



|               |  |     |    |  |          |                                                              
|-------------- |  | --- | -- |  | -------- | -------------------------------------------------------------
|Name           |  | Age |    |  | Position
|Dawn G. Lepore |  |     | 56 |  |          | President, Chief Executive Officer, and Chairman of the Board
|Yukio Morikubo |  |     | 51 |  |          | Vice President, Strategy, General Counsel and Secretary      
|Robert Potter  |  |     | 45 |  |          | Vice President, Chief Accounting Officer                     
|Tracy Wright   |  |     | 39 |  |          | Vice President, Chief Finance Officer                        

Dawn G. Lepore has served as President, Chief Executive Officer and Chairman of the Board of drugstore.com since October 2004.
Ms. Lepore served as Vice ChairmanActive Trader, Technology, Operations, Administration and Business Strategy of The Charles Schwab Corporation, or CSC, from August 2003 to October 2004. CSC, through Charles Schwab & Co., Inc.,
or Schwab, and its other operating subsidiaries, is a financial services firm. Ms. Lepore served as Vice ChairmanTechnology, Active Trader, Operations, and Administration of CSC and Schwab from May 2003 until August 2003, as Vice
Chairman



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Technology, Operations and Administration of CSC and Schwab from July 2002 until May 2003, as Vice ChairmanTechnology and Administration of CSC and Schwab from 2001 to 2002, as Vice
Chairman and Chief Information Officer of CSC and Schwab from 1999 to 2001 and as Executive Vice President and Chief Information Officer of CSC and Schwab from 1993 to 1999. She joined Schwab in 1983. Ms. Lepore serves as a director of
eBay Inc. and The New York Times Company.

Yukio Morikubo has served as Vice President, General Counsel and Secretary
of drugstore.com since November 2006 and as Vice President, Strategy since April 2007. From April 2005 to September 2006, Mr. Morikubo was Vice President, General Counsel and Corporate Secretary of Advanced Digital Information Corporation, a
provider of intelligent data storage hardware and software solutions that was acquired in August 2006 by Quantum Corporation. He served as Chief Counsel, International of Cingular Wireless, LLC, formerly AT&T Wireless Services, Inc., a
wireless service provider, from 1996 to 1999 and again from 2000 until April 2005. Mr. Morikubo previously practiced with the law firm of Perkins Coie LLP and served as an auditor and tax consultant with KPMG LLP.

Robert Potter has served as Vice President, Chief Accounting Officer of drugstore.com since May 2008, Chief Accountant since
December 2006, and as Senior Director and Corporate Controller for drugstore.com from 2004 to 2006. Prior to joining drugstore.com, he served as Corporate Controller for Midstream Technologies, Inc., a technology company, from 2000 to 2004.
Mr. Potter previously held senior positions with Mosaix, Inc., PHAMIS, Inc., Aldus Corporation and Ernst & Young LLP.

Tracy Wright has served as Vice President, Chief Finance Officer of drugstore.com since May 2008, Vice President of Financial Planning and Analysis since August 2007, and as Senior Director of
Financial Planning and Analysis from 2003 to July 2007. Prior to joining drugstore.com, Ms. Wright held financial leadership roles at Western Wireless International, Freeinternet.com, and PriceWaterhouseCoopers LLP.

Non-Executive Officers

Jon Axelsson has served as Vice President of Operations since June 2009. Mr. Axelsson joined drugstore.com in 2008. Prior to joining drugstore.com Mr. Axelsson held management positions with Wawa,
Inc., QVC, Inc., May Department Stores, and UPS.

Perry Evoniuk has served as Vice President, Enterprise Architecture
since January 2009. Mr. Evoniuk joined drugstore.com in 1999 and has held several positions managing development and implementation of our web store infrastructure. Prior to joining drugstore.com, Mr. Evoniuk served in research and
development positions at Attachmate Corporation, a host connectivity provider, and at Hughes Aircraft, an aerospace and defense company.

Clifford Cancelosiwas appointed to Vice President and Chief Information Officer of drugstore.com in February 2011. Prior to joining drugstore.com, Mr. Cancelosi led the technology and
eCommerce strategy group for Alvarez & Marsal, and served senior leadership roles in the Operations and Merchant Technologies divisions of Amazon.com.

Julie Johnston has served as Vice President, OTC Merchandising of drugstore.com since December 2006 and as the Senior Category Manager for Personal Care with drugstore.com from 2000 to 2006. From
1992 to 1999, Ms. Johnston served in a number of positions at Sears, Roebuck and Co., an international department store company, including Senior Buyer from 1996 to 1999.

Ronald E. Kelly has served as Vice President, Customer Care and Logistics of drugstore.com since June 2006, and as Senior Director of Site Development and Customer Care and Logistics for
drugstore.com from 2003 to 2006. From 2001 to 2003, he served as Director of Customer Care with drugstore.com. From 1999 to 2001, Mr. Kelly served as a Senior Financial Analyst and later as Director of Procurement for drugstore.com.



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David Lonczak has served as our Chief Marketing Officer since March 2007 and has
served as our Vice President, Marketing since December 2006. In early 2006, Mr. Lonczak began serving as Senior Director of Marketing in Pharmacy for drugstore.com, and served as General Manager of Vision for drugstore.com from 2005 to 2006.
From 2002 to 2005, Mr. Lonczak served in a number of positions with Cingular Wireless, LLC, formerly AT&T Wireless Services, Inc., a wireless service provider, including Vice President, eCommerce from 2004 to 2005.

Kathleen McNeill has served as our Vice President of Beauty since December 2006. Ms. McNeill joined drugstore.com in June
2006 as our General Manager, Beauty. From 2005 to June 2006, Ms. McNeill served as Vice President of Flagship Stores with Bath and Body Works, a division of Limited Brands, Inc., a specialty retail company. From 2000 to 2005, Ms. McNeill
served in a number of positions, including Skincare Merchandise manager with Sephora, USA, Inc., the cosmetic retailer division of Moët Hennessy Louis Vuitton, an international luxury products retailer.

Stan Pavlovsky has served as Vice President, Vision Direct, since January 2009. Mr. Pavlovsky joined drugstore.com in 2004,
in our financial planning and analysis group before moving over to our vision business. Prior to joining the company, Mr. Pavlovsky held positions in financial and business analysis at Microsoft Corporation, a software company, and The Boeing
Company, an aerospace company and aircraft manufacturer.

Jim Steeb serves as our chief executive officer of Salu
Beauty, Inc., (Salu) a wholly-owned subsidiary of drugstore.com inc., acquired in 2010. Mr. Steeb has more than 25 years of experience in executive management, marketing, finance and IT. He joined Salu as CEO and president in 1999. Previously
he held leadership positions with Care Wise, Inc., Access Health, Inc., and Baxter Healthcare Corporation.

Ramer Holtanwas appointed to Vice President, Marketing in November 2010. Mr. Holtan joined drugstore.com in 2000 as a financial analyst and moved to marketing in 2001, where he has held management positions in the areas of retention marketing, pricing
strategy, and marketing analytics, as well as serving as general manager of Vision from 2004 to 2005. Prior to joining drugstore.com, Mr. Holtan spent five years working for Arthur Andersen LLP in the Economic and Financial Consulting group.



|ITEM 1A. | RISK FACTORS
|-------- | ------------

You
should carefully consider the following risks and uncertainties associated with our company and ownership of our securities. If any of the following risks actually occurs, our business, financial condition, or operating results could be materially
adversely affected. This could cause the trading price of our common stock to decline, and you could lose all or part of your investment. Some statements in this annual report (including some of the following risk factors) are forward-looking
statements. See the section entitled Special Note Regarding Forward-Looking Statements in Part I, Item 1 of this annual report.

We face significant competition from both traditional and online retailers.

The market segments in which we compete are rapidly evolving and intensely competitive, and we have many competitors in different industries, including both the retail and e-commerce services industries.
These competitors include chain drugstores, mass-market retailers, warehouse clubs, supermarkets, specialty retailers, major department stores, insurers and health care providers, national optical chains, eye care professionals, Internet portals and
online service providers that feature shopping services, and various online stores that offer products within one or more of our product categories. Many of our current and potential competitors have longer operating histories, larger customer
bases, greater brand recognition, and significantly greater financial, marketing, and other resources than we have. They may be able to secure merchandise from vendors on more favorable terms, operate with a lower cost structure, adopt more
aggressive pricing policies, or devote more



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resources to technology development and marketing than we do. To the extent we can respond with more aggressive discounts, shipping rates, or other promotions, we cannot ensure that these will be
successful and in any event, our margins will be negatively affected. In addition, other companies in the retail and e-commerce service industries may enter into business combinations or alliances that would strengthen their competitive positions
and prevent them, their affiliated companies, or their strategic partners from entering into relationships with us.

As
various Internet market segments obtain large, loyal customer bases, participants in those segments may expand into the market segments in which we operate. In addition, new and expanded Web technologies may further intensify the competitive nature
of online retail and allow our competitors to duplicate many of the products, services, and content offered on our site. We believe that the Internet facilitates entry into the retail market and comparison shopping and renders it inherently more
competitive than conventional retailing formats. We expect competition in the e-commerce channel to intensify, and this increased competition may reduce our ability to grow and, as a result, reduce our revenue, increase our operating expenses, or
both, and harm our business.

Our revenue growth and profitability depends on the continued growth of demand for the products we offer.

Demand for many of our products, and, therefore, our business, is affected by changes in consumer preferences, general
economic and business conditions, and world events. For example, macro-economic trends in the United States and abroad, threatened or actual terrorist attacks or armed hostilities (or the resulting security concerns), or natural disasters could
create economic and consumer uncertainty and delays in and increased costs of product shipments to and from us, which may decrease demand. A softening of demand, for whatever reason, may result in decreased revenue or growth, which could prevent us
from achieving or sustaining profitability. Revenue growth or profitability may not be sustainable and our company-wide and by-segment percentage growth rates may decrease in the future.

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors, including:



| |  |  | our ability to retain and increase sales to existing customers, attract new customers, and satisfy our customers demands;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | the frequency and size of customer orders and the quantity and mix of products our customers purchase;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | changes in consumer acceptance and usage of the Internet, online services, and e-commerce;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | the price we charge for our products and for shipping those products, or changes in our pricing policies or the pricing policies of our competitors;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the extent to which we offer our customers, and our customers take advantage of, free shipping or other promotional discounts;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to acquire merchandise, manage inventory, and fulfill orders;
| | - |  | -------------------------------------------------------------------------



| |  |  | technical difficulties, system downtime, or interruptions;
| | - |  | ----------------------------------------------------------



| |  |  | timing and costs of upgrades and developments in our systems and infrastructure;
| | - |  | --------------------------------------------------------------------------------



| |  |  | timing and costs of marketing and other investments;
| | - |  | ----------------------------------------------------



| |  |  | disruptions in service by shipping carriers;
| | - |  | --------------------------------------------



| |  |  | the introduction by our competitors of websites, products, or services;
| | - |  | -----------------------------------------------------------------------



| |  |  | changes in the mix of products purchased by our customers (for example, if our OTC net sales do not grow as much as we anticipate or the proportion of
OTC net sales compared to net sales in vision segments is lower than we anticipate, our margins will be lower than we currently plan);
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| |  |  | the effects of strategic alliances, potential acquisitions, and other business combinations, and our ability to successfully and timely integrate them
into our business; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in government regulation.
| | - |  | ---------------------------------

In addition, our operating expenses are largely based on anticipated revenue trends and a high percentage of our expenses are fixed in the short term. As a result, a delay in generating or recognizing
revenue for any reason could result in substantial additional operating losses.

A portion of our revenues is also seasonal in
nature. Traditional retail seasonality affects our OTC business, resulting in higher revenues in the fourth quarter of each year as compared to other quarters. We may be unable to manage the increased sales effectively, and increases in inventory in
anticipation of holiday sales could negatively affect our cash flow. In addition, sales of some health and beauty products are driven, to some extent, by seasonal purchasing patterns and seasonal product changes, such as diet products, cold and flu
medications, and products with holiday-specific varieties. Consumer fads and other changes in consumer trends may also cause shifts in purchasing patterns, resulting in significant fluctuations in our operating results from one quarter to the next.

Our evolving business model and the unpredictability of our industry make it difficult for us to forecast accurately the
level or source of our revenues and our rate of growth. We believe that, because of these factors, historical trends and quarter-to-quarter comparisons of our operating results are not necessarily meaningful and should not be relied on as an
indicator of our future performance. In the past, our operating results have sometimes been, and it is likely that in some future quarter or quarters they will be, below the expectations of investors and securities analysts. In that event, the price
of our common stock may fall substantially, and stockholders may lose all or a part of their investment.

If our marketing efforts are
not effective at attracting and retaining customers at an acceptable cost, we will be unable to achieve consistent profitability.

If we do not maintain our brand and continue to increase awareness of our products and services, we may not build a critical mass of customers. Promoting and positioning our brand depends largely on the
success of our marketing efforts and our ability to provide consistent, high quality customer experiences. We believe that, because we are a small company with low public brand awareness in an increasingly competitive market, achieving significant
market awareness will require significant marketing expense. To promote our brand and our products and services, we have incurred and expect to continue to incur substantial expense in our marketing efforts both to attract and to retain customers.
Our promotional activities may not be effective at building our brand awareness and customer base to the extent necessary to generate sufficient revenue to become consistently profitable. Search engine and other online marketing initiatives comprise
a substantial part of our marketing efforts, and our success depends in part on our ability to manage costs associated with these initiatives, or to find other channels to acquire and retain customers cost-effectively. The demand for and cost of
online advertising has been increasing and may continue to increase. An inability to acquire and retain customers at a reasonable cost would increase our operating costs and prevent us from maintaining profitability.

If we fail to integrate, maintain or enhance our strategic relationships to help promote our website and expand our product offerings, our
development could be hindered.

We have entered, or expect to enter, into a number of strategic partnerships to build,
host, and market websites and to process and fulfill orders, most recently, with Rite Aid Corporation, Medco Health Solutions, Inc., Luxottica Group S.p.A., and BioScrip Pharmacy Services, Inc. We believe that our relationships with these and other
strategic partners, Internet portals, third-party distributors, and manufacturers are critical to attract customers, to facilitate broad market acceptance of our products and the drugstore.com brands, and to enhance our sales and marketing
capabilities. We expect to continue to evaluate and consider a wide array of potential strategic partnerships as part of our growth strategy. Any of these transactions could be material to our financial



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condition and results of operations. If we are unable to develop or maintain key relationships, our ability to attract customers would suffer and our business would be adversely affected. The
process of integrating and maintaining strategic partnerships may create unforeseen operating difficulties and expenditures and is itself risky. Such risks include a diversion of management time, as well as a shift of focus from operating the
businesses, to issues related to integration and administration of the strategic partnerships; partners having interests, strategies or goals inconsistent with ours; business decisions or other actions of our partners that may result in harm
to our reputation or adversely affect the value of our investment in the partnership. Such partnerships require a significant investment of time and resources, and we may not generate sufficient revenues to offset this investment. We may incur
additional operating losses and expenses as a result of the operations of the strategic partners or the partnerships. In addition, we are subject to many risks beyond our control that influence the success or failure of our strategic partners or
partnerships, including their ability to perform according to our partners and our expectations. Our business could be harmed if any of our strategic partners were to experience financial or operational difficulties or if other corporate
developments adversely affect their performance under their agreements with us.

Our future growth strategy may depend in part on our
ability to acquire complementary or strategic businesses. Any such acquisitions could result in dilution, operating difficulties, difficulties in integrating acquired businesses, and other harmful consequences.

We have acquired, and may in the future acquire, complementary or strategic businesses, technologies, services, and products as part of
our strategy to increase our net sales and customer base. The process of integrating acquisitions into our business and operations has resulted in, and may in the future result in:



| |  |  | unforeseen operating difficulties and expenditures;
| | - |  | ---------------------------------------------------



| |  |  | disruption of our ongoing business, including loss of management focus on existing businesses and resources that would otherwise be available for
operation, ongoing development and expansion of our business;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | problems retaining key personnel of the businesses that we acquire;
| | - |  | -------------------------------------------------------------------



| |  |  | additional operating losses and expenses of the businesses we acquired or in which we invested;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | the potential impairment of tangible assets, such as inventory, and intangible assets and goodwill acquired in the acquisitions;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------



| |  |  | the potential impairment of customer and other relationships of the business that we acquired or in which we invested or our own customers as a result
of any integration of operations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the difficulty of incorporating acquired technology and rights into our offerings and unanticipated expenses related to such integration;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the difficulty of integrating a new companys accounting, financial reporting, management, information, human resource and other administrative
systems to permit effective management, and the lack of control if such integration is delayed or not implemented; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the difficulty of implementing at companies we acquire the controls, procedures and policies appropriate for a larger public company.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------

To the extent we miscalculate our ability to integrate and properly manage acquired businesses,
technologies, services, and products, or we depend on the continued service of acquired personnel who choose to leave, we may have difficulty in achieving our operating and strategic objectives. In addition, we may not realize the anticipated
benefits of any acquisition.

We may be subject to unanticipated problems and liabilities of acquired companies. While we
attempt in our acquisitions to determine the nature and extent of any pre-existing liabilities, and to obtain indemnification rights



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from the previous owners for acts or omissions arising prior to the date of acquisition, resolving issues of liability between the parties could involve a significant amount of time, manpower and
expense. If we or any of our subsidiaries were to be unsuccessful in a claim for indemnity from the seller of a business that we acquire, the liability imposed on us or our subsidiary could have a material adverse effect on us. We may not be able to
assimilate successfully the additional personnel, operations, acquired technology or products or services into our business. Further, the physical expansion in facilities that could occur as a result of any acquisition may result in disruptions that
could seriously impair our business. In addition, due to the recent disruptions in the global financial markets, valuations supporting our acquisitions could change rapidly, and we could determine that such valuations have experienced impairments
which could adversely impact our financial results.

We may be unable to identify suitable acquisition opportunities or to
negotiate and complete acquisitions on favorable terms, or at all. In addition, any future acquisitions may require substantial capital resources, and, to the extent it is available, we may need to obtain additional capital or financing, from time
to time, to fund these activities. This could result in potentially dilutive issuances of equity securities or the incurrence of debt, contingent liabilities, or amortization or impairment expenses related to goodwill and other intangible assets,
any of which could harm our business, financial condition, and results of operation. Sufficient capital or financing may not be available to us on satisfactory terms, or at all.

In connection with our acquisition of Salu, Inc., now Salu Beauty, Inc., we have entered a new line of business  clinical skincare and spa products  with greater targeted international
operations. We cannot assure you that our expansion into this business line will succeed.

We recently entered the
clinical skincare and spa products business with our acquisition of Salu, Inc., now Salu Beauty, Inc. We cannot assure that our expansion into these businesses will succeed. We have limited experience in the sale of clinical skincare and spa
products, particularly to targeted international markets. While we have operations in Canada, we have not previously had operations outside of North America. Our entry into this area will require us to devote substantial financial, technical,
managerial and other resources. As noted above, international expansion comes with substantial risks. We may not be able to successfully integrate the additional personnel, operations, acquired technology or products or services of Salu into our
business and there is no guarantee that key personnel of Salu will continue to work for us.

In addition, in connection with
the acquisition, certain senior management employees of Salu will be eligible to receive performance incentive payments in cash for each of the 2010 and 2011 fiscal years with an aggregate value of up to $2.5 million if certain financial performance
targets are achieved. These bonuses may limit our cash available to make future acquisitions and operate our business, and may affect our ability to obtain alternative financing. It is uncertain whether we will benefit financially from this
acquisition.

We are expanding into international markets, causing our business to be increasingly susceptible to international business
risks and challenges that could affect our profitability.

Through our contract with FiftyOne, Inc. and certain
operations of our newly acquired subsidiary, Salu, Inc., now Salu Beauty, Inc., we sell certain OTC products in international markets and expect to expand into international markets more aggressively in the future. To date, our international
business activities have been limited. Our lack of a track record outside the United States increases the risks described below. In addition, our experience in the United States may not be relevant to establishing a business outside the United
States. Accordingly, our international expansion strategy is subject to significant execution risk, and we cannot assure that our strategy will be successful. International sales are subject to inherent risks that could adversely affect our
operating results, including:



| |  |  | the risk that our marketing strategies will not translate well to international markets and that we will need to expend resources to adapt those
strategies for a variety of new markets;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the need to develop new supplier and manufacturer relationships;
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| |  |  | the need to comply with additional U.S. and foreign laws and regulations to the extent applicable, including but not limited to, restrictions on
advertising practices, regulations governing online services, restrictions on importation of specified or proscribed items, importation quotas, consumer protection laws, enforcement of intellectual property rights, laws dealing with consumer and
data protection, privacy, encryption, and restrictions on pricing or discounts;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | unexpected changes in international regulatory requirements and tariffs, and geopolitical events such as war and terrorist attacks;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | managing fluctuations in currency exchange rates;
| | - |  | -------------------------------------------------



| |  |  | difficulties in staffing and managing foreign operations;
| | - |  | ---------------------------------------------------------



| |  |  | greater difficulty in accounts receivable collection from overseas customers;
| | - |  | -----------------------------------------------------------------------------



| |  |  | potential adverse tax consequences in the U.S. and in foreign jurisdictions; and
| | - |  | --------------------------------------------------------------------------------



| |  |  | uncertain political and economic climates.
| | - |  | ------------------------------------------

To the extent we generate significant international sales, any negative impact on our international operations could negatively affect our revenues and operating results. In addition, it is costly to
establish, develop, and maintain international operations and websites that promote our brand internationally, which could further harm our revenues and operating results.

If the recent global economic crisis has a disproportionate impact on our business or that of our significant partners and suppliers, our business and results of operations would be harmed.

Deterioration in the U.S. and global credit markets and the financial services industry could negatively affect our
business or that of our significant partners and suppliers. Tightening of credit and the recent decline in the housing market has led to a lack of consumer confidence and a reduction in business activity generally, which could significantly harm our
revenues and operating results. In addition, our vendors could experience serious cash flow or other financial or operational problems due to the current economic conditions. As a result, our vendors may attempt to increase prices, alter payment
terms, or seek other relief in order to offset these problems. Vendors may further be forced to reduce production, shut down operations or file for bankruptcy protection, which in some cases could have a significant impact on our ability to serve
the markets needs. In addition, access to credit from financial institutions may not be available. We do not expect the current economic conditions to improve significantly in the near future, and any continuation and/or worsening of the
economic environment could intensify the adverse affects of these difficult market conditions.

We may be unable to obtain the
additional capital we need in the future to support our growth.

Our available funds may not be sufficient to meet all
of our long-term business development requirements, and we may seek to raise additional funds through public or private debt or equity financings. Due to the recent tightening of the credit and equity markets, any additional financing that we may
need may not be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, our strategic flexibility or ability to develop and grow our business may be significantly limited. In March
2011, we entered into a loan and security agreement with our existing bank, which includes a revolving three-year line of credit allowing for borrowings up to $40.0 million, which accrue interest at LIBOR plus 2.5%  3%, or prime plus
0%  0.5%. This agreement replaced our two-year $25.0 million line of credit scheduled to mature in March 2011. As of January 2, 2011, $13.0 million was outstanding under the line of credit, which was refinanced under the new
three-year line of credit maturing in March 2014.

Advances available under the revolving line of credit are limited, based on
eligible inventory, accounts receivable, cash and investment balances, and balances outstanding under our line of credit. The agreement contains certain covenants that are customary in transactions of this nature, including a prohibition on other
debt



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and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain financial
covenants. The agreement identifies certain events of default that are customary for transactions of this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this
facility or other instruments when due, the occurrence of a material adverse change, violations of any covenants, a material cross-default to our other debt, or a change of control. In the event we are not in compliance with certain financial
covenants contained in the line of credit agreement, and are unable to obtain a waiver from the bank, borrowing available under the line of credit may be suspended until such time the covenant violations are remediated.

There are risks associated with our indebtedness.

At January 2, 2011, we had $14.6 million of debt obligations outstanding, as well as $26.5 million of available borrowing capacity under our existing three-year line of credit. We may incur
additional indebtedness in the future, including under our revolving line of credit, through additional capital leases, or through public or private offerings of debt securities. Our outstanding indebtedness and any additional indebtedness we incur
may have important consequences, including, without limitation, the following:



| |  |  | we will be required to use cash to pay the principal of and interest on our indebtedness;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | our indebtedness and leverage may increase our vulnerability to adverse changes in general economic and industry conditions, as well as to competitive
pressure;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain additional financing for working capital, capital expenditures and for general corporate and other purposes may be limited; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our flexibility in planning for, or reacting to, changes in our business and our industry may be limited.
| | - |  | ---------------------------------------------------------------------------------------------------------

Our ability to make payments of principal of and interest on our indebtedness depends upon our future performance, which will be subject
to general economic conditions, industry cycles and financial, business and other factors affecting our consolidated operations, many of which are beyond our control. If we are unable to generate sufficient cash flow from operations in the future to
service our debt, we may be required to, among other things:



| |  |  | seek additional financing in the debt or equity markets;
| | - |  | --------------------------------------------------------



| |  |  | refinance or restructure all or a portion of our indebtedness;
| | - |  | --------------------------------------------------------------



| |  |  | sell selected assets;
| | - |  | ---------------------



| |  |  | reduce or delay planned capital expenditures; or
| | - |  | ------------------------------------------------



| |  |  | reduce or delay planned operating expenditures.
| | - |  | -----------------------------------------------

Such measures might not be sufficient to enable us to service our debt. In addition, any such financing, refinancing or sale of assets might not be available on economically favorable terms or at all.

If people or property are harmed by the products we sell, product liability claims could damage our business and reputation.

Some of the products we sell may expose us to product liability claims relating to personal injury, death, or property
damage caused by these products and may require us to take actions such as product recalls. Any such product liability claim or product recall may result in adverse publicity regarding us and the products we sell, which may harm our reputation. If
we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in
litigation expenses, our management could be required to spend valuable time in the defense against these claims, and our reputation could suffer, any of which could harm our business. Some of our vendors do not indemnify us against product
liability. Further, our liability



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insurance may not be adequate to protect us from all liability that may be imposed as a result of these claims, and we cannot be certain that insurance will continue to be available to us on
economically reasonable terms, or at all. Any imposition of product liability that is not covered by vendor indemnification or our insurance could harm our business, financial condition, and operating results.

Most of our fulfillment operations and owned inventory are located in a limited number of distribution facilities, and any significant disruption
of this centers operations would hurt our ability to make timely delivery of our products.

We conduct most of
our fulfillment operations from our distribution facility in Swedesboro, New Jersey. Our distribution center in Swedesboro, our inventory storage facility in nearby Logan Township, New Jersey, and inventory held by a third-party fulfillment partner
in Columbus, Ohio house our entire owned product inventory other than a small amount held by Salus Australian subsidiary. In January 2010, we closed our Ferndale, Washington facility and transferred our vision inventory to our distribution
facility in Swedesboro, New Jersey. We recently entered into an agreement with GSI Commerce Solutions, Inc. (GSI Commerce) by which GSI Commerce will fulfill orders for us from a distribution center in the Western United States beginning
later in 2011. Additionally, BioScrip Pharmacy Services, Inc., fulfills all prescription orders through our website from its mail-order distribution center in Columbus, Ohio. A natural disaster or other catastrophic event, such as an earthquake,
fire, flood, severe storm, break-in, server or systems failure, terrorist attack, or other comparable event at our New Jersey facilities or our fulfillment partners Ohio facilities would cause interruptions or delays in our business and loss
of inventory and could render us unable to process or fulfill customer orders in a timely manner, or at all. Further, we have no formal disaster recovery plan, and our business interruption insurance may not adequately compensate us for losses that
may occur. In the event that a significant part of our New Jersey facilities or our fulfillment partners Ohio facilities were destroyed or our operations were interrupted for any extended period of time, our business, financial condition, and
operating results would be harmed.

We are dependent on a limited number of fulfillment and distribution partners. If we are unable to
obtain shipments of product from our vendors and deliver merchandise to our customers in a timely and cost-effective manner, our business and results of operations would be harmed.

We cannot control all of the various factors that might affect our timely and cost-effective procurement of products from our vendors and
delivery of products to our customers. We use a third-party fulfillment partner in Columbus, Ohio to fulfill Salu orders. We also rely on a limited number of third-party carriers for shipments of products to and from our distribution facilities and
those of our third-party fulfillment partners and to customers. We are therefore subject to the risks, including increased fuel costs, security concerns, labor disputes, union organizing activity, and inclement weather, associated with our
carriers ability to provide product fulfillment and delivery services to meet our distribution and shipping needs. Failure to procure and deliver merchandise, either to us or our fulfillment partners or to our customers, in a timely and
accurate manner would harm our reputation, the drugstore.com brands, our business, and our results of operations. In addition, any increase in fulfillment costs and expenses could adversely affect our business and operating results.

Our plans to automate our New Jersey distribution center, to have GSI Commerce to fulfill orders for us from a west coast distribution facility or
to expand to a third distribution center in the Midwest may be delayed or result in greater costs or business interruption than we anticipate, interfering with our ability to deliver merchandise to our customers in a timely and cost-effective
manner, and our business and results of operations would be harmed.

We have recently entered into an agreement with
GSI Commerce to fulfill orders for us from a distribution center in the Western United States. We have also begun the process of upgrading the automation of our New Jersey distribution center. In addition, we have recently begun to explore
strategies to expand our fulfillment operations to include a third distribution facility in the Midwestern United States. These initiatives will require significant capital resources as well as attention from our management team and may require us
to divert those



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resources from the operation of our primary businesses. In addition, unexpected delays or increased costs of these initiatives could cause interruptions or delays in our business, and disruption
in our inventory processes while we build out these facilities could render us unable to process or fulfill customer orders in a timely manner, or at all and our business, financial condition, and operating results would be harmed.

If we are unable to optimize management of our distribution centers, we may be unable to meet customer demand.

Our ability to meet customer demand may be significantly limited if we do not successfully operate our distribution centers, including in
connection with any plans for new distribution centers or our plans to move our Salu fulfillment operations to our own distribution centers. Because it is difficult to predict sales volume, we may be unable to manage our facilities in an optimal
way, which may result in excess or insufficient inventory, warehousing, fulfillment, or distribution capacity. In addition, failure to control product damage and shrinkage effectively through security measures and inventory management practices
could adversely affect our operating margins. Our margins and revenues may also be affected if we are unable to obtain products from manufacturers and wholesalers timely and on favorable terms. In addition, if we need to increase our distribution
capacity sooner than anticipated, including in connection with any plans to move our Salu fulfillment operations, that expansion would require additional financing that may not be available to us on favorable terms when required, or at all.

Under our distribution agreement with GNC, and consignment arrangements with other partners, we maintain inventory of third
parties products in our primary distribution center, thereby increasing the complexity of tracking inventory in, and the operation of, our distribution center. Our failure to properly handle third party inventory that we hold would result in
unexpected costs and other harm to our business and reputation.

We need to manage changing and expanding operations.

Over the past several years, we have significantly expanded our operations, including through Salu, and we anticipate
that we will continue to expand. Our past growth has placed, and we expect that our anticipated future operations and expansion will continue to place, a significant strain on our managerial, operational, financial, and other resources. Some of the
administrative and operational challenges we have faced in the past as a result of our expansion and seasonal growth include the management of an expanded number of product offerings; the assimilation of systems and technologies of acquired
companies; increased pressure on our senior management; and increased demand on our systems and internal controls. Our ability to manage our operations and expansion effectively depends on the continued development and implementation of plans,
systems, and controls that meet our operational, financial, and management needs. If we are unable to develop or implement these plans, systems, or controls or otherwise manage our operations and growth effectively, we will be unable to increase
gross margins or achieve consistent profitability, and our business will be harmed.

The seasonality of our business places increased
strain on our operations.

We expect the largest amount of our net sales to occur during our fourth quarter. If we do
not stock or restock popular products in sufficient amounts such that we fail to meet customer demand, it could significantly affect our revenue and our future revenue. If we overstock products, we may be required to take significant inventory
markdowns or write-offs, which could reduce our gross margins. We may experience an increase in our shipping cost due to complimentary upgrades, split-shipments, and additional long-zone shipments necessary to ensure timely delivery for the holiday
season. If our systems and processes are not prepared to address peak volumes during high demand seasons, holidays, and events, we may experience system interruptions that make our websites unavailable or prevent us from efficiently fulfilling
orders, which may reduce the volume of goods we sell and the attractiveness of our products and services. In addition, we may be unable to staff our distribution centers adequately during these peak periods, and delivery companies may be unable to
meet the seasonal demand.



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A disruption in our operations could materially and adversely affect our business, results of
operations and financial condition.

Any disruption to our operations, including system, network, telecommunications,
software or hardware failures, and any damage to our physical locations, could materially and adversely affect our business, results of operations and financial condition.

Our operations are subject to the risk of damage or interruption from:



| |  |  | fire, flood, earthquake or other natural disasters;
| | - |  | ---------------------------------------------------



| |  |  | power losses and interruptions;
| | - |  | -------------------------------



| |  |  | Internet, telecommunications or data network failures;
| | - |  | ------------------------------------------------------



| |  |  | physical and electronic break-ins or security breaches;
| | - |  | -------------------------------------------------------



| |  |  | computer viruses;
| | - |  | -----------------



| |  |  | acts of terrorism; and
| | - |  | ----------------------



| |  |  | other similar events.
| | - |  | ---------------------

If any of these events occur, it could result in interruptions, delays or cessations in service to customers of our partners e-commerce businesses and adversely impact our partners e-commerce
businesses. These events could also prevent us from fulfilling orders for our partners e-commerce businesses. Our partners might seek significant compensation from us for their losses. Even if unsuccessful, this type of claim likely would be
time-consuming and costly for us to address and damaging to our reputation.

Our primary data centers are located at the
facilities of a third-party hosting company. We do not control the security, maintenance or operation of these facilities, which are also susceptible to similar disasters and problems. Further, we have no formal disaster recovery plan, and our
insurance policies may not cover us for losses related to these events, and even if they do, they may not adequately compensate us for any losses that we or our partners may incur. Any system failure that causes an interruption of the
availability of our partners e-commerce businesses could reduce the attractiveness of our partners e-commerce businesses to consumers and result in reduced revenues, which could materially and adversely affect our business, results of
operations and financial condition.

We have significant inventory risk.

We must maintain sufficient inventory levels to operate our business successfully, including meeting the inventory needs of our strategic
partners and the expectations of our customers and those of our strategic partners that we will have the products they order in stock. However, we must also guard against the risk of accumulating excess inventory. This risk would be further
exacerbated by our proposed expansion to a second and third distribution center. We are exposed to significant inventory risks as a result of rapid changes in product cycles, changes in consumer tastes, uncertainty of success of product launches,
seasonality, manufacturer backorders, and other vendor-related problems. In order to be successful, we must accurately predict these trends and events, which we may be unable to do, and avoid over- or under-stocking products. Our ability to stock
products properly also depends on our strategic partners ability to predict and to keep us timely informed of these trends and events in their businesses. In addition, demand for products can change significantly between the time product
inventory is ordered and the time it is available for sale. When we begin selling a new product, it is particularly difficult to forecast product demand accurately. A failure to optimize inventory would increase our expenses if we have too much
inventory, and would harm our margins by requiring us to make split shipments for backordered items or pay for expedited delivery from the manufacturer if we had insufficient inventory. In addition, we may be unable to obtain certain products for
sale on our websites as a result of general shortages (for example, in the case of some medications), manufacturer policies (for example, in the case of some contact



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lenses and prestige beauty items), manufacturer or distributor problems, or popular demand. Failure to have inventory in stock when a customer orders it could cause us to lose that order or that
customer. The acquisition of some types of inventory, or inventory from some of our sources, may require significant lead time or prepayment, and this inventory may not be returnable. We carry a broad selection of products and significant inventory
levels of a substantial number of products, and we may be unable to sell this inventory in sufficient quantities or during the relevant selling seasons. The occurrence of one or more of these inventory risks may adversely affect our business and
operating results.

Our vendor relationships subject us to a number of risks.

We have significant vendors that are important to our sourcing of merchandise. We do not have long-term arrangements with most of our
vendors to guarantee availability of merchandise, particular payment terms, or extension of credit limits. If our current vendors were to stop selling merchandise to us on acceptable terms, we may not be able to acquire merchandise from other
vendors in a timely and efficient manner and on acceptable terms, or at all.

If we do not attract and retain qualified personnel, or if
our key employees fail to perform, our ability to execute our business strategy will be impaired.

We are dependent on
our key personnel, and our success depends in large part on our ability to attract and retain qualified personnel. All of our employees, including our executive officers, can terminate their employment with us at any time. If we experience
significant turnover or difficulty in recruiting new personnel, or if our key employees fail to perform as expected, our ability to execute our business strategy will be impaired.

Changes in our senior management may have an adverse effect on our ability to execute our business strategy.

Our success depends largely on the efforts and abilities of our senior management to execute our business plan. Changes in our senior management may be disruptive to our business and may adversely affect
our operations. For example, when we have changes in senior management positions, we may elect to adopt different business strategies or plans. Any new strategies or plans, if adopted, may not be successful and if any new strategies or plans do not
produce the desired results, our business may suffer.

Any errors in filling or packaging the contact lenses we dispense may expose us
to liability and negative publicity.

Errors relating to our contact lens dispensing process may result in liability
for us that our insurance may not cover. Because we distribute contact lenses directly to the consumer, we are one of the most visible participants in the distribution chain and therefore have increased exposure to liability claims. Our general
liability, product liability, and professional liability insurance may not cover potential claims of this type or may not be adequate to protect us from all liabilities that may be imposed if any such claims were to be successful.

Errors by either us or our competitors may also produce significant adverse publicity either for us or for the online vision industry in
general. Because of the significant amount of press coverage on Internet retailing, we believe that we are subject to a higher level of media scrutiny than other prescription product channels. The amount of negative publicity that we or the online
vision industry receives as a result of prescription processing errors could be disproportionate in relation to the negative publicity received by other eye care professionals making similar mistakes. We have no control over the practices of our
competitors, and we cannot ensure that our prescription processing operates completely without error. We believe customer acceptance of our online shopping experience is based in large part on consumer trust, and errors by us or our competitors and
related negative publicity could erode this trust or prevent it from growing. This could result in an immediate reduction in the amount of orders we receive, adversely affect our revenue growth, and harm our business and operating results.



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Governmental regulation of our business could require significant expenditures, and failure to comply
with regulations could result in civil and criminal penalties.

Our business is subject to extensive federal, state and
local regulations. For example:



| |  |  | the sale, advertisement, and promotion of, among other things, contact lenses, OTC and homeopathic medications, dietary supplements, medical devices,
cosmetics, foods, and other consumer products that we sell are subject to regulation by the Food and Drug Administration, or FDA, the Federal Trade Commission, or FTC, the Consumer Product Safety Commission, and state regulatory authorities, as the
case may be; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our vision business is also subject to the Fairness to Contact Lens Consumers Act and related regulations of the FTC, which requires all patients to
renew their contact lens prescriptions annually and requires third-party contact lens sellers, like Vision Direct, to verify these prescriptions in accordance with specified procedures.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

As we expand our product and service offerings and more non-pharmaceutical products become subject to FDA, FTC, and other regulation,
more of our products and services may become subject to regulation. In addition, regulatory requirements to which our business is subject may expand over time, and some of these requirements may have a disproportionately negative effect on Internet
retailers. For example, the federal government and a majority of states now regulate the retail sale of OTC products containing pseudoephedrine that might be used as precursors in the manufacture of illegal drugs. As a result, we are currently
unable to sell these products to customers residing in states that require retailers to obtain a physical form of identification or maintain a signature log. In addition to regulating the claims made for specific types of products, the FDA and the
FTC may attempt to regulate the content included on websites that market products to consumers. Complying with regulations is time-consuming, burdensome, and expensive and could delay our introduction of new products or services.

As our website is accessible over the Internet in multiple states and other countries, and if and when we expand our marketing strategies
to other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. Our failure to qualify in a state or country in which we are required to do so could subject us to taxes and
penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results, and financial
condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could harm our business.

The laws and regulations applicable to our business often require subjective interpretation, and we cannot be certain that our efforts to
comply with these regulations will be deemed sufficient by the appropriate regulatory agencies. Violations of any regulations could result in various civil and criminal penalties, including suspension or revocation of our licenses or registrations,
seizure of our inventory, or monetary fines, any of which could harm our business, financial condition, or operating results. Compliance with new laws or regulations could increase our expenses or lead to delays as we adjust our websites and
operations.

Restrictions imposed by, and costs of complying with, governmental regulation of the Internet and data transmission over
the Internet could harm our business.

We are subject to the same federal, state, and local laws generally applicable
to businesses, as well as those directly applicable to companies conducting business online, including consumer protection laws, user privacy laws, and regulations prohibiting unfair and deceptive trade practices. Further, the growth of online
commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the
increasing use of the Internet, many additional laws and regulations relating to the Internet are being



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debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, user privacy, fraud, quality of products and services, taxation,
advertising, intellectual property rights, and information security. Applicability of existing laws to the Internet relating to issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity, and
personal privacy could also harm our business. For example, U.S. and international laws regulate our ability to use customer information and to develop, buy, and sell mailing lists. The vast majority of these laws were adopted before the advent of
the Internet, and do not contemplate or address the unique issues raised by the Internet. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act, are only beginning to be interpreted by the courts, and their
applicability and reach are therefore uncertain. The restrictions imposed by, and the costs of complying with, current and possible future laws and regulations related to businesses conducted on the Internet could harm our business, operating
results, and financial condition.

Healthcare reform measures and related changes in applicable federal and state laws could adversely
affect our business.

The efforts of governmental and third-party payers to contain or reduce the costs of healthcare
may adversely affect our business, operating results, and financial condition. Recently, there have been, and we expect that there will continue to be, a number of legislative and regulatory proposals aimed at changing the healthcare system,
including for example, restructuring the tax benefits available through flexible spending accounts and/or health savings accounts by limiting the eligibility of non-prescription products. If the laws or regulations are changed to limit further the
tax benefits through these accounts, such a change could have an adverse effect on our business by reducing revenues and eroding our margins.

We are subject to a number of risks related to payments we accept and process for third parties.

We accept payments by a variety of methods, including credit cards, gift certificates, and third-party payors such as Pay Pal, Google
Checkout, and Bill Me Later. In addition, we serve as a payment processing service provider for certain of our strategic partners. As we offer new payment options to our customers and processing services to our strategic partners, we may be subject
to additional regulations, compliance requirements, and fraud. For credit card payments and other third-party payors, we pay interchange and other fees, which may increase over time, raising our operating costs and lowering our profit margins. In
addition, we have additional contractual obligations to our strategic partners regarding the payment processing services we provide them, and conversely depend on our strategic partners to meet their obligations to us and to the third-party payors,
and any failure of us or our partners to meet those obligations could expose us to additional fees and expenses. We are also subject to payment card association operating rules and certification requirements, both as a merchant and as a service
provider, which could change or be reinterpreted to make compliance difficult or impractical. If we fail to comply with these rules or requirements, we may be subject to fines and higher transaction fees and lose our ability to accept credit card
payments from our customers and those of our strategic partners or to facilitate other types of online payments, and our business and operating results could be adversely affected.

If we are required to collect sales and use taxes on the products we sell in additional jurisdictions, we may be subject to liability for past sales and our future sales may decrease.

Currently, decisions of the U.S. Supreme Court restrict the ability of states to collect state and local sales and use
taxes with respect to sales made by companies lacking a physical presence in the state. Based on this case law, we have historically only collected and remitted sales and use taxes in the states of Washington and New Jersey where our corporate
offices and distribution centers have been located. However, a number of states have passed or are considering passing initiatives that could test the Supreme Courts position regarding sales and use taxes on Internet sales. The operation of
our distribution centers, the operations of any future distribution centers, our drop-shipping agreements with vendors, our arrangements with marketing affiliates, and other aspects of our evolving business, however, may result in additional sales
and use tax collection obligations. In addition, one or more other states may successfully assert that we should collect and remit sales and use or other taxes on the sale



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of our products in that state. One or more states or the federal government may seek, either through unilateral action or through federal legislation, to impose sales or other tax collection
obligations on out-of-jurisdiction companies that engage in electronic commerce as we do.

Effective July 2008, New York
imposed such a sales tax obligation requirement on on-line retailers that use New York residents to directly or indirectly refer potential customers, via a link on an Internet Website or otherwise, to the online retailer. As a result, we began
collecting and remitting sales tax in New York in July 2008. Since then, other states have enacted legislation similar to New Yorks, including Rhode Island in June 2009, North Carolina in August 2009, and Illinois in March 2011. In
response to recently imposed state sales tax requirements for online retailers, we have suspended certain marketing affiliate relationships with persons and entities residing in Rhode Island and North Carolina, which may cause our sales to decline.
Other states are considering similar laws, and if such laws become effective, we may have to change or limit our marketing activities in those states or face additional sales tax collection and remittance obligations, either of which could have a
negative effect on our sales.

Because our newly acquired subsidiary, Salu, is located in California and has distribution
activities in Ohio, we also collect sales tax in both California and Ohio on its sales. In conjunction with our fulfillment agreement with GSI Commerce, we will be required to collect sales tax in Nevada. If we proceed with our plans to open a
Midwest distribution center, we will likely be required to collect in the state where it is located as well.

In addition, one
or more states could begin to impose sales taxes on sales of prescription products, which are not generally taxed at this time. While we believe we are in compliance with existing laws and regulations, we could be subject to significant fines
or other payments for any unintentional past failure to comply with tax regulations. This could result in substantial tax liabilities for our past sales, decrease our ability to compete with traditional retailers, and otherwise harm our business,
financial condition, and operating results.

Pending an authoritative reconciliation of these initiatives with the common law,
and potentially for years into the future if any challenge to these initiatives resulted in a reversal by the courts of the long-standing restriction on states ability to tax out-of-state sellers, we could be required to collect and remit
sales and use taxes in states other than Washington, New York, New Jersey, California, Ohio, and Nevada. The imposition of additional tax obligations on our business by state and local governments could create significant administrative burdens for
us, decrease our future sales, and harm our cash flow and operating results.

We may be unable to increase the migration of consumers of
health, beauty, clinical skincare, and vision products from brick-and-mortar stores to our online solution, which would harm our revenues and prevent us from becoming profitable.

If we do not continue to attract and retain higher volumes of online customers to our Internet stores at a reasonable cost, we will not be
able to increase our revenues or achieve consistent profitability. Our success depends on our ability to continue to convert a large number of customers from traditional shopping methods to online shopping for health, beauty, wellness, vision, and
pharmacy products. Specific factors that could prevent widespread customer acceptance of our online solution include:



| |  |  | shipping charges, which do not apply to purchases made at a brick-and-mortar store;
| | - |  | -----------------------------------------------------------------------------------



| |  |  | delivery time associated with Internet orders, as compared to the immediate receipt of products at a brick-and-mortar store;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | delays in deliveries to customers;
| | - |  | ----------------------------------



| |  |  | lack of consumer awareness of our websites;
| | - |  | -------------------------------------------



| |  |  | additional steps and delays in verifying prescriptions for prescription products;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | regulatory restrictions or reform at the state and federal levels that could affect our ability to serve our customers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



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| |  |  | customer concerns about the security of online transactions, identity theft, or the privacy of their personal information;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | product damage from shipping or shipments of wrong or expired products from us or other vendors, resulting in a failure to establish, or loss of,
customers trust in buying drugstore items online;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | delays in responses to customer inquiries;
| | - |  | ------------------------------------------



| |  |  | difficulties or delays in returning or exchanging orders; and
| | - |  | -------------------------------------------------------------



| |  |  | activity that diminishes a users online experience or subjects online shoppers to security risks, such as viruses, spam, spyware, phishing
(spoofing e-mails directed at Internet users), denial of service attacks directed at Internet service providers and online businesses, and breaches of data security.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Expanding the breadth and depth of our product and service offerings is expensive and difficult, and we may receive no benefit from our expansion.

We intend to continue to expand the breadth and depth of our product and service offerings by promoting new or
complementary products or sales formats. Expansion of our offerings in this manner could require significant additional expenditures and could strain our management, financial, and operational resources. For example, we have launched our microsites
in an initiative to design separate web stores dedicated to specific categories of products and certain mobile platforms to expand the availability of our site to mobile telephone and other device users. Additionally, we may need to incur
significant marketing expenses, develop relationships with new fulfillment partners or manufacturers, or comply with new regulations. We may be unable to expand our product and service offerings or sales formats in a cost-effective or timely manner,
and any new offerings or formats may not generate satisfactory revenues to offset the costs involved. Furthermore, any new product or service offering or sales format that is not favorably received by consumers could damage the reputation of our
brand. A lack of market acceptance of our efforts or our inability to generate sufficient revenues to offset the cost of expanded offerings could harm our business.

Increasing concern about privacy, spam, and the use and security of customer information could restrict our marketing efforts and harm our business.

Internet retailers are also subject to increasing regulation and scrutiny relating to privacy, spam, and the use and security of personal
user information. These regulations, along with increased governmental or private enforcement (for example, by Internet service providers), may increase the cost of growing our business. Current and proposed regulations and enforcement efforts may
restrict our ability to collect and use demographic and personal information from users and send promotional e-mails, which could be costly or harm our marketing efforts. For example, if one or more Internet service providers were to block our
promotional e-mails to customers, our ability to generate orders and revenue could be harmed. Further, any violation of privacy, anti-spam, or data protection laws or regulations may subject us to fines, penalties, and damages and may otherwise have
a material adverse effect on our business, results of operations, and financial condition.

Our network and communications systems are
vulnerable to system interruption and damage, which could harm our operations and reputation.

Our ability to receive
and fulfill orders promptly and accurately is critical to our success and largely depends on the efficient and uninterrupted operation of our computer and communications hardware and software systems. We experience periodic system interruptions that
impair the performance of our transaction systems or make our websites inaccessible to our customers. These systems interruptions may prevent us from efficiently accepting and fulfilling orders, sending out promotional e-mails and other customer
communications in a timely manner, introducing new products and features on our website, promptly responding to customers, or providing services to third parties. Frequent or persistent interruptions in our services could cause current or potential
customers to believe that our systems are unreliable, which could cause them to avoid our websites,



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drive them to our competitors, and harm our reputation. To minimize future system interruptions, we need to continue to add software and hardware and to improve our systems and network
infrastructure to accommodate increases in website traffic and sales volume, to replace aging hardware and software, and to make up for several years of underinvestment in technology. We may be unable to promptly and effectively upgrade and expand
our systems and integrate additional functionality into our existing systems. Any unscheduled interruption in our services, especially during the holiday shopping season, could result in fewer orders, additional operating expenses, or reduced
customer satisfaction, any of which would harm our revenues and operating results and could delay or prevent our becoming consistently profitable. In addition, the timing and cost of upgrades to our systems and infrastructure may substantially
affect our ability to maintain profitability.

Our systems and operations, and those of our suppliers and Internet service
providers, are vulnerable to damage or interruption from fire, flood, earthquakes, power loss, server failure, telecommunications and Internet service failure, acts of war or terrorism, computer viruses and denial-of-service attacks, physical or
electronic break-ins, sabotage, and similar events. Any of these events could lead to system interruptions, service delays, and loss of critical data for us, our suppliers, or our Internet service providers, and could prevent us from accepting and
fulfilling customer orders. Any significant interruption in the availability or functionality of our websites or our customer processing, distribution, or communications systems, for any reason, could seriously harm our business, financial
condition, and operating results. While we do have backup systems for some aspects of our operations, we do not have fully redundant backup systems or a formal disaster recovery plan. Our business interruption insurance may be inadequate to
compensate for all losses that may occur.

Security breaches could damage our reputation, expose us to liability, or otherwise harm our
business.

Although we have developed systems and processes that are designed to protect customer information and
prevent fraudulent transactions, data loss and other security breaches, failure to prevent or mitigate such breaches may adversely affect our operating results. To succeed, we must provide a secure transmission of confidential information over the
Internet and protect the confidential customer and patient information we retain, such as credit card numbers and prescription records. A third party who compromises or breaches the physical and electronic security measures we use to protect
transaction data and customer records could misappropriate proprietary information, cause interruptions in our operations, damage our computers or those of our customers, or otherwise harm our business. Any of these could harm our reputation and
expose us to a risk of loss or litigation and possible liability. We may need to expend significant resources to protect against security breaches or to address problems caused by breaches, and our insurance may not be adequate to reimburse us for
losses caused by security breaches.

If we do not respond to rapid technological changes, our services could become obsolete and our
business would be seriously harmed.

As the Internet and online commerce industry evolve, we must license technologies
useful in our business, enhance our existing services, develop new services and technologies that address the increasingly sophisticated and varied needs of our prospective customers and respond to technological advances and emerging industry
standards and practices on a cost-effective and timely basis. We may not be able to successfully implement new technologies or adapt our web stores, proprietary technology, and transaction-processing systems to meet customer requirements or emerging
industry standards. Failure to successfully and timely do so could adversely affect our ability to build the drugstore.com brand and attract and retain customers.

We may be unable to protect our intellectual property, and we may be found to infringe proprietary rights of others, which could harm our business, brand, and reputation.

Our success depends in substantial part on our proprietary rights, including our technology, copyrights, trademarks, service marks, trade
dress, trade secrets, and similar intellectual property. We rely on a combination of patent, trademark, trade secret, and copyright law, as well as contractual restrictions to protect our proprietary



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rights. Despite our efforts to protect our proprietary rights, however, unauthorized parties may attempt to copy, obtain, and use technology or information that we regard as proprietary, such as
our sales formats, the technology used to operate our website, our website content, and our trademarks. In addition, the laws of many countries do not protect our proprietary rights to the same extent as the laws of the United States.

We own a number of domain names, hold nine patents, and have registered several trademarks and filed applications for a number of other
trademarks in the United States and several other countries. We may be unable to secure the trademark registrations or patents for which we have applied, which could negatively affect our business. Our competitors or others may adopt marks or
service names similar to ours, which could impede our ability to build brand identity and lead to customer confusion, and owners of other registered trademarks or trademarks that incorporate variations of our marks could bring potential trade name
or trademark infringement claims against us. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States, and effective patent, copyright, trademark, and trade secret
protection may not be available in such jurisdictions. Our business could be harmed if we are unable to protect or preserve the value of our trademarks, patents, copyrights, trade secrets, or other proprietary rights for any reason, or if we are
subject to any claims or customer confusion related to our intellectual property or any failure or inability to protect our proprietary rights.

Litigation or proceedings before the U.S. Patent and Trademark Office or the World Intellectual Property Organization may be necessary in the future to enforce our intellectual property rights, to protect
our trade secrets and domain names, or to determine the validity and scope of the proprietary rights of others. Any litigation or adverse priority proceeding or other efforts to protect our intellectual property could result in substantial costs and
diversion of resources and could seriously harm our business and operating results. Third parties have in the past, and may in the future, also assert claims against us alleging infringement, misappropriation, or other violations of patent,
trademark, or other proprietary rights held by them, whether or not their claims have merit. For example, one of our subsidiaries was sued over alleged copyright and trademark violations based on use of pop-up advertising, although this
action was settled in June 2004 without any material adverse effects to us. We expect that participants in our markets will be increasingly subject to infringement claims as the number of services and competitors in our industry segment grows. Any
such claims, whether they are with or without merit or are determined in our favor, could be time-consuming, result in costly litigation, divert the attention of our management, cause service upgrade delays, and harm our business or operating
results. Furthermore, as a result of infringement claims we may be required to enter into costly royalty or licensing agreements, which may not be available on terms that are acceptable to us, or at all. If a third party successfully asserts an
infringement claim against us and we are required to pay monetary damages or royalties or we are unable to obtain suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis,
our business could be adversely affected.

The third-party licenses on which we rely may not continue to be available to us on
commercially reasonable terms. The loss of such licenses could require us to incur greater cost or change our business plans, either of which could harm our business.

We have a history of generating significant losses, and may not be able to sustain profitability.

We have an accumulated deficit of $774.8 million through January 2, 2011. To date, we have had only four profitable quarters, and we may never achieve profitability on a full-year or consistent
basis. As a result, our stock price may decline and stockholders may lose all or a part of their investment in our common stock.

Our
stock price is likely to continue to fluctuate, which could result in substantial losses for stockholders.

The market
price of our common stock has been, and is likely to continue to be, extremely volatile. Our stock price could be subject to wide fluctuations in response to a number of factors, including those described in this annual report, some of which are
beyond our control, and these fluctuations could result in substantial losses for stockholders.



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In the past, securities class action and derivative litigation has often been brought
against a company following periods of volatility in the market price of its securities. We have been named in such lawsuits in the past, including certain putative class action and derivative suits filed against us and certain of our current and
former officers and directors in 2004. Although the courts dismissed these lawsuits, we may be the target of similar litigation in the future. Securities litigation could result in substantial costs and divert managements attention and
resources, which could seriously harm our business and operating results and cause the trading price of our stock to decline.

Certain
stockholders own a significant amount of our common stock, which could discourage an acquisition of drugstore.com or make removal of incumbent management more difficult.

Amazon.com beneficially owns approximately 12% of our outstanding stock, and is entitled to designate a director to serve on our board of
directors, currently Geoffrey R. Entress. Kleiner Perkins Caufield and Byers, or KPCB, owns approximately 9% of our outstanding stock, Samana Capital, L.P. (formerly Ziff Asset Management, L.P.), or Samana, owns approximately 8% of our
outstanding stock, Discovery Group I, LLC owns approximately 9% of our outstanding stock, and T. Rowe Price Associates, Inc. owns approximately 7% of our outstanding stock. Because each owns a significant percentage of our capital stock, any of
these stockholders, or more than one of them, could significantly influence all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Furthermore,
because of these substantial equity stakes in drugstore.com, competitors of these stockholders, or other potential acquirers could decide not to merge with, or acquire, us. In addition, in the case of a potential acquisition of drugstore.com by
another party, a substantial equity stake in drugstore.com could prevent the tax-free treatment of an acquisition, making drugstore.com a less attractive acquisition candidate. In addition, if any of our significant stockholders were to sell a
substantial quantity of their holdings in a short period of time, our stock price could decline.

At January 2, 2011, we
had approximately $626.9 million of federal net operating loss carry-forwards that will expire beginning in 2018. Internal Revenue Code Section 382 imposes limitations on our ability to utilize net operating losses if we experience an ownership
change. An ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. The value of the stock at the time of an ownership
change is multiplied by the applicable long-term tax exempt interest rate to calculate the annual limitation. Any unused annual limitation may be carried over to later years. Based upon our cumulative historic ownership activity, it likely results
in a significant limitation on the utilization of our net operating loss carryforwards. Also, if we were to have an extraordinary amount of shares acquired, for example more than 40.0 million from a new or existing 5% shareholder or if we were
to be acquired, then based on our current fair value and the low long-term tax exempt interest rate, utilization of a significant amount of our net operating losses could be further limited.



|ITEM 1B. | UNRESOLVED STAFF COMMENTS
|-------- | -------------------------

None.



|ITEM 2. | PROPERTIES
|------- | ----------

Our principal
executive offices are located in Bellevue, Washington, where we lease approximately 53,000 square feet under a lease that expires in July 2013, with two separate five-year renewal options that, if exercised, would extend the lease expiration to July
2023. Our primary distribution facility for our OTC and vision segments is located in Swedesboro, New Jersey, where we lease approximately 270,000 square feet under a lease that expires in December 2020, with options to renew for two additional
five-year periods. We also lease an inventory storage facility in Logan Township, New Jersey for 85,000 square feet through February 2013. We lease approximately 11,500 square feet under a lease that expires in March 2016 for our principal customer
care center, which is located in Halifax, Nova Scotia, Canada.



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Our subsidiary Salu leases approximately 10,000 square feet under a lease that expires in
June 2016 for its principal corporate offices located in Gold River, California. Skincarestore Australia Pty Ltd., a subsidiary of Salu, leases approximately 2,000 square feet in Roselle, New South Wales, Australia, under a sublease that expires in
November 2014, for retail space used for a salon and spa and related business purposes.

We continue to make improvements to
our existing New Jersey distribution center to improve capacity and increase efficiency. Our overall goal is to leverage our existing distribution center as much as possible, and in 2011 we plan to make technology investments in supply chain
infrastructure to support fulfillment capabilities from multiple distribution centers. We have recently entered into an agreement with GSI Commerce by which GSI Commerce will fulfill orders for us from a distribution center in the Western United
States. Also, in December 2010 we made purchase commitments for approximately $5.0 million of software and hardware to automate our New Jersey distribution center. In addition, we have recently begun to explore strategies to expand our fulfillment
operations to include a third distribution facility in the Midwestern United States. Management regularly reviews our anticipated requirements for all of our facilities and the costs and benefits associated with new facilities, and, based on that
review, may adjust other of our facilities needs, as well.



|ITEM 3. | LEGAL PROCEEDINGS
|------- | -----------------

See
Note 9 of our consolidated financial statements, Commitments and ContingenciesLegal Proceedings, included in Part IV, Item 15 of this annual report.



|ITEM 4. | RESERVED
|------- | --------



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PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
|------- | -------------------------------------------------------------------------------------------------------------

Market Information

Our common stock is traded on the NASDAQ Global Market under the symbol DSCM. The following table sets forth, for the periods indicated, the high and low sales prices of our common stock, as
reported by the NASDAQ Global Market.



|                                  |  |      |      |  |     |   |      | 
|--------------------------------- |  | ---- | ---- |  | --- | - | ---- | 
|                                  |  | High |      |  | Low |  
|Fiscal Year Ended January 2, 2011 |  |      |      |  |     |   |      | 
|First Quarter                     |  | $    | 3.95 |  |     | $ | 2.60 | 
|Second Quarter                    |  | $    | 3.95 |  |     | $ | 2.92 | 
|Third Quarter                     |  | $    | 3.21 |  |     | $ | 1.48 | 
|Fourth Quarter                    |  | $    | 2.34 |  |     | $ | 1.55 | 
|                                  |  |     
|                                  |  | High |      |  | Low |  
|Fiscal Year Ended January 3, 2010 |  |      |      |  |     |   |      | 
|First Quarter                     |  | $    | 1.47 |  |     | $ | 0.65 | 
|Second Quarter                    |  | $    | 2.09 |  |     | $ | 1.07 | 
|Third Quarter                     |  | $    | 2.72 |  |     | $ | 1.54 | 
|Fourth Quarter                    |  | $    | 3.59 |  |     | $ | 2.19 | 

Holders of Record

As of March 4, 2011, there were approximately 822 holders of record of our common stock, and a much larger number of beneficial
owners.

Dividends

We have never declared or paid cash or stock dividends on our capital stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our
business and do not anticipate paying any dividends in the foreseeable future.

Recent Sales of Unregistered Securities

None.

Issuer Purchases of
Equity Securities

The following table sets forth all purchases of our capital stock made by or on behalf of drugstore.com
or any affiliated purchasers during the fourth quarter of 2010. The shares represent shares of restricted stock that we withheld from shares otherwise due to be released to certain of our employees under the terms of restricted stock award
agreements in settlement of our tax withholding obligations with respect to such employees.



|                |  |                             |         |  |                                |   |      | 
|--------------- |  | --------------------------- | ------- |  | ------------------------------ | - | ---- | 
|Period          |  | Total no.of sharespurchased |         |  | Average pricepaid per share(1) |  
|October 2, 2010 |  |                             | 6,496   |  |                                | $ | 1.84 | 
|October 3, 2010 |  |                             | 98,197  |  |                                | $ | 1.84 | 
|Total           |  |                             | 104,693 |  |                                |   |      | 



|(1) | Price paid reflects the value of shares withheld based on the closing price of our common stock on Monday, October 4, 2010.
|--- | ---------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

In addition, for the majority of restricted stock units we grant, the number of shares
issued on the date the restricted stock units vest is net of the minimum statutory withholding requirements that we pay in cash to the appropriate taxing authorities on behalf of our employees. We have not included these withheld shares in the
common stock repurchase totals in the table above.

We presently have no publicly announced repurchase plan or program, but
intend to continue to allow participants to satisfy statutory minimum tax withholding obligations in connection with the vesting of outstanding restricted stock and restricted stock units through the withholding of shares.

Stock Performance Graph

The graph below shows the relative investment performance of our common stock, the NASDAQ Stock Market Index and the Morgan Stanley
High-Technology Index for the last five years. The following graph is presented pursuant to SEC rules and is not meant to be an indication of our future performance.

LOGO



|                                 |  |          |        |  |            |   |        |            |  |   |            |  |  |          |       |  |          |   |        |  |  |   |        | 
|-------------------------------- |  | -------- | ------ |  | ---------- | - | ------ | ---------- |  | - | ---------- |  |  | -------- | ----- |  | -------- | - | ------ |  |  | - | ------ | 
|                                 |  | 1/1/2006 |        |  | 12/31/2006 |   |        | 12/30/2007 |  |   | 12/28/2008 |  |  | 1/3/2010 |       |  | 1/2/2011 |  
|drugstore.com                    |  | $        | 100.00 |  |            | $ | 128.42 |            |  | $ | 115.09     |  |  | $        | 40.35 |  |          | $ | 108.42 |  |  | $ | 77.54  | 
|NASDAQ Stock Market (U.S.) Index |  | $        | 100.00 |  |            | $ | 109.52 |            |  | $ | 121.27     |  |  | $        | 69.39 |  |          | $ | 102.89 |  |  | $ | 120.29 | 
|Morgan Stanley High Tech Index   |  | $        | 100.00 |  |            | $ | 108.81 |            |  | $ | 120.51     |  |  | $        | 63.30 |  |          | $ | 110.70 |  |  | $ | 127.19 | 



27



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##### Table of Contents

|ITEM | 6. SELECTED FINANCIAL DATA
|---- | --------------------------



|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|------------------------------------------------------------- |  | ----------------------------------------------- | ----------- | - | ------- | - | ---------- | ---- |  | - | ---------- | - |  | ---- | ---------- | - |  | - | ---------- | -
|                                                              |  | Fiscal Year                                     |            
|                                                              |  | 2010                                            |             |   | 2009(2) |   |            | 2008 |  |   | 2007       |   |  | 2006 |           
|                                                              |  | (in thousands, except share and per share data) |            
|Consolidated Statements of Operations Data:                   |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Net sales                                                     |  | $                                               | 456,507     |   |         | $ | 375,574    |      |  | $ | 322,214    |   |  | $    | 289,188    |   |  | $ | 247,744    |  
|Loss from continuing operations                               |  |                                                 | (9,614      | ) |         |   | (9,854     | )    |  |   | (18,907    | ) |  |      | (19,110    | ) |  |   | (20,136    | )
|Gain from discontinued operations, net of tax (1)             |  |                                                 | 6,064       |   |         |   | 8,477      |      |  |   | 10,620     |   |  |      | 7,599      |   |  |   | 5,380      |  
|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Net loss                                                      |  | $                                               | (3,550      | ) |         | $ | (1,377     | )    |  | $ | (8,287     | ) |  | $    | (11,511    | ) |  | $ | (13,026    | )
|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Basic and diluted loss from continuing operations per share   |  | $                                               | (0.09       | ) |         | $ | (0.10      | )    |  | $ | (0.20      | ) |  | $    | (0.20      | ) |  | $ | (0.20      | )
|Basic and diluted gain from discontinued operations per share |  | $                                               | 0.06        |   |         | $ | 0.09       |      |  | $ | 0.11       |   |  | $    | 0.08       |   |  | $ | 0.06       |  
|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Basic and diluted net loss per share                          |  | $                                               | (0.03       | ) |         | $ | (0.01      | )    |  | $ | (0.09      | ) |  | $    | (0.12      | ) |  | $ | (0.14      | )
|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Weighted average shares outstanding                           |  |                                                 | 102,217,033 |   |         |   | 96,950,189 |      |  |   | 96,481,787 |   |  |      | 95,350,046 |   |  |   | 93,405,405 |  
|                                                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Consolidated Balance Sheet Data:                              |  |                                                 |             |   |         |   |            |      |  |   |            |   |  |      |            |   |  |   |            |  
|Cash, cash equivalents and marketable securities              |  | $                                               | 33,531      |   |         | $ | 36,853     |      |  | $ | 38,194     |   |  | $    | 36,249     |   |  | $ | 40,639     |  
|Cash dividends declared per common share                      |  |                                                 |            |   |         |   |           |      |  |   |           |   |  |      |           |   |  |   |           |  
|Working capital                                               |  |                                                 | 42,506      |   |         |   | 42,986     |      |  |   | 34,463     |   |  |      | 35,529     |   |  |   | 41,125     |  
|Total assets                                                  |  |                                                 | 200,372     |   |         |   | 154,529    |      |  |   | 152,549    |   |  |      | 175,408    |   |  |   | 168,322    |  
|Long-term debt obligations, less current portion              |  |                                                 | 13,985      |   |         |   | 3,011      |      |  |   | 2,567      |   |  |      | 1,221      |   |  |   | 1,839      |  
|Total stockholders equity                                    |  | $                                               | 121,329     |   |         | $ | 97,666     |      |  | $ | 94,200     |   |  | $    | 94,368     |   |  | $ | 92,678     |  



|(1) | The results of operations of our mail-order pharmacy and local pick-up pharmacy segments have been classified as discontinued operations in all periods presented.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Fiscal year 2009 was a 53-week year, all other fiscal years presented were 52-week years.
|--- | -----------------------------------------------------------------------------------------



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##### Table of Contents

|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------

Forward-Looking Statements

This annual report on Form 10-K and the
documents incorporated into this annual report by reference contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 based on our expectations, estimates and projections as of the date of this
filing. Actual results may differ materially from those expressed in forward-looking statements. All statements made in this annual 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, including statements regarding:



| |  |  | our beliefs regarding the impact of recently issued standards that are not yet effective will have on our consolidated financial statements upon
adoption;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the potential of any legal proceedings or claims to have, individually or in the aggregate, a material adverse effect on our business prospects,
financial condition, or operating results;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the affects of leveraging our capabilities in Internet marketing, merchandising, fulfillment, and customer care in the health, beauty, and wellness
arena, including through our strategic partnerships and our microsite strategy, on future growth in our OTC segment;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our beliefs regarding the adequacy of our liquidity in light of our operations and anticipated capital expenditures;
| | - |  | --------------------------------------------------------------------------------------------------------------------



| |  |  | whether the internal controls of Salu have materially affected, or will likely materially affect, our internal controls over financial reporting;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our expectation that we will continue to evaluate and consider a wide array of potential strategic partnerships as part of our growth strategy;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the future impact of, or the parties performance under, our agreements with BioScrip and BioScrip Pharmacy Services, including our expected gain
on the sale over fiscal 2011 and the impact on our net income (loss);
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our expectations regarding our continued marketing and merchandising strategies, including the expansion of our product offerings and the continuation
of our shipping or other promotions;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our expectations and assumptions underlying our valuation of our equity awards;
| | - |  | -------------------------------------------------------------------------------



| |  |  | the future launch of new or improved technology or additional websites, including for our strategic partners and in conjunction with our microsite
strategy; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | managements outlook on our net sales, net income (loss), adjusted EBITDA, ongoing adjusted EBITDA and other financial results for the first
quarter and full year of 2011.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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 cause our actual
results to differ significantly from managements expectations are discussed further in the section entitled Risk Factors in Part I, Item 1A of this annual report. 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.

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in
Part IV, Item 15 of this annual report.



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##### Table of Contents

Overview

drugstore.com, inc. is a leading online retailer of health, beauty, clinical skincare, and vision products. We provide a convenient, private, and informative shopping experience while offering a wide
assortment of products through our web stores located on the Internet as follows:



|                                |  |                                
|------------------------------- |  | -------------------------------
|Health, Beauty & Pharmacy       |  | OTC Partnerships               
|www.drugstore.com               |  | www.medcohealthstore.com       
|www.Beauty.com                  |  | www.riteaidonlinestore.com     
|www.SkinStore.com (1)           |  | www.spalook.com(1)             
|www.DrWeilVitaminAdvisor.com(3) |  |                                
|                                | 
|Microsites                      |  | Vision and Vision Partnerships 
|www.thenaturalstore.com         |  | www.VisionDirect.com           
|www.athisbest.com               |  | www.LensMart.com               
|www.sexualwellbeing.com         |  | www.Lensworld.com              
|www.allergysuperstore.com       |  | www.LensQuest.com              
|www.vitaminemporium.com         |  | www.pearlevisioncontacts.com(2)
|                                |  | www.lenscrafterscontacts.com(2)



|(1) | On February 19, 2010, we completed the acquisition of Salu, Inc., now Salu Beauty, Inc. (Salu), owner of SkinStore.com and operator and fulfillment partner for the
spalook.com web store. See Note 2 of our consolidated financial statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | In January 2011, we launched two of our partnership sites with Luxottica Group, S.p.A. (Luxottica), a global leader in the design, manufacturing and distribution of
fashion, luxury, and sport eyewear.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We act as the exclusive fulfillment provider for customized nutritional supplements sold through www.DrWeilVitaminAdvisor.com, www.DrWeil.com, and other
Dr. Weil-related websites.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Business Segments; Growth Strategies

We operate our business in two business segments: over-the-counter or OTC and vision.



| |  |  | OTC. Our OTC segment includes all non-prescription products sold online through our health and beauty web stores, microsites, and our
partnership web stores. We source our OTC products from various manufacturers and distributors. We also sell advertising on our primary OTC site www.drugstore.com. Our business strategy is to offer our customers a wide selection of health,
beauty, and wellness products at competitive prices and provide a superior online shopping experience. We are able to offer a significantly broader assortment of products, with greater depth in each product category, than brick-and-mortar drugstores
and provide a broad array of interactive tools and information on our websites to help consumers make informed purchasing decisions.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Key drivers of our OTC growth strategy for our OTC segment include expanding into new marketing channels and enhanced use of mobile and social media, continued ramp up of microsites, growth in
partnerships, international expansion, and overall increased customer conversion from site improvements and enhancements. We will continue to enter into new marketing channels, such as Buy.com, which we launched in the fourth quarter of 2010, and
ShopRunner.com and eBay.com, which we launched in the first quarter of 2011. In addition, we will continue to make investments in social media advertising and increasing our fan following population. We also recently launched new device agnostic
mobile stores and plan on launching a variety of applications, or apps, in 2011. We expect continued growth from our microsites, both from the five microsites we have launched to date as well as additional microsites we plan to launch in 2011.
Microsites allow us to better target specific customers with tailored marketing programs, by offering a larger assortment of niche specific SKUs and product content. We anticipate continued growth from our partnerships with Medco Health Services,
Inc. (Medco), which we recently extended the agreement with Medco through 2018, and Rite



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##### Table of Contents

Aid Corporation (Rite Aid) as they continue to attract new customers to the websites and generate more orders from site visitors. Finally, we plan to make improvements to site navigation and look
and feel of our sites to improve customer conversion. With these initiatives, we will continue to capitalize on our leadership position in health and beauty online, and continue to expand our categories and employ our strategy of being the
when, where, and how of health, beauty, and wellness.



| |  |  | Vision. Our vision segment includes contact lenses and eye accessories sold through our vision web stores. We purchase our contact lens
inventory directly from various manufacturers and other distributors. We have a strategic multi-year e-commerce partnership with Luxottica, a global leader in the design, manufacturing and distribution of fashion, luxury, and sport eyewear. Through
this partnership, we will develop branded contact lens e-commerce sites for Luxotticas North American businesses such as LensCrafters, Pearle Vision, and Sears Optical. In January 2011, we launched two Luxottica branded sites,
www.lenscrafterscontacts.com and www.pearlevisioncontacts.com. In 2011, we plan to continue to drive new customer growth through promotional offers on our owned vision sites and launch additional Luxottica branded sites.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Business Acquisition

On February 19, 2010, we acquired Salu. The acquisition was made pursuant to an Agreement and Plan of Merger, dated as of December 27, 2009, by and among drugstore.com, Silk Acquisition
Corporation, a Delaware corporation and a wholly owned subsidiary of drugstore.com, Salu, certain stockholders of Salu, and a representative of all stockholders of Salu. As consideration for their shares of Salu, the stockholders of Salu received
$19.4 million in cash (less approximately $1.9 million of Salus transaction expenses and the repayment of Salus outstanding debt obligation of $2.6 million paid out of the merger consideration) and 5,425,678 shares of drugstore.com
common stock with a fair value of $17.3 million. Of this initial consideration, drugstore.com paid approximately $2.7 million in cash and 816,450 shares of our common stock into escrow to secure post-closing indemnification obligations of
Salus stockholders. Additionally, certain employees of Salu are eligible to receive a performance incentive payment payable in cash over a two-year period commencing in fiscal year 2010 with an aggregate value of $2.5 million if the surviving
entity achieves certain financial and other performance targets.

On the acquisition date, we recorded a liability of $0.5
million which represented the fair value of the portion of the performance incentive payment that will be accounted for as additional consideration. Any adjustments to the fair value of our initial estimate of the performance incentive payment may
affect our consolidated statements of operations and could have a material impact on our financial results. In 2010, approximately $0.2 million of the initial purchase price, equal parts of cash and stock, was reimbursed and $0.2 million was due
from escrow in connection with adjustments allowed for under the Agreement and Plan of Merger. Also in 2010, we reduced the performance incentive liability to $0.3 million and recorded a benefit to the statement of operations of $0.2 million.

We financed a portion of the cash payable at the closing of the acquisition described above by borrowing $10.0 million under
our revolving two-year line of credit pursuant to our March 2009 loan and security agreement with our existing bank. In conjunction with the acquisition, we also paid $1.4 million in transaction fees in the first quarter of 2010. In 2010, we also
incurred integration costs and purchase accounting adjustments of approximately $0.7 million, which are recorded in general and administrative expenses and cost of sales ($0.1 million) in our statements of operations. Salus results of
operations are included in the consolidated statements of operations beginning February 20, 2010, and generated net sales of $42.3 million, and net income of $2.3 million, excluding integration costs and purchase accounting adjustments of $0.3
million.

Discontinued Operations

On July 29, 2010, drugstore.com and DS Pharmacy, Inc., our wholly owned subsidiary, entered into a second amendment to the asset purchase agreement dated May 5, 2010, as amended July 14,
2010, with



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##### Table of Contents

BioScrip, Inc., and BioScrip Pharmacy Services, Inc., its wholly owned subsidiary (BioScrip), of which the sale closed on July 30, 2010. Under the terms of the agreement, BioScrip Pharmacy
Services purchased substantially all of the assets of DS Pharmacy for a purchase price of $10.5 million, subject to adjustment for changes in gross profit of the business. Of this initial consideration, BioScrip paid $5.0 million in connection with
closing, with $0.5 million accounting for the purchase of inventory and $4.5 million accounting for the purchase of other assets. BioScrip will pay the remaining $5.5 million of the consideration into escrow in installments, based on the monthly
profitability of the business, over the 12 months following the closing. The final amount paid out of escrow will be determined after the 12-month period based on the profitability of the prescription pharmacy business during that period. For the
year ended January 2, 2011, we recognized $1.6 million of the contingent consideration and will continue to earn all or a portion of the remaining consideration of $3.9 million over the remaining contract period in 2011. Additionally, the
parties entered into a 5-year marketing agreement allowing drugstore.com pharmacy customers to continue to order as they always have through the drugstore.com web store. Under the agreement, 12 months following the closing of July 30, 2010,
BioScrip will pay drugstore.com a fee to continue to market the drugstore.com pharmacy, which will be served by BioScrip. We consider the marketing service fees to be indirect cash inflows of our discontinued mail-order pharmacy segment, as the fees
earned are not a significant source of ongoing future revenue.

On September 3, 2008, we entered into an amended and
restated main agreement with Rite Aid whereby we transferred to Rite Aid the rights to our local pick-up pharmacy business (LPU), which included prescription refills sold online through the drugstore.com web store or the Rite Aid online store and
picked up by customers at Rite Aid stores, in exchange for $9.9 million, paid in ten monthly installments beginning in September 2008. We recorded the purchase price as a deferred gain that we recognized over the ten-month contractual payment period
ended June 2009. Additionally, Rite Aid paid drugstore.com ongoing marketing service fees for the continued marketing of Rite Aids LPU offering on the drugstore.com site during the term of the agreement, which terminated in May 2010. In
addition the pharmacy agreement terminated as of July 2010.

We have classified the results of operations of our mail-order
pharmacy and LPU business segments as discontinued operations in the accompanying consolidated financial statements for all periods presented.

We operate using a 52/53-week retail calendar year with each of the fiscal quarters in a 52-week year representing a 13-week period. Fiscal year 2010 was a 52-week year, fiscal year 2009 was a 53-week
year, with the fourth quarter of 2009 representing a 14-week period, and fiscal year 2008 was a 52-week year. To make results comparable on a 52-week basis for the purpose of presenting normalized growth rates, net sales growth rate comparisons for
2010 and 2009 below have been multiplied by a fraction of 52/53.

Results of Operations

Customer and Order Data

We define new and repeat customer orders as orders generated through our health and beauty web stores, microsites, and our vision web stores, excluding our partnership orders with Medco, Rite Aid and
Spalook and orders generated through Dr. Weil-related web stores. We define total orders as all orders fulfilled through our distribution centers. Mixed orders across one or more of our business segments are reported to each individual segment,
but are included only as one order in the number of total customer orders shipped. Orders from new customers increased year-over-year in 2010 by 16% to 1.9 million orders and increased year-over-year in 2009 by 17% to 1.6 million orders.
These increases are primarily the result of expansion into new marketing channels, and in 2010, 128,000 new orders generated from our acquisition of Salu. Orders from repeat customers as a percentage of total orders decreased year-over-year to 65%
in 2010 compared to 68% in 2009 and 72% in 2008 as a result of our partnership orders becoming an increasing proportion of our total orders. Our partnership orders, as defined above, totaled 576,000 in 2010 and 268,000 in 2009.



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Net Sales



|                                  |  |                                       |         |  |          |  |      |                 |  |   |          |  |  |                 |      |   |  |   |         | 
|--------------------------------- |  | ------------------------------------- | ------- |  | -------- |  | ---- | --------------- |  | - | -------- |  |  | --------------- | ---- | - |  | - | ------- | 
|                                  |  | Fiscal Year2010                       |         |  | % Change |  |      | Fiscal Year2009 |  |   | % Change |  |  | Fiscal Year2008 |     
|                                  |  | (in thousands, except per order data) |        
|Total net sales                   |  | $                                     | 456,507 |  |          |  | 21.5 | %               |  | $ | 375,574  |  |  |                 | 16.6 | % |  | $ | 322,214 | 
|Total customer orders shipped     |  |                                       | 7,078   |  |          |  | 19.2 | %               |  |   | 5,938    |  |  |                 | 12.0 | % |  |   | 5,300   | 
|Total average net sales per order |  | $                                     | 65      |  |          |  | 3.2  | %               |  | $ | 63       |  |  |                 | 3.3  | % |  | $ | 61      | 

Net sales include
gross revenues from sales of product, shipping fees, service fees, and advertising revenues, net of discounts, provision for sales returns, and other allowances. Net sales also include consignment service fees earned from our arrangements with
certain partners, under which we do not take title to the inventory and do not establish pricing. We record on a net basis consignment service fees, which constitute approximately 1% of total net sales in each period presented.

Total net sales increased approximately 22% year-over-year in 2010 as a result of the acquisition of Salu on February 19, 2010,
which generated $42.3 million of net sales in 2010, and increases in order volume and net sales per order. Normalized to exclude the extra week in 2009, net sales increased 24% year-over-year in 2010. Order volumes increased year-over-year in 2010,
primarily reflecting a 21% increase in orders in our OTC segment. Net sales per order increased year-over-year in 2010 as a result of an increase in net sales per order in both our OTC and vision segments.

Total net sales increased 17% year-over-year in 2009 as a result of an increase in order volume, the 53-week year in 2009 compared to the
52-week year in 2008, and an increase in the average net sales per order. Normalized to exclude the extra week in 2009, net sales increased 14% year-over-year in 2009. Order volumes increased year-over-year in 2009, reflecting a 19% and 6% increase
in orders in our OTC and vision segments, respectively. Net sales per order increased year-over-year in 2009 as a result of an increase in net sales per order in our vision segment, partially offset by a decrease in net sales per order in our OTC
segment. Revenues from repeat customers, excluding partnerships, were 72%, 74% and 76% in 2010, 2009, and 2008 respectively.

OTC Net
Sales



|                                       |  |                                       |         |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |         |  
|-------------------------------------- |  | ------------------------------------- | ------- | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------- | -
|                                       |  | Fiscal Year2010                       |         |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                                       |  | (in thousands, except per order data) |        
|OTC net sales                          |  | $                                     | 385,234 |   |          |  | 25.5 | %               |  | $ | 306,854  |   |  |                 | 17.7 | % |  | $ | 260,794 |  
|Percentage of total net sales from OTC |  |                                       | 84.4    | % |          |  |      |                 |  |   | 81.7     | % |  |                 |      |   |  |   | 80.9    | %
|OTC customer orders shipped            |  |                                       | 6,490   |   |          |  | 21.1 | %               |  |   | 5,358    |   |  |                 | 19.1 | % |  |   | 4,498   |  
|OTC average net sales per order        |  | $                                     | 59      |   |          |  | 3.5  | %               |  | $ | 57       |   |  |                 | -1.7 | % |  | $ | 58      |  

Net sales in our OTC
segment increased approximately 26% year-over-year in 2010 as a result of an increase in order volume and average net sales per order. Normalized to exclude the extra week in 2009, net sales in our OTC segment increased 28% year-over-year in 2010.
The number of orders in our OTC segment grew year-over-year by 21% in 2010. Orders from both new and repeat customers increased as a result of: (a) orders generated from our acquisition of Salu on February 19, 2010, (b) orders driven
by our partnerships with Medco and Rite Aid, and (c) orders through new and existing marketing channels. The year-over-year increase in the average net sales per order in our OTC segment in 2010 resulted primarily from a shift in mix to higher
priced items, primarily driven by the acquisition of Salu, which has higher average net sales per order. Net sales generated by our acquisition of Salu in 2010 were $42.3 million, and net sales generated by our partnerships with Medco and Rite Aid
in 2010 were $19.0 million compared to $8.9 million in 2009.



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Net sales in our OTC segment increased 18% year-over-year in 2009 as a
result of an increase in order volume and the 53-week year in 2009 compared to the 52-week year in 2008, partially offset by a decrease in average net sales per order. OTC net sales, normalized to exclude the 53rdweek in the year, increased 15% year-over-year in 2009. The number
of orders in our OTC segment grew year-over-year by 19% in 2009 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
by adding website enhancements and offering a broader selection of basic necessity items and hard-to-find specialty items through the addition of new SKUs, which encourages customers to return to our websites and make repeat, replenishment, and
impulse purchases, and to a lesser extent, orders driven by our partnerships with Rite Aid and Medco. The slight year-over-year decrease in average net sales per order in 2009 resulted from a decrease in shipping revenue as customers took advantage
of free shipping offers and choose not to use expedited shipping methods, increased discounts driven by promotional activity, and a slight decrease in the number of units per order, partially offset by a shift in product mix to higher priced items.

Vision Net Sales



|                                          |  |                                       |        |   |          |  |     |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|----------------------------------------- |  | ------------------------------------- | ------ | - | -------- |  | --- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------ | -
|                                          |  | Fiscal Year2010                       |        |   | % Change |  |     | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                                          |  | (in thousands, except per order data) |       
|Vision net sales                          |  | $                                     | 71,273 |   |          |  | 3.7 | %               |  | $ | 68,720   |   |  |                 | 11.9 | % |  | $ | 61,420 |  
|Percentage of total net sales from vision |  |                                       | 15.6   | % |          |  |     |                 |  |   | 18.3     | % |  |                 |      |   |  |   | 19.1   | %
|Vision customer orders shipped            |  |                                       | 591    |   |          |  | 0.5 | %               |  |   | 588      |   |  |                 | 6.3  | % |  |   | 553    |  
|Vision average net sales per order        |  | $                                     | 121    |   |          |  | 3.4 | %               |  | $ | 117      |   |  |                 | 5.4  | % |  | $ | 111    |  

Net sales in our vision segment increased 4% year-over-year in 2010 as a result of an increase in orders and net
sales per order. Normalized to exclude the extra week in 2009, net sales in our vision segment increased 6% year-over-year in 2010. Net sales in our vision segment increased 12% year-over-year in 2009 as a result of an increase in order volume, an
increase in average net sales per order, and the 53-week year in 2009 compared to the 52-week year in 2008. Vision net sales normalized to exclude the 53rdweek in the year, increased 10% year-over-year in 2009. The year-over-year increase in average net sales per order in
2010 and 2009 was driven primarily by customers making larger quantity purchases, price increases for certain SKUs (none of which were individually material), and sales of higher-priced newer technology contact lenses, partially offset by increased
use of discount and promotional offers by our customers. Orders in our vision segment in 2010 were consistent and orders increased year-over-year in 2009, primarily as a result of increased new customer orders driven by promotional offers.

Cost of Sales and Gross Margin



|                              |  |                  |         |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |         |  
|----------------------------- |  | ---------------- | ------- | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------- | -
|                              |  | Fiscal Year2010  |         |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                              |  | ($ in thousands) |        
|Total cost of sales           |  | $                | 322,011 |   |          |  | 22.3 | %               |  | $ | 263,350  |   |  |                 | 15.7 | % |  | $ | 227,531 |  
|Total gross profit dollars    |  | $                | 134,496 |   |          |  | 19.8 | %               |  | $ | 112,224  |   |  |                 | 18.5 | % |  | $ | 94,683  |  
|Total gross margin percentage |  |                  | 29.5    | % |          |  |      |                 |  |   | 29.9     | % |  |                 |      |   |  |   | 29.4    | %

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. We net against cost of sales payments that we receive from vendors in connection with volume purchases or rebate allowances and payment discount terms.

Total cost of sales increased year-over-year in absolute dollars in 2010 and 2009 as a result of growth in order volume and net sales in our OTC and vision segments. Total gross margin percentage
decreased year-over-year in



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2010 primarily as a result of a decrease in our OTC segment margin due to increased new customer promotions, downward marketplace pricing pressures, and lower advertising revenue. Gross margin
percentage increased year-over-year in 2009 primarily as a result of a fifty basis point improvement in our OTC segment margin.

Shipping



|                         |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|------------------------ |  | ---------------- | ------ | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------ | -
|                         |  | Fiscal Year2010  |        |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                         |  | ($ in thousands) |       
|Shipping activity:       |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|Shipping revenue         |  | $                | 15,018 |   |          |  | 10.7 | %               |  | $ | 13,567   |   |  |                 | -1.7 | % |  | $ | 13,804 |  
|Shipping costs           |  |                  | 34,744 |   |          |  | 22.4 | %               |  |   | 28,379   |   |  |                 | 9.5  | % |  |   | 25,911 |  
|                         |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|Net shipping loss        |  | $                | 19,726 |   |          |  | 33.2 | %               |  | $ | 14,812   |   |  |                 | 22.3 | % |  | $ | 12,107 |  
|                         |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|Percentage of net sales: |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|Shipping revenue         |  |                  | 3.3    | % |          |  |      |                 |  |   | 3.6      | % |  |                 |      |   |  |   | 4.3    | %
|Shipping costs           |  |                  | 7.6    | % |          |  |      |                 |  |   | 7.6      | % |  |                 |      |   |  |   | 8.0    | %
|Net shipping loss        |  |                  | 4.3    | % |          |  |      |                 |  |   | 3.9      | % |  |                 |      |   |  |   | 3.8    | %

We include in net sales
our revenues from shipping charges to customers, and we include in cost of sales outbound shipping costs. Our net shipping loss increased year-over-year in absolute dollars and as a percentage of net sales in 2010 and 2009, primarily as a result of
a decrease in shipping revenue resulting from an increase in the number of customers using free shipping offers, a reduced number of customers choosing expedited shipping methods for their orders, and the elimination of surcharges for APO/FPO and
Alaska and Hawaii orders in the fourth quarter of 2008, combined with a greater proportion of OTC orders, which have a higher shipping cost than orders in our vision segment. We expect to continue to subsidize a portion of customers shipping
costs for the foreseeable future, through certain free shipping promotions, as a strategy to attract and retain customers.

OTC Cost of
Sales and Gross Margin



|                            |  |                  |         |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |         |  
|--------------------------- |  | ---------------- | ------- | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------- | -
|                            |  | Fiscal Year2010  |         |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                            |  | ($ in thousands) |        
|OTC cost of sales           |  | $                | 267,681 |   |          |  | 27.2 | %               |  | $ | 210,456  |   |  |                 | 16.8 | % |  | $ | 180,252 |  
|OTC gross profit dollars    |  | $                | 117,553 |   |          |  | 21.9 | %               |  | $ | 96,398   |   |  |                 | 19.7 | % |  | $ | 80,542  |  
|OTC gross margin percentage |  |                  | 30.5    | % |          |  |      |                 |  |   | 31.4     | % |  |                 |      |   |  |   | 30.9    | %

Cost of sales in our OTC
segment increased year-over-year in absolute dollars in 2010, as a result of growth in order volumes and net sales generated from the acquisition of Salu, growth in net sales from our partnerships with Medco and Rite Aid, and growth in net sales
generated through existing and new marketing channels. Our gross margin percentage decreased year-over-year in 2010 as a result of increased promotional activity, softness in discretionary consumer spending, declining advertising revenue as a result
of changes in our marketing services agreement, manufacturer out of stocks and discontinued product lines, and lower margin growth from our Medco and Rite Aid partnerships, partially offset by net sales generated by Salu, which has historically
higher margins, and reduced OTC product costs and increased vendor subsidies.

Cost of sales in our OTC segment increased
year-over-year in absolute dollars in 2009, as a result of growth in order volume and net sales. The year-over-year increase in gross margin percentage in this segment in 2009 resulted primarily from improvements in product margins in a majority of
our product categories as a result of our ongoing pricing and sourcing initiatives and better targeted promotional efforts, partially offset by higher customer use of discount offers.



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##### Table of Contents

Vision Cost of Sales and Gross Margin



|                               |  |                  |        |   |          |  |     |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|------------------------------ |  | ---------------- | ------ | - | -------- |  | --- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------ | -
|                               |  | Fiscal Year2010  |        |   | % Change |  |     | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                               |  | ($ in thousands) |       
|Vision cost of sales           |  | $                | 54,330 |   |          |  | 2.7 | %               |  | $ | 52,894   |   |  |                 | 11.9 | % |  | $ | 47,279 |  
|Vision gross profit dollars    |  | $                | 16,943 |   |          |  | 7.1 | %               |  | $ | 15,826   |   |  |                 | 11.9 | % |  | $ | 14,141 |  
|Vision gross margin percentage |  |                  | 23.8   | % |          |  |     |                 |  |   | 23.0     | % |  |                 |      |   |  |   | 23.0   | %

Cost of sales in our
vision segment increased year-over-year in absolute dollars in 2010 and 2009, as a result of an increase in net sales. Gross margin percentage in 2010 benefited year-over-year by lower product costs through our joint sourcing agreement with
Luxottica, partially offset by increased discounts and promotional offers. Additionally, cost of sales increased due to a greater mix of higher priced inventory related to the build-up of inventory to support the move in the first quarter of 2010 of
our vision fulfillment operations from Ferndale, Washington to our distribution center in Swedesboro, New Jersey, and a one-time inventory shrinkage charge related to the migration of inventory to a new perpetual inventory system. Gross margin
percentage in 2009 remained consistent year-over-year.

Fulfillment and Order Processing Expense



|                                         |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|---------------------------------------- |  | ---------------- | ------ | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------ | -
|                                         |  | Fiscal Year2010  |        |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                                         |  | ($ in thousands) |       
|Fulfillment and order processing expense |  | $                | 49,604 |   |          |  | 18.4 | %               |  | $ | 41,891   |   |  |                 | 7.7  | % |  | $ | 38,896 |  
|Percentage of net sales                  |  |                  | 10.9   | % |          |  |      |                 |  |   | 11.2     | % |  |                 |      |   |  |   | 12.1   | %
|Fixed and variable cost information:     |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|Variable costs                           |  | $                | 36,194 |   |          |  | 21.9 | %               |  | $ | 29,700   |   |  |                 | 12.9 | % |  | $ | 26,307 |  
|Fixed costs                              |  | $                | 13,410 |   |          |  | 10.0 | %               |  | $ | 12,191   |   |  |                 | -3.2 | % |  | $ | 12,589 |  

Fulfillment and order
processing expenses include payroll and related expenses for personnel engaged in purchasing, fulfillment, distribution, and customer care activities (including warehouse and vision prescription verification personnel), distribution center equipment
and packaging supplies, credit card processing fees, and bad debt expenses. These expenses also include rent and depreciation related to equipment and fixtures in our distribution centers and call center facility. Variable fulfillment costs
represent the incremental costs of fulfilling, processing, and delivering the orders that are variable based on sales volume.

Variable fulfillment and order processing expenses increased year-over-year in absolute dollars in 2010 primarily as a result of a 21%
increase in order volume in our OTC segment, and to a lesser extent, a higher fulfillment cost for Salu, which is provided by a third party fulfillment partner. Fixed fulfillment and order processing expenses increased year-over-year in 2010,
primarily due to the addition of Salus fulfillment costs of $1.3 million, an increase in stock-based compensation expense of $0.4 million as a result of stock awards approved at our stockholder meeting on June 10, 2010, partially offset
by a reduction in depreciation expense of $0.4 million related to equipment and software purchases being fully depreciated in prior periods. Fulfillment and order processing expenses as a percentage of net sales improved year-over-year in 2010, due
to cost containment efforts and the fact that our fixed fulfillment costs were spread across a higher revenue base.

Variable
fulfillment and order processing expenses increased year-over-year in absolute dollars in 2009 primarily as a result of a 19% increase in order volume in our OTC segment, partially offset by a reduction in labor fulfillment costs resulting from
process improvements made in our primary distribution center and efficiencies gained as a result of increased order volume. Fixed fulfillment and order processing expenses decreased year-over-year by $0.4 million in 2009 primarily as a result of a
decrease in consulting fees of approximately $0.9 million related to process improvement projects, partially offset by increased depreciation expense of $0.3 million related to equipment and software purchases, and increased operating expenses of



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$0.2 million. Fulfillment and order processing expenses as a percentage of net sales decreased in 2009 as a result of a 30 basis point improvement in variable costs as a percentage of net sales,
due to increased efficiencies in our primary distribution facility, and a 70 basis improvement in fixed costs as a percentage of sales, due to fixed costs spread across a higher revenue base, and to a lesser extent, a reduction in consulting
expenses.

Marketing and Sales Expense



|                            |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |      |   |  |   |        |  
|--------------------------- |  | ---------------- | ------ | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ---- | - |  | - | ------ | -
|                            |  | Fiscal Year2010  |        |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |     
|                            |  | ($ in thousands) |       
|Marketing and sales expense |  | $                | 46,550 |   |          |  | 23.4 | %               |  | $ | 37,727   |   |  |                 | 16.2 | % |  | $ | 32,464 |  
|Percentage of net sales     |  |                  | 10.2   | % |          |  |      |                 |  |   | 10.0     | % |  |                 |      |   |  |   | 10.1   | %

Marketing and sales
expenses include advertising expenses, promotional expenditures, web analytic tools, web design, and payroll and related expenses for personnel engaged in marketing and merchandising activities. Advertising expenses include our obligations under
various advertising contracts. Advertising and other promotional costs, which consist primarily of online advertising, and to a lesser extent, royalty and public relations expenditures, are expensed as incurred, and were $34.2 million in 2010,
$27.3 million in 2009, and $22.8 million in 2008.

Marketing and sales expenses increased year-over-year in absolute
dollars and as a percentage of net sales in 2010 primarily as a result of an increase of $6.9 million in paid search, affiliate, and portal costs, driven by order volume, growth in new customer orders, the addition of Salus online marketing
costs, and growth in partnership marketing costs; increased stock-based compensation of $0.6 million as a result of stock awards approved at our stockholder meeting on June 10, 2010; and an increase of $1.2 million from the addition of
Salus other marketing costs.

Marketing and sales expenses increased year-over year in absolute dollars but decreased as
a percentage of net sales in 2009 primarily from an increase of $4.5 million in paid search, affiliate, and portal costs, driven primarily by order volume, growth in new customer orders, and growth in partnership marketing costs, and a $0.8 million
increase in employee related costs.

Marketing and sales expense per new customer, excluding partnership marketing costs and
orders, was $24 in 2010, $22 in 2009 and $23 in 2008. The year-over-year increase in 2010 marketing cost per new customer is primarily due to a higher mix of new customer orders, which have a higher acquisition cost, and an increase in marketing
investments associated with our microsites and international initiatives as well as a shift in marketing channel mix related to social networks and marketplaces. The year-over-year decrease in 2009 marketing cost per new customer, excluding
partnerships, is primarily due to the acquisition of new customers in lower cost marketing channels.

Technology and Content Expense



|                               |  |                  |        |   |          |  |     |                 |  |   |          |   |  |                 |     |   |  |   |        |  
|------------------------------ |  | ---------------- | ------ | - | -------- |  | --- | --------------- |  | - | -------- | - |  | --------------- | --- | - |  | - | ------ | -
|                               |  | Fiscal Year2010  |        |   | % Change |  |     | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |    
|                               |  | ($ in thousands) |       
|Technology and content expense |  | $                | 27,303 |   |          |  | 9.8 | %               |  | $ | 24,864   |   |  |                 | 8.1 | % |  | $ | 22,995 |  
|Percentage of net sales        |  |                  | 6.0    | % |          |  |     |                 |  |   | 6.6      | % |  |                 |     |   |  |   | 7.1    | %

Technology and content
expenses consist primarily of payroll and related expenses for personnel engaged in developing, maintaining, and making routine upgrades and improvements 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.



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Technology and content expenses increased year-over-year in absolute dollars but decreased
as a percentage of net sales in 2010 primarily from: the addition of $1.6 million of Salus technology costs; an increase in depreciation expense of $1.1 million related to the completion of internally developed software projects and the
acquisition of software and computer equipment to enhance our websites and IT infrastructure; an increase in stock-based compensation expense of $0.5 million as a result of stock awards approved at our stockholder meeting on June 10, 2010;
partially offset by a decrease in employee-related costs of approximately $0.9 million related to reduced employee compensation. Technology and content expenses increased year-over-year in absolute dollars but decreased as a percentage of net sales
in 2009 primarily from: increases in depreciation costs of $1.5 million related to the completion of internally developed software projects and the acquisition of software and computer equipment to enhance our websites and IT infrastructure; and an
increase in employee related expenses of $0.4 million, primarily driven by a slight increase in headcount and other compensation, partially offset by a reduction in stock compensation expense.

Technology and content expenses as a percentage of net sales decreased in 2010 and 2009 as a result of fixed costs being spread across a
higher revenue base.

General and Administrative Expense



|                                   |  |                  |        |   |          |  |      |                 |  |   |          |   |  |                 |       |   |  |   |        |  
|---------------------------------- |  | ---------------- | ------ | - | -------- |  | ---- | --------------- |  | - | -------- | - |  | --------------- | ----- | - |  | - | ------ | -
|                                   |  | Fiscal Year2010  |        |   | % Change |  |      | Fiscal Year2009 |  |   | % Change |   |  | Fiscal Year2008 |      
|                                   |  | ($ in thousands) |       
|General and administrative expense |  | $                | 20,221 |   |          |  | 14.6 | %               |  | $ | 17,642   |   |  |                 | -11.2 | % |  | $ | 19,866 |  
|Percentage of net sales            |  |                  | 4.4    | % |          |  |      |                 |  |   | 4.7      | % |  |                 |       |   |  |   | 6.2    | %

General and administrative
expenses consist of payroll and related expenses for executive and administrative personnel, corporate facility expenses, including depreciation on equipment and leasehold improvements, professional service expenses, intangible asset amortization,
and other general corporate expenses.

General and administrative expenses increased year-over-year in absolute dollars by
$2.6 million, but decreased as a percentage of net sales in 2010. Of the increase, $1.3 million relates to stock compensation as a result of stock awards approved at our stockholder meeting on June 10, 2010, $1.9 million related to the addition
of Salus general and administrative costs, and a $1.2 million benefit realized in 2009 from the resolution of our New Jersey sales tax case. Partially offsetting these increases is a reduction in professional fees of approximately $1.0 million
related to consulting projects focused on our profitability initiatives in 2009, a reduction in employee related expenses of $0.7 million, and a decrease of approximately $0.3 million related to increased purchase card program incentives and general
cost reductions. Additionally, 2010 included a $1.4 million transaction fee related to the acquisition of Salu and the issuance of a fully vested warrant with a fair value of $0.7 million issued in exchange for three years of advisory services,
partially offset by the absence of 2009 expenses of $1.0 million for an advisory fee related to our strategic alliance with Luxottica, $0.4 million of expenses related to the Salu acquisition, and a charge of $0.5 million related to a legal
settlement.

General and administrative expenses decreased in both absolute dollars and as a percentage of net sales in 2009
compared to the prior year. The year-over-year decrease of $2.2 million resulted primarily from: a decrease in stock-based compensation of $1.9 million primarily due to option grants becoming fully vested in 2008; a decrease in professional fees of
$1.6 million primarily related to pricing and sourcing initiatives that were incurred in the prior year; a $0.4 million decrease in amortization as a result of certain intangible assets being fully amortized; and to a lesser extent, in the first
half of 2009, a decrease of $1.6 million related to the settlement of our New Jersey sales tax case, and reduced insurance costs of $0.4 million. These decreases were partially offset by the a legal settlement of $0.5 million, a $1.0 million
advisory fee related to our strategic alliance with Luxottica, increased employee related expenses of $1.5 million, and $0.4 million of expenses related to our acquisition of Salu.



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General and administrative expenses as a percentage of net sales decreased in 2010 and 2009
as a result of fixed costs spread across a higher revenue base.

Interest Income and Expense



|                               |  |                  |      |   |                 |   |    |                 |  |   |     | 
|------------------------------ |  | ---------------- | ---- | - | --------------- | - | -- | --------------- |  | - | --- | 
|                               |  | Fiscal Year2010  |      |   | Fiscal Year2009 |   |    | Fiscal Year2008 | 
|                               |  | ($ in thousands) |     
|Interest (expense) income, net |  | $                | (432 | ) |                 | $ | 46 |                 |  | $ | 631 | 

Interest income
consists of earnings on our cash, cash equivalents, and marketable securities, and interest expense consists primarily of interest associated with debt obligations. The year-over-year increase in net interest expense in 2010 was primarily from an
increase in interest expense resulting from higher borrowings on our line of credit primarily due to the acquisition of Salu and receiving lower returns on a year-over-year lower average balance of cash, cash equivalents, and marketable securities.
The year-over-year decrease in net interest income in 2009 was primarily a result of receiving lower returns on cash, cash equivalents, and marketable securities balances, partially offset by a decrease in interest expense as we decreased our
outstanding debt obligations.

Gain from Discontinued Operations



|                                  |  |                  |       |  |          |  |       |                 |  |   |          |  |  |                 |       |   |  |   |        | 
|--------------------------------- |  | ---------------- | ----- |  | -------- |  | ----- | --------------- |  | - | -------- |  |  | --------------- | ----- | - |  | - | ------ | 
|                                  |  | Fiscal Year2010  |       |  | % Change |  |       | Fiscal Year2009 |  |   | % Change |  |  | Fiscal Year2008 |      
|                                  |  | ($ in thousands) |      
|Gain from discontinued operations |  | $                | 6,064 |  |          |  | -28.5 | %               |  | $ | 8,477    |  |  |                 | -20.2 | % |  | $ | 10,620 | 

The gain from
discontinued operations in 2010 represents the gain on the sale and the operations of our discontinued mail-order pharmacy segment as a result of our sale of our mail-order pharmacy assets to BioScrip, which closed on July 30, 2010. See Note 3
of our consolidated financial statements, Discontinued Operations, included in Part IV, Item 15 of this annual report. The gain from discontinued operations in 2009 represents the operations of both our discontinued
mail-order pharmacy segment of $2.5 million and $5.9 million received from Rite Aid related to the sale of our local pick-up pharmacy (LPU) business. The gain from discontinued operations in 2008 also represents the operations of both our
discontinued mail-order pharmacy segment of $2.5 million and $5.7 million generated by discontinued operations prior to the sale of the LPU business to Rite Aid in September 2008, and a net $2.3 million from the sale of discontinued operations
related to LPU, comprised of $4.0 million payment, a $0.3 million gain from the sale of inventory, partially offset by the acceleration amortization of $1.9 million of prepaid marketing costs.

Non-GAAP Measures

Adjusted EBITDA
and Ongoing Adjusted EBITDA

The following table provides information regarding our adjusted EBITDA, including a
reconciliation of net loss to adjusted EBITDA, for the last three fiscal years (in thousands):



|                                   |  |             |        |   |      |   |        |      |  |   |        |  
|---------------------------------- |  | ----------- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                   |  | Fiscal Year |       
|                                   |  | 2010        |        |   | 2009 |   |        | 2008 | 
|Net loss                           |  | $           | (3,550 | ) |      | $ | (1,377 | )    |  | $ | (8,287 | )
|Amortization of intangible assets  |  |             | 434    |   |      |   | 477    |      |  |   | 867    |  
|Amortization of non-cash marketing |  |             |       |   |      |   |       |      |  |   | 3,435  |  
|Stock-based compensation           |  |             | 8,949  |   |      |   | 5,400  |      |  |   | 7,564  |  
|Depreciation                       |  |             | 13,733 |   |      |   | 12,682 |      |  |   | 10,912 |  
|Interest income, net               |  |             | 432    |   |      |   | (46    | )    |  |   | (631   | )
|                                   |  |             |        |   |      |   |        |      |  |   |        |  
|Adjusted EBITDA                    |  | $           | 19,998 |   |      | $ | 17,136 |      |  | $ | 13,860 |  
|                                   |  |             |        |   |      |   |        |      |  |   |        |  



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The following table provides information regarding our ongoing adjusted EBITDA, including a
reconciliation of adjusted EBITDA to ongoing adjusted EBITDA, for the last three fiscal years (in thousands):



|                                                                     |  |             |        |   |      |   |        |      |  |   |         |  
|-------------------------------------------------------------------- |  | ----------- | ------ | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                                     |  | Fiscal Year |       
|                                                                     |  | 2010        |        |   | 2009 |   |        | 2008 | 
|Adjusted EBITDA                                                      |  | $           | 19,998 |   |      | $ | 17,136 |      |  | $ | 13,860  |  
|Less: Proceeds from the sale of LPU                                  |  |             |       |   |      |   | (5,946 | )    |  |   | (11,515 | )
|Less: Discontinued mail-order pharmacy operations                    |  |             | (6,437 | ) |      |   | (2,603 | )    |  |   | (2,610  | )
|Less: Litigation related settlements                                 |  |             |       |   |      |   | (725   | )    |  |   |        |  
|Add: Vision migration charges                                        |  |             | 650    |   |      |   |       |      |  |   |        |  
|Add: Salu and Luxottica transaction and integration related costs    |  |             | 2,130  |   |      |   | 1,400  |      |  |   |        |  
|Add: New Jersey sales tax and interest                               |  |             |       |   |      |   |       |      |  |   | 380     |  
|Add: DC process improvement and profitability initiatives consulting |  |             |       |   |      |   |       |      |  |   | 2,339   |  
|                                                                     |  |             |        |   |      |   |        |      |  |   |         |  
|Ongoing Adjusted EBITDA                                              |  | $           | 16,341 |   |      | $ | 9,262  |      |  | $ | 2,454   |  
|                                                                     |  |             |        |   |      |   |        |      |  |   |         |  

To supplement the consolidated financial statements presented in accordance with U.S. generally accepted
accounting principles (GAAP), we use the non-GAAP measure of adjusted EBITDA, defined as earnings before interest, taxes, depreciation, and amortization of intangible assets, adjusted to exclude the impact of stock-based compensation expense. We
also use the non-GAAP measure of ongoing adjusted EBITDA, defined as adjusted EBITDA excluding the impact of expenses or income from discontinued operations, certain legal actions, settlements and related costs outside our normal course of business,
restructuring and severance costs, impairment charges, and certain other one-time charges and credits specifically identified in the non-GAAP reconciliation financial schedules included in this annual report. These non-GAAP measures are provided to
enhance the users overall understanding of our current financial performance. Management believes that adjusted EBITDA and ongoing adjusted EBITDA, as defined, provides useful information to us and to investors by excluding certain items that
may not be indicative of our core operating results. In addition, because we have historically provided adjusted EBITDA and have recently begun to provide ongoing adjusted EBITDA measures to investors, management believes that including adjusted
EBITDA and ongoing adjusted EBITDA measures provides consistency in the our financial reporting. However, adjusted EBITDA and ongoing adjusted EBITDA should not be considered in isolation, or as a substitute for, or as superior to, net income/loss,
cash flows, or other consolidated income/loss or cash flow data prepared in accordance with GAAP, or as a measure of our profitability or liquidity. Although adjusted EBITDA and ongoing adjusted EBITDA are frequently used as measures of operating
performance, they are not necessarily comparable to other similarly titled captions of other companies due to differences in methods of calculation. Net income/loss is the closest financial measure prepared by us in accordance with GAAP in terms of
comparability to adjusted EBITDA and ongoing adjusted EBITDA.

Adjusted EBITDA and ongoing adjusted EBITDA have increased
year-over-year in 2010 and 2009, primarily as a result of a year-over-year increase in gross profit dollars of $22.3 million and $17.5 million in 2010 and 2009, respectively, driven primarily by increased sales volume. Additionally, fixed costs as a
percentage of revenue have decreased year-over-year in 2010 and 2009 as a result of costs being spread across a higher revenue base.

Significant Accounting Judgments

The preparation of financial statements in conformity with 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 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. Significant accounting policies are included in Note 1 of our consolidated financial



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statements included in Part IV, Item 15 of this annual report. 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 revenue from product sales or services rendered (including advertising revenues), net of sales tax, 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. Revenue arrangements with multiple deliverables are divided into separate units and revenue is allocated using estimated selling prices if we do not have vendor-specific objective evidence or
third-party evidence of the selling prices of the deliverables.

Revenues are recorded when the products are shipped and title
passes to customers, net of promotional discounts, cancellations, rebates, and returns allowances. 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 evaluate whether it is appropriate to record the gross amount of product
sales and related costs or the net amounts earned. 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. In addition, when we report revenue from fulfillment partnerships, we include in revenues, the costs of the products sold and our variable fulfillment costs to fulfill each order that are received from
our fulfillment partners.

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 write down required for excess and
obsolete inventory. Historically, inventory write downs have not differed materially from our estimates.

These assumptions
about future write-downs of inventory are inherently uncertain. As a measure of sensitivity, for every 1% of additional inventory allowance at January 2, 2011 we would have recorded an additional cost of sales of approximately $0.5 million.



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Goodwill, Indefinite lived and Other Intangible Assets

We test for impairment of goodwill during the fourth quarter of each year and whenever indicators of impairment occur. The first phase of
the test screens for impairment, while the second phase of the test (if necessary) measures the amount of impairment. The first phase is performed by comparing the fair value of the applicable reporting unit to its carrying value. Fair value is
determined using either a discounted cash flow methodology or methodology based on comparable market prices. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that
goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.

During fiscal 2010, 2009 and 2008 we estimated the fair value of our reporting units by preparing a discounted cash flow analysis using
forward looking projections of our estimated future operating results. Based on the results of the discounted cash flow analysis each year, we concluded that the fair value of our reporting units exceeded the carrying value, and therefore goodwill
was not impaired. We also considered as an indicator of market value the market value of our common stock during the fourth quarter of the respective fiscal years.

The significant assumptions used in our discounted cash flow analysis included: projected operating results, the discount rate used to present value future cash flows, and capital expenditures. Projected
operating results assumptions include sales growth assumptions which are based on historical trends, and to a lesser extent, future sales growth from new strategic partnerships or initiatives. Also included in projected operating results are gross
margin and operating cost growth assumptions which are based on the historical relationship of those measures compared to sales. Our discount rate is a market participant weighted average cost of capital (WACC). Financial and credit
markets directly impact our fair value measurement through our weighted average cost of capital that we use to determine our discount rate. Our capital expenditure assumptions are based on our planned capital expenditures for existing and new
projects. Sensitivity tests were performed on our significant assumptions and determined that a reasonable, negative change in assumptions would not impact our conclusions.

We review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment exists. When facts and circumstances indicate that the
carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. The determination of whether the asset is recoverable is based on any excess of the carrying value over the expected future cash flows, as estimated
through undiscounted cash flows, excluding interest charges. If it is not recoverable, any resulting impairment charge would be measured 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.

We review our
indefinite-lived intangible assets, other than goodwill, for impairment annually during the fourth quarter or when an indicator of impairment exists. We compare the carrying value of the asset to its estimated fair value based upon a discounted cash
flow analysis and record an impairment charge when the carrying value of the asset exceeds the estimated fair value. Based upon our review, we recorded no impairment for amortized or unamortized long-lived assets in fiscal 2010, 2009, or 2008.

Stock-Based Compensation

We measure compensation cost for all stock-based awards at fair value on the date of grant and recognize compensation cost over the service period for awards expected to vest. We calculate the fair value
of our stock options and stock appreciation rights granted to employees using the Black-Scholes option pricing model using the single-option approach. The fair value of restricted stock is determined based on the number of shares granted and the
quoted price of our common stock. The fair value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line method. We base our computation of expected volatility on our



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historical volatility, adjusted for changes in capital structure and corporate changes, information available that may indicate future volatility, and observable mean reversion tendencies of
historical volatility. Our expected term estimates are based on a comprehensive weighted average life (WAL) analysis. The WAL analysis provides a historical based platform for use in developing expected term estimates for the future based on the
historically observed time periods from grant date through post-vesting activities, such as exercise and cancellation. 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 to employee subgroups, based on the
weighted average termination behavior of those subgroups. 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. Our estimated forfeiture rates at in 2010 and 2009 were both 15% for restricted stock awards and units and 35% for stock options
and stock appreciation rights. A 1% change in our estimated forfeiture rates combined would have had an approximate $0.1 million impact on our 2010 net loss. See Note 12 of our consolidated financial statements, Employee Benefit
Plans, included in Part IV, Item 15 of this annual report.

Recent Accounting Pronouncements

See Note 1 of our consolidated financial statements, The Company and Summary of Significant Accounting PoliciesNew
Accounting Pronouncements, included in Part IV, Item 15 of this annual report.

Liquidity and Capital Resources

We have an accumulated deficit of $774.8 million through January 2, 2011. To date, we have had only four profitable
quarters, and we may never achieve profitability on a full-year or consistent basis. We expect to incur a net loss in the first quarter of 2011 and possibly longer.

Our primary source of cash is sales made through our websites, for which we collect cash from our customers and payments received from our fulfillment partners. 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 this section and in the sections entitled
Risk Factors, in Part I, Item 1A of this annual report.

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. 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, U.S. government agency obligations, and corporate notes and
bonds, are considered short-term as they are available to fund current operations. In addition, in March 2011, we entered into a new three-year line of credit agreement with our existing bank, which replaced our existing two-year $25.0 million line
of credit, allowing for borrowings of up to $40.0 million in the aggregate through March 2014, which is available to fund operations, capital expenditures, or finance acquisitions, as needed. As of January 2, 2011, the available borrowings
under the two-year line of credit were approximately $11.5 million, and in March 2011, the available borrowings under the three-year line of credit were approximately $26.5 million. In the event we are not in compliance with certain financial
covenants contained in the line of credit agreement, and are unable to obtain a waiver from the bank, borrowing available under the line of credit may be temporarily suspended until such time the covenant violations are remediated.



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As of January 2, 2011, our cash and money market funds include $5.0 million that
serves as collateral on a contract. The contract is cancelable with 30-days written notice and therefore the cash equivalent is considered readily available within 30-days.

On February 19, 2010, we completed our acquisition of Salu. See Note 2 of our consolidated financial statements, Acquisition of Salu included in Part VI, Item 15 of this
annual report. In connection with this acquisition, we financed a portion of the cash payable at the closing of the acquisition by borrowing $10.0 million under our previous two-year revolving line of credit, which accrued interest at the higher of
the prime rate plus 0.50% (3.75% at January 2, 2011). The balance outstanding under the line of credit was $13.0 million as of January 2, 2011 and was refinanced under the new three-year revolving line of credit entered into in March 2011.

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 pursue business or technology acquisitions or invest in additional distribution centers) 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.

Discussion of Cash Flows

The following table provides information
regarding our cash flows for the last three fiscal years (in thousands):



|                                                     |  |             |         |   |      |   |        |      |  |   |        |  
|---------------------------------------------------- |  | ----------- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                     |  | Fiscal Year |        
|                                                     |  | 2010        |         |   | 2009 |   |        | 2008 | 
|Net cash provided by (used in):                      |  |             |         |   |      |   |        |      |  |   |        |  
|Continuing operating activities                      |  | $           | 15,960  |   |      | $ | 2,380  |      |  | $ | 319    |  
|Discontinued operating activities                    |  | $           | (2,394  | ) |      | $ | 1,420  |      |  | $ | 9,594  |  
|Continuing investing activities                      |  | $           | (24,538 | ) |      | $ | (4,302 | )    |  | $ | (4,454 | )
|Discontinued investing activities                    |  | $           | (1,073  | ) |      |   |       |      |  |   |       |  
|Financing activities                                 |  | $           | 10,307  |   |      | $ | (2,520 | )    |  | $ | 1,166  |  
|Net increase (decrease) in cash and cash equivalents |  | $           | (1,738  | ) |      | $ | (3,022 | )    |  | $ | 6,625  |  

Cash provided by
(used in) operating activities. Our operating cash flows result primarily from cash received from our customers, fulfillment partners, and advertising and other service revenue, offset by cash payments we make for products and services, employee
compensation, payment processing and related transaction costs, and interest payments on our debt obligations. Cash received from customers and other activities generally corresponds to our net sales, and because our customers primarily use credit
cards to buy from us, our receivables from customers settle quickly. Working capital at any specific point in time is subject to many variables, including seasonality, inventory management and category expansion, the timing of cash receipts and
payments, vendor payment terms, and valuation of cash equivalents and marketable securities.

Net cash provided by continuing
operations in 2010 reflects non-cash expenses of $23.2 million, cash provided by working capital of $2.4 million, which includes a $7.9 million increase in accounts payable due to the timing of vendor payments and cash used of $5.2 million to
purchase inventory, partially offset by a loss from continuing operations of $9.6 million. Net cash provided by continuing operations in 2009 reflects non-cash



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expenses of $18.5 million, partially offset by a loss from continuing operations of $9.9 million, and uses of working capital of $6.3 million, which includes $7.7 million to purchase inventory
and a $5.4 million increase in accounts receivable. In 2008, net cash provided by continuing operations reflects non-cash expenses of $19.3 million, offset by a loss from continuing operations of $18.9 million.

Net cash provided by continuing operations increased year-over-year in 2010 by $13.6 million, primarily from an increase in cash provided
from working capital of $8.7 million due primarily to collections on accounts receivable and a decrease in cash used to purchase inventory, and a $4.7 million increase in non-cash expenses, primarily from a $3.5 million increase in stock
compensation as a result of stock awards approved at our stockholder meeting on June 10, 2010 and a $1.0 million increase in depreciation expense. Net cash provided by continuing operations increased year-over-year in 2009 by $2.3 million,
primarily from a $9.0 million decrease in the loss from continuing operations, partially offset by an increase of $6.3 million in cash used for working capital purposes and lower non-cash expenses of $0.8 million resulting from lower stock-based
compensation, partially offset by higher depreciation expense.

Net cash used in discontinued operations increased
year-over-year in 2010 by $3.8 million, primarily from a $2.4 million decrease in the gain from discontinued operations and an increase of $1.4 million used to settle assets and liabilities of our mail-order pharmacy business. Net cash provided by
discontinued operations decreased year-over-year in 2009 by $8.1 million, primarily from a $2.1 million decrease in the gain from discontinued operations and a decrease of $6.0 million used primarily for the final settlement of assets and
liabilities held by our discontinued LPU business in 2008 upon the sale to Rite Aid.

Cash provided by (used in) investing
activities. Our net cash flows used in investing activities include the purchase of marketable securities, the acquisition of fixed assets and intangible assets, and the acquisition of Salu, partially offset by the net proceeds received from the
sales and maturities of marketable securities and proceeds from the sale of discontinued operations.

Net cash used in
continuing investing activities in 2010 reflects $18.0 million of cash used to acquire Salu, net of $1.4 million of cash acquired, $13.1 million used to purchase fixed assets and intangible assets, and $22.4 million used to purchase marketable
securities, partially offset by $5.0 million of proceeds received for the sale of certain assets of our mail-order pharmacy, and $23.9 million from sales and maturities of marketable securities. Net cash used in investing activities in 2009 reflects
the purchase of marketable securities of $15.9 million and the purchase of fixed assets and intangible assets of $8.5 million, partially offset by the $5.9 million of cash proceeds received from the sale of the LPU business and $14.1 million from
sales and maturities of marketable securities. Net cash used in investing activities in 2008 reflects the purchase of marketable securities of $46.9 million and the purchase of fixed assets of $13.2 million, partially offset by the $4.0 million of
cash proceeds received from the sale of the LPU business and $51.7 million from sales and maturities of marketable securities.

Net cash used in continuing investing activities increased year-over-year in 2010 by $20.2 million, primarily as a result of the
acquisition of Salu and increased purchases of fixed assets. Net cash used in investing activities decreased year-over-year in 2009, primarily as a result of a decrease in the purchase of fixed assets and intangible assets, offset by the proceeds
received from the sale of discontinued operations.

Net cash used in discontinued investing activities in 2010 represents the
software development costs incurred related to the systems integration between our mail-order pharmacy and BioScrip.

Cash
provided by (used in) financing activities. Our net cash flows from financing activities represent cash provided from borrowings under our revolving bank line of credit to fund capital expenditures, acquisitions, and operations, and the exercise
of options and shares purchased under our employee stock purchase plan, which terminated in the second quarter of 2009, partially offset by payments on our debt obligations.

Net cash provided by financing activities in 2010 represents $10.0 million of proceeds received from the line of credit for the Salu acquisition and $0.8 million received from the exercise of stock
options, partially offset by



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$0.5 million used to pay debt obligations and purchase treasury stock. Net cash used in financing activities in 2009 represents $3.0 million of proceeds received from the line of credit,
partially offset by $5.6 million used to pay debt obligations. Net cash provided by financing activities in 2008 represents $5.0 million of proceeds received from the line of credit and $0.5 million received from the exercise of stock options,
partially offset by $4.4 million used to pay debt obligations. Net cash provided by financing activities increased year-over-year in 2010 by $12.8 million primarily due to the proceeds received from the line of credit, which were used to acquire
Salu, and lower payments on debt obligations. Net cash used in financing activities increased year-over-year in 2009 by $3.7 million, primarily due to a decrease in proceeds received from borrowings under our revolving line of credit, an increase in
payments on debt obligations, and a decrease in proceeds received from the exercise of stock options and employee stock purchase plan primarily due to the expiring of the employee stock purchase plan in June 2009.

Contractual Obligations and Commitments

In March 2011, we entered into a loan and security agreement with our existing bank, which includes a revolving three-year line of credit allowing for borrowings up to $40.0 million, which accrue interest
at LIBOR plus 2.5%-3%, or prime plus 0%-0.5%. This agreement replaces our two-year $25.0 million line of credit originally scheduled to mature in March 2011. As of January 2, 2011, $13.0 million was outstanding under the line of credit, which
was refinanced under the new three-year line of credit maturing in March 2014. Availability under the line of credit was also reduced by a $541,000 letter of credit we provided to our corporate headquarters landlord. As of January 2, 2011, the
available borrowings under the two-year line of credit were approximately $11.5 million and in March 2011, the available borrowings under the three-year line of credit were approximately $26.5 million. Advances available under the revolving line of
credit are limited, based on eligible inventory, accounts receivable, cash and investment balances, and balances outstanding under our line of credit. The agreement contains certain covenants that are customary in transactions of this nature,
including a prohibition on other debt and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain financial covenants. As of
January 2, 2011, we exceeded our capital expenditure covenant of $14.0 million by $0.1 million, and as of January 30, 2011 we failed our adjusted quick ratio covenant, which were both waived in conjunction with the March 2011 loan and
security agreement renewal. In our new agreement, the adjusted quick ratio definition was redefined to reduce the possibility of non-compliance in the future. The agreement identifies certain events of default that are customary for transactions of
this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this facility or other instruments when due, the occurrence of a material adverse change, violations of
any covenants, a material cross-default to our other debt, or a change of control. As of January 2, 2011, none of these events had occurred.

We also lease equipment and software under non-cancelable capital leases. Capital lease obligations bear interest ranging from 3% to 8% and mature 24- 36 months from the date of funding. We secured
additional funds of $1.7 million during 2010 and $0.2 million during 2009, through capital lease financing agreements. We are in compliance with all covenants required by these agreements.

Our principal executive offices are located in Bellevue, Washington, where we lease approximately 53,000 square feet under a lease that
expires in July 2013, with two separate five-year renewal options that, if exercised, would extend the lease expiration to July 2023. Our primary distribution facility for our OTC and vision segments is located in Swedesboro, New Jersey, where we
lease approximately 270,000 square feet under a lease that expires in December 2020, with options to renew for two additional five-year periods. We also lease an inventory storage facility in Logan Township, New Jersey for 85,000 square feet through
February 2013. We lease approximately 11,500 square feet under a lease that expires in March 2016 for our principal customer care center, which is located in Halifax, Nova Scotia, Canada. Our subsidiary Salu leases approximately 10,000 square feet
under a lease that expires in June 2016 for its principal corporate offices located in Gold River, California. Skincarestore Australia Pty Ltd., a subsidiary of Salu, leases approximately 2,000 square feet in Roselle, New South Wales, Australia,
under a sublease that expires in November 2014, for retail space used for a salon and spa and related business purposes.



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As of January 2, 2011, our principal commitments consisted of obligations outstanding
under capital and operating leases, our line of credit, and purchase commitments as follows (in thousands):



|                        |  |                       |        |  |          |   |       |           |  |   |           |  |  |           |       |  |  |   |       | 
|----------------------- |  | --------------------- | ------ |  | -------- | - | ----- | --------- |  | - | --------- |  |  | --------- | ----- |  |  | - | ----- | 
|                        |  | Payment Due by Period |       
|                        |  | Total                 |        |  | < 1 year |   |       | 1-3 years |  |   | 3-5 years |  |  | > 5 years |      
|Capital leases (1)      |  | $                     | 1,657  |  |          | $ | 625   |           |  | $ | 1,032     |  |  | $         |      |  |  | $ |      | 
|Line of credit (2)      |  |                       | 16,359 |  |          |   | 1,009 |           |  |   | 15,350    |  |  |           |      |  |  |   |      | 
|Operating leases (3)    |  |                       | 17,823 |  |          |   | 3,120 |           |  |   | 7,092     |  |  |           | 4,002 |  |  |   | 3,609 | 
|Purchase commitment (4) |  |                       | 4,980  |  |          |   | 4,980 |           |  |   |          |  |  |           |      |  |  |   |      | 
|                        |  |                       |        |  |          |   |       |           |  |   |           |  |  |           |       |  |  |   |       | 
|                        |  | $                     | 40,819 |  |          | $ | 9,734 |           |  | $ | 23,474    |  |  | $         | 4,002 |  |  | $ | 3,609 | 
|                        |  |                       |        |  |          |   |       |           |  |   |           |  |  |           |       |  |  |   |       | 



|(1) | Capital lease obligations consist primarily of technology and operations assets.
|--- | --------------------------------------------------------------------------------

|(2) | Line of credit includes our borrowings on our line of credit with our bank, which was refinanced in March 2011, with a maturity date of March 2014 and respective
interest payments
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | Operating lease obligations consist of office building, distribution center, and call center leases.
|--- | ----------------------------------------------------------------------------------------------------

|(4) | In December 2010, we entered into an agreement to purchase approximately $5.0 million of hardware and software to automate our primary distribution center.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements.

Management Outlook

For the first quarter of fiscal year 2011, we are targeting net sales in the range of $123.0 million to $126.0 million. We anticipate net
loss for the first quarter in the range of $0.7 million to $2.5 million, adjusted EBITDA in the range of $2.7 million to $4.3 million and ongoing adjusted EBITDA in the range of $2.0 million and $3.5 million.

For fiscal 2011, we are targeting net sales in the range of $515.0 million to $530.0 million, net income in the range of $200,000 to $2.5
million, adjusted EBITDA in the range of $18.3 million to $22.7 million and ongoing adjusted EBITDA in the range of $16.0 million to $20.0 million. We are also projecting total gross margins for 2011 of 28.2-28.7%, reflecting gross margins in OTC of
29-29.5% and vision of 24-24.5%.

The following table provides information regarding our guidance for adjusted EBITDA and
ongoing adjusted EBITDA, including a reconciliation of net income (loss) to adjusted EBITDA and ongoing adjusted EBITDA (in thousands):



|                                      |  |                                 |       |   |                                    |   |        |            |  |   |           |   |  |   |        |  
|------------------------------------- |  | ------------------------------- | ----- | - | ---------------------------------- | - | ------ | ---------- |  | - | --------- | - |  | - | ------ | -
|                                      |  | Three Months EndedApril 3, 2011 |       |   | Twelve Months EndedJanuary 1, 2012 |  
|                                      |  | Range High                      |       |   | Range Low                          |   |        | Range High |  |   | Range Low |  
|Net income (loss)                     |  | $                               | (700  | ) |                                    | $ | (2,500 | )          |  | $ | 2,500     |   |  | $ | 200    |  
|Amortization of intangible assets     |  |                                 | 135   |   |                                    |   | 135    |            |  |   | 525       |   |  |   | 525    |  
|Stock-based compensation              |  |                                 | 1,500 |   |                                    |   | 1,600  |            |  |   | 7,000     |   |  |   | 6,000  |  
|Depreciation                          |  |                                 | 3,200 |   |                                    |   | 3,300  |            |  |   | 12,000    |   |  |   | 11,000 |  
|Interest expense, net                 |  |                                 | 165   |   |                                    |   | 165    |            |  |   | 650       |   |  |   | 550    |  
|                                      |  |                                 |       |   |                                    |   |        |            |  |   |           |   |  |   |        |  
|Adjusted EBITDA                       |  | $                               | 4,300 |   |                                    | $ | 2,700  |            |  | $ | 22,675    |   |  | $ | 18,275 |  
|                                      |  |                                 |       |   |                                    |   |        |            |  |   |           |   |  |   |        |  
|Less: Discontinued Rx mail operations |  |                                 | (800  | ) |                                    |   | (700   | )          |  |   | (2,675    | ) |  |   | (2,275 | )
|                                      |  |                                 |       |   |                                    |   |        |            |  |   |           |   |  |   |        |  
|Ongoing Adjusted EBITDA               |  | $                               | 3,500 |   |                                    | $ | 2,000  |            |  | $ | 20,000    |   |  | $ | 16,000 |  
|                                      |  |                                 |       |   |                                    |   |        |            |  |   |           |   |  |   |        |  

These projections are subject to substantial uncertainty. See Risk Factors, in Part I,
Item 1A of this annual report and Special Note Regarding Forward-Looking Statements above.



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|ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
|-------- | ---------------------------------------------------------

We have assessed our vulnerability to certain market risks, including interest rate risk associated with marketable securities, accounts receivable, accounts payable, capital lease obligations, and cash
and cash equivalents. Due to the short-term nature of these investments and our investment policies and procedures, we have determined that the risk associated with interest rate fluctuations related to these financial instruments is not material to
us.

Our financing facilities expose our net earnings to changes in short-term interest rates because interest rates on the
underlying obligations are variable. Borrowings outstanding under the variable interest-bearing financing facilities totaled $13.0 million at January 2, 2011 and the highest interest rate attributable to this outstanding balance was 4.5% at
January 2, 2011. A change in net earnings resulting from a hypothetical 10% increase or decrease in interest rates would not be material.

We have investment risk exposure arising from our investments in marketable securities due to volatility of the bond market in general, company-specific circumstances, and changes in general economic
conditions. As of January 2, 2011, we had $13.1 million of securities classified as marketable securities. We regularly review the carrying value of our investments and identify and record losses when events and circumstances
indicate that declines in the fair value of such assets below our accounting basis are other-than-temporary.



|ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- | -------------------------------------------

The financial statements required pursuant to this item are filed under Part IV, Item 15(a)(1) of this annual report. The financial statement schedule required under Regulation S-X is filed under
Part IV, Item 15(a)(2) of this annual report.



|ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | ------------------------------------------------------------------------------------

None.



|ITEM 9A. | CONTROLS AND PROCEDURES
|-------- | -----------------------

Evaluation of
Disclosure Controls and Procedures

Under the supervision of and with the participation of our management, including our
chief executive officer, chief accounting officer, and general counsel, we performed an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934,
as amended, or the Exchange Act). Based on that evaluation, our management, including our chief executive officer, chief accounting officer, and general counsel, concluded that, as of January 2, 2011, our disclosure controls and procedures were
effective to provide reasonable assurance that all material information required to be disclosed in reports filed or submitted by us under the Exchange Act is made known to management in a timely fashion.

The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 are filed as exhibits 31.1 and 31.2, respectively, in
this Form 10-K.

Managements Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining an adequate system of internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f)) under the Exchange Act). Management evaluated the effectiveness of our internal control over financial reporting based on criteria established in Internal



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ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. Managements assessment of and conclusion on the effectiveness of
internal control over financial reporting did not include the internal controls of Salu, Inc. which is included in the 2010 consolidated financial statements of drugstore.com, inc. and constituted $45.6 million and $36.6 million of total and net
assets, respectively, as of January 2, 2011 and $42.3 million and $2.0 million of net sales and net income, respectively, for the year then ended. Based on its evaluation, management concluded that, as of January 2, 2011, our system of
internal control over financial reporting was effective. Ernst & Young LLP, an independent registered public accounting firm, has issued an attestation report on the effectiveness of our internal control over financial reporting as of
January 2, 2011, which is included below.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting during the most recently completed fiscal quarter that have
materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Limitations on
Controls

Management does not expect that our disclosure controls and procedures or our internal control over financial
reporting will prevent or detect all error and fraud. Any control system, no matter how well designed and operated, is based on certain assumptions and can provide only reasonable, not absolute, assurance that its objectives will be met. In
addition, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within drugstore.com have been detected.



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Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

drugstore.com, inc.

We have
audited drugstore.com, inc.s internal control over financial reporting as of January 2, 2011, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission (the COSO criteria). drugstore.com, inc.s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial
reporting included in the accompanying Managements Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the companys internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered
necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A companys
internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted
accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions
and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections
of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

As indicated in the accompanying Managements Report on Internal Control over Financial Reporting, managements assessment of
and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Salu, Inc. which is included in the 2010 consolidated financial statements of drugstore.com, inc. and constituted $45.6 million
and $36.6 million of total and net assets, respectively, as of January 2, 2011 and $42.3 million and $2.0 million of net sales and net income, respectively, for the year then ended. Our audit of internal control over financial reporting of
drugstore.com, inc. also did not include an evaluation of the internal control over financial reporting of Salu, Inc.

In our
opinion, drugstore.com, inc. maintained, in all material respects, effective internal control over financial reporting as of January 2, 2011, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of drugstore.com, inc. as of January 2, 2011
and January 3, 2010, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended January 2, 2011 of drugstore.com, inc., and our report dated
March 18, 2011 expressed an unqualified opinion thereon.

/s/ Ernst & Young LLP

Seattle, Washington

March 18, 2011



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|ITEM 9B. | OTHER INFORMATION
|-------- | -----------------

2011 Bonus Plan

In February 2011, the compensation committee approved an incentive bonus plan under which our executive officers are eligible to receive cash bonuses for fiscal year 2011, based on a two-pronged
assessment: (i) company performance, as demonstrated by our achievement of certain net revenue and adjusted EBITDA objectives; and (ii) the individuals performance.

Each executive officer is assigned an initial target bonus percentage based on his or her position and responsibilities. Initial target
bonuses as a percentage of base salary for each named executive officer remained unchanged from 2010 levels. Ms. Lepore is eligible to receive an initial target bonus of up to 150% of her 2011 salary, Mr. Morikubo is eligible to receive an
initial target bonus of up to 40% of his 2011 salary, and each of Mr. Potter and Ms. Wright is eligible to receive an initial target bonus of up to 35% of his or her 2011 salary.

Under the company performance component of the 2011 bonus plan, if we achieve specific graduated net revenue and adjusted EBITDA
thresholds, each named executive officer could be eligible to receive anywhere from 0% of his or her initial target bonus amount, if we fail to meet certain minimum net revenue and adjusted EBITDA thresholds, to 40% to 55% if we perform within the
range we have targeted for the year to 130%, if we vastly exceed our guidance for the year. The compensation committee reserved the right to exercise discretion in determining the final amounts to be paid under the bonus plan.

The individual performance component of each named executive officers actual bonus is a function of (i) his or her initial
target bonus and (ii) an individual performance adjustment. Under this component of the bonus plan, a named executive officers ultimate bonus amount, that is, his or her initial target bonus amount multiplied by the company performance
payout factor, is then adjusted again by a multiplier of 0% to 130%, based on his or her individual job performance. As under the company performance component of the bonus plan, the compensation committee reserved the right to exercise discretion
in determining the final amounts to be paid under the bonus plan.

Executive Officer Change-in-Control Agreements

Each of Robert Potter, Vice President, Chief Accounting Officer, Yukio Morikubo, Vice President, Strategy, General Counsel and Secretary,
and Tracy Wright, Vice President, Chief Finance Officer, was previously party to a change in control agreement that our compensation committee approved in January 2009. On January 28, 2011, our compensation committee, recognizing that the earlier
agreements were not entirely consistent with the committees intent, approved, and in February 2011, the Company and the individuals entered into, change in control agreements that replaced the earlier agreements.

All provisions of the 2011 agreements are the same as the prior agreements with one exception. Under the earlier agreements, any
acceleration of vesting of equity in connection with a change of control or termination of employment was governed by the 2008 equity incentive plan and/or the applicable form of equity award agreement. The 2011 change in control agreements provide
that in the event that the executive officers employment is terminated without cause or he or she terminates his or her employment for good reason upon or within one year of a change in control of drugstore.com, all of the officers then
outstanding and unvested equity awards will vest as of the date of any such termination whether or not they would have otherwise vested under the 2008 equity incentive plan and/or the applicable form of equity award agreement.

As under the earlier agreements, in the event of a termination without cause or a voluntary termination of employment for good reason in
connection with a change of control (as earlier described), we will pay the officer a lump sum severance payment equal to one year of his or annual salary in effect immediately prior to the change in control or as of the end of the previous calendar
year, whichever is greater, plus one year of target bonus for the year of the change in control, and he or she will be entitled to receive company-paid premiums for health care



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coverage pursuant to the Consolidated Omnibus Reconciliation Act of 1985, as amended (COBRA) for a period of up to twelve months.

Also, in the event that the benefits provided to an executive officer under these change in control agreements constitute
parachute payments within the meaning of Section 280G of the Internal Revenue Code and may subject such benefits to the excise tax imposed by Section 4999 of the Internal Revenue Code, the benefits will be (1) paid in full, or (2)
reduced so the executive is not subject to excise taxation, whichever results in the named executive officers receipt of the greatest after-tax amount.

Each executive officers receipt of these benefits will be subject to his or her compliance with our confidentiality agreement and his or her execution of a release of claims in the form customarily
used by us in connection with the termination of an executive officers employment.

For purposes of the change in
control agreements, change in control has the definition provided in our 2008 Plan and means:



| |  |  | A change in the ownership of the Company where any person or affiliated group acquires stock constituting more than 50% of the total voting power of
the stock of the Company;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A change in the effective control of the Company where a majority of members of the board of directors is replaced during any twelve (12) month period
by directors whose appointment or election is not endorsed by a majority of the members of the board of directors prior to the appointment or election; or
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A change in the ownership of a substantial portion of the Companys assets where any person or affiliated group acquires (or has acquired during
the previous twelve (12) month period) assets from the Company that have a value equal to or more than 50% of the value of all of the assets of the Company immediately prior to such acquisition(s).
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

For purposes of the change in control agreements, cause means:



| |  |  | any act of personal dishonesty in connection with his or her responsibilities as an employee intended to result in substantial personal enrichment of
the executive;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the executives conviction of, or plea of nolo contendere to, a felony;
| | - |  | -----------------------------------------------------------------------



| |  |  | the executives gross misconduct; or
| | - |  | ------------------------------------



| |  |  | the executives continued failure to perform the duties and responsibilities of his or her position after notice and the lapse of a two week cure
period during which the failure remained uncured.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

For purposes of the change in control agreements,
good reason means any of the following uncured events:



| |  |  | a material reduction of the officers authority, duties or responsibilities;
| | - |  | ----------------------------------------------------------------------------



| |  |  | a material reduction in the officers base compensation; or
| | - |  | -----------------------------------------------------------



| |  |  | a material change in the geographic location where the officer must perform his or her services; provided that no relocation of fifty (50) miles or
less will be deemed material for purposes of the change in control agreements.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Before an executive may
resign for good reason under the change in control agreements, he or she must provide the company with written notice within ninety (90) days of the initial event constituting good reason and a period of at least thirty (30) days must have lapsed
during which the event remained uncured.

The foregoing description is not complete and is qualified by reference to the full
text of the form of change in control agreement filed herewith as Exhibit 10.29.



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PART III



|ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
|-------- | -------------------------------------------------------

Directors and Executive Officers

Information regarding our executive
officers required by Part III, Item 10 is set forth in the section entitled BusinessDirectors and Officers, in Part I, Item 1 of this annual report. Information regarding our directors required by Part III,
Item 10 is incorporated into this annual report by reference to the section entitled Proposal No. 1Election of Directors in our proxy statement for our annual meeting of stockholders to be held on June 9,
2011, or the 2011 Proxy Statement.

Information relating to compliance with Section 16(a) of the Securities Exchange Act
of 1934, as amended, required by Part III, Item 10 is incorporated into this annual report by reference to the section entitled Section 16 Beneficial Ownership Reporting Compliance in the 2011 Proxy Statement.

Code of Business Conduct and Ethics

Our board of directors has adopted a code of business conduct and ethics, or Code, applicable to all directors, officers and employees of drugstore.com, including our chief executive officer, chief
finance officer, chief accounting officer, and controller. You may obtain a copy of the Code, without charge, on written request to Investor Relations, drugstore.com, inc., 411 108thAvenue NE, Suite 1400, Bellevue, Washington 98004, or by calling (425) 372-3200.



|ITEM 11. | EXECUTIVE COMPENSATION
|-------- | ----------------------

Information regarding executive compensation required by Part III, Item 11 is incorporated into this annual report by reference to
the section entitled Executive Compensation in the 2011 Proxy Statement.



|ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
|-------- | ----------------------------------------------------------------------------------------------

Information regarding our equity compensation plans required by Part III, Item 12 is incorporated into this annual report by
reference to in the section entitled Securities Authorized for Issuance under Equity Compensation Plan in the 2011 Proxy Statement.

Information regarding security ownership of certain beneficial owners and management and related stockholder matters required by Part III, Item 12 is incorporated into this annual report by reference
to the section entitled Security Ownership of Certain Beneficial Owners and Management in the 2011 Proxy Statement.



|ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
|-------- | -------------------------------------------------------------------------

Information regarding certain relationships and related transactions required by Part III, Item 13 is incorporated into this annual report by reference to the section entitled Transactions
with Related Persons in the 2011 Proxy Statement.



|ITEM 14. | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- | --------------------------------------

Information regarding principal accountant fees and services required by Part III, Item 14 is incorporated into this annual report by reference to the section entitled Proposal
No. 3Ratification of Appointment of Independent Public Accounting Firm in the 2011 Proxy Statement.



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PART IV



|ITEM 15. | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
|-------- | -------------------------------------------



| | (a) | The following documents are filed as a part of this annual report on Form 10-K:
| | --- | -------------------------------------------------------------------------------

1. Index to Consolidated Financial Statements:



|                                                        |  |      |     | 
|------------------------------------------------------- |  | ---- | --- | 
|                                                        |  | Page |    
|Report of Independent Registered Public Accounting Firm |  |      | F-1 | 
|Consolidated Balance Sheets                             |  |      | F-2 | 
|Consolidated Statements of Operations                   |  |      | F-3 | 
|Consolidated Statements of Stockholders Equity         |  |      | F-4 | 
|Consolidated Statements of Cash Flows                   |  |      | F-5 | 
|Notes to Consolidated Financial Statements              |  |      | F-6 | 

2. Index to Financial Statement Schedules:



|                                              |  |  |      | 
|--------------------------------------------- |  |  | ---- | 
|Schedule IIValuation and Qualifying Accounts |  |  | F-34 | 

All other schedules
have been omitted because the required information is shown in the consolidated financial statements or the accompanying notes, or is not applicable or required.

3. Index of Exhibits:



|           |  |                                                                                                                                                                                                                                                                                                                               
|---------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Exhibit Description                                                                                                                                                                                                                                                                                                           
|2.1        |  | Definitive Agreement and Plan of Merger with Salu, Inc. (incorporated by reference to Exhibit 2.1 to drugstore.com, inc.s Current Report on Form 8-K dated February 19, 2010
(SEC File No. 000-26137)).                                                                                                                      
|           | 
|2.2        |  | Asset Purchase Agreement by and among DS Pharmacy, Inc., drugstore.com, inc. BioScrip, inc. and BioScrip Pharmacy Services, Inc., dated May 5, 2010 (incorporated by reference to
Exhibit 2.1 to drugstore.com, inc.s Current Report on Form 8-K dated May 14, 2010 (SEC File No. 000-26137)).                               
|           | 
|2.3        |  | First Amendment to Asset Purchase Agreement between drugstore.com, inc. and BioScrip, Inc., dated July 14, 2010 (incorporated by reference to Exhibit 10.1 to drugstore.com,
inc.s Current Report on Form 8-K dated July 19, 2010 (SEC File No. 000-26137)).                                                                 
|           | 
|2.4        |  | Second Amendment to Asset Purchase Agreement between drugstore.com, inc. and BioScrip, Inc., dated July 29, 2010 (incorporated by reference to Exhibit 2.1 to drugstore.com,
inc.s Current Report on Form 8-K dated August 2, 2010 (SEC File No. 000-26137)).                                                                
|           | 
|3.1        |  | Amended and Restated Certificate of Incorporation of drugstore.com, inc. (incorporated by reference to Exhibit 3.2 to drugstore.com, inc.s Registration Statement on Form S-1
filed February 9, 2000 (Registration No. 333-96441)).                                                                                          
|           | 
|3.1a       |  | Certificate of Designation of Series 1 Preferred Stock of drugstore.com, inc. (incorporated by reference to Exhibit 3.1a to drugstore.com, inc.s Quarterly Report on Form 10-Q
for the Quarter Ended July 2, 2000 (SEC File No. 000-26137)).                                                                                 
|           | 
|3.2        |  | Amended and Restated Bylaws of drugstore.com, inc. dated January 26, 2009 (incorporated by reference to Exhibit 3.1 to drugstore.com inc.s Current Report on Form 8-K dated
January 26, 2009 (SEC File No. 000-26137)).                                                                                                      
|           | 
|4.1        |  | Warrant issued to Lehman Brothers, Inc. on November 16, 2006, on the cancellation of the warrant issued to Heidrick & Struggles, Inc. on February 14, 2005 (incorporated by
reference to Exhibit 4.2 to drugstore.com inc.s Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2006 (SEC File No. 000-26137)).



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|           |  |                                                                                                                                                                                                                                                                                                                                    
|---------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Exhibit Description                                                                                                                                                                                                                                                                                                                
|4.2        |  | Form of Warrant (incorporated by reference to Exhibit 4.1 to drugstore.com inc.s Quarterly Report on Form 10-Q for the Quarter Ended July 1, 2007 (SEC File No.
000-26137)).                                                                                                                                                      
|           | 
|4.3        |  | Form of Warrant (incorporated by reference to Exhibit 4.1 to drugstore.com inc.s Quarterly Report on Form 10-Q for the Quarter Ended September 30, 2007 (SEC File No.
000-26137)).                                                                                                                                                
|           | 
|4.4        |  | 1998 Stock Plan, as amended June 21, 2000 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.s Quarterly Report on Form 10-Q for the Quarter Ended July 2, 2000)
(SEC File No. 000-26137)).                                                                                                                         
|           | 
|4.5        |  | 2008 Equity Incentive Plan (incorporated by reference to Appendix A to the registrants proxy statement dated February 23, 2009).                                                                                                                                                                                                  
|           | 
|4.6        |  | Restricted Stock Agreement between the Company and Dawn G. Lepore dated October 3, 2008 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Current Report
on Form 8-K dated October 2, 2008 (SEC File No. 000-26137)).                                                                                            
|           | 
|4.7        |  | Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.s Current Report on Form 8-K dated October 2, 2008 (SEC File No.
000-26137)).                                                                                                                                                 
|           | 
|4.8        |  | Form of Stock Option Agreement (incorporated by reference to Exhibit 10.3 to drugstore.com, inc.s Current Report on Form 8-K dated October 2, 2008 (SEC File No.
000-26137))                                                                                                                                                      
|           | 
|4.9        |  | Form of Stock-Settled Stock Appreciation Right Agreement (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Quarterly Report on Form 10-Q for the quarter
ended September 27, 2009 (Registration No. 000-26137)).                                                                                                 
|           | 
|4.10       |  | Form of Stock-Settled Stock Appreciation Right Agreement between the Company and Dawn Lepore (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.s Quarterly
Report on Form 10-Q for the quarter ended September 27, 2009 (Registration No. 000-26137)).                                                             
|           | 
|4.11       |  | Form of Restricted Stock Unit Agreement                                                                                                                                                                                                                                                                                            
|           | 
|4.12       |  | Form of Restricted Stock Unit Agreement between the Company and Dawn Lepore                                                                                                                                                                                                                                                        
|           | 
|10.1       |  | Form of Indemnification Agreement between drugstore.com, inc. and each of its officers and directors (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s
Registration Statement on Form S-1 filed May 19, 1999 (Registration No. 333-78813)).                                                                      
|           | 
|10.2       |  | Fourth Amended and Restated Investors Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by reference to Exhibit 10.12 to
drugstore.com, inc.s Registration Statement on Form S-1/A filed July 8, 1999 (Registration No. 333-78813)).                                            
|           | 
|10.3       |  | Addendum dated June 17, 1999, to Fourth Amended and Restated Investors Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors
(incorporated by reference to Exhibit 10.25 to drugstore.com, inc.s Registration Statement on Form S-1/A filed June 28, 1999 (Registration No. 333-78813)).          
|           | 
|10.4       |  | Form of Second Addendum to Fourth Amended and Restated Investors Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors (incorporated by
reference to Exhibit 10.32 to drugstore.com, inc.s Registration Statement on Form S-1/A filed July 20, 1999 (Registration No. 333-78813)).                
|           | 
|10.5       |  | Third Addendum dated January 24, 2000, to Fourth Amended and Restated Investors Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain investors
(incorporated by reference to Exhibit 10.38 to drugstore.com, inc.s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).



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|           |  |                                                                                                                                                                                                                                                                                                                                                                       
|---------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Exhibit Description                                                                                                                                                                                                                                                                                                                                                   
|10.6       |  | Fourth Addendum dated September 29, 2000, to Fourth Amended and Restated Investors Rights Agreement dated May 19, 1999, among drugstore.com, inc. and certain
investors (incorporated by reference to Exhibit 10.7 to drugstore.com, inc.s Registration Statement on Form S-3/A filed October 2, 2000 (Registration No. 333-45266)).                                
|           | 
|10.7       |  | Fifth Amended and Restated Voting Agreement dated December 23, 1999, among drugstore.com, inc. and certain founders and investors (incorporated by reference to Exhibit 10.20 to
drugstore.com, inc.s Registration Statement on Form S-1 filed February 9, 2000 (Registration No. 333-96441)).                                                                       
|           | 
|10.8       |  | Governance Agreement dated June 17, 1999, among drugstore.com, inc., General Nutrition Corporation and General Nutrition Investment Company (incorporated by reference to
Exhibit 10.30 to drugstore.com, inc.s Registration Statement on Form S-1/A filed June 28, 1999 (Registration No. 333-78813)).                                                              
|           | 
|10.9       |  | Registration Rights Agreement dated as of December 8, 2003 by and among drugstore.com, inc. and the other signatories thereto (incorporated by reference to Exhibit 10.1 to
drugstore.com, inc.s Current Report on Form 8-K filed December 23, 2003 (SEC File No. 000-26137)).                                                                                       
|           | 
|10.10      |  | Lease Agreement dated August 30, 1999, between DS Distribution, Inc. and the Northwestern Mutual Life Insurance Company (incorporated by reference to Exhibit 10.1 to
drugstore.com, inc.s Quarterly Report on Form 10-Q for the quarter ended October 3, 1999 (SEC File No. 000-26137)).                                                                            
|           | 
|10.11      |  | Amendment No. 1 to Lease Agreement dated December 10, 2003, between DS Distribution, Inc. and Liberty Vendor I, L.P (as successor in interest to the Northwestern Mutual
Life Insurance Company) (incorporated by reference to Exhibit 10.23 to drugstore.com inc.s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003 (SEC File No. 000-26137)).
|           | 
|10.12      |  | Amendment No. 2 to Lease Agreement dated December 1, 2009, between DS Distribution, Inc. and Liberty Vendor I, L.P (as successor in interest to the Northwestern Mutual
Life Insurance Company).                                                                                                                                                                      
|           | 
|10.13      |  | Lease of Office Space dated December 23, 2010 between Crombie Developments Ltd and DS Distribution Canada Ltd.                                                                                                                                                                                                                                                        
|           | 
|10.14      |  | Industrial Building Lease dated June 20, 2007 between DS Distribution, Inc. and U.S. Industrial REIT II (incorporated by reference to Exhibit 10.17 to drugstore.com,
inc.s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2008 (SEC File No. 000-26137)).                                                                                        
|           | 
|10.15      |  | First Amendment to Industrial Building Lease dated October 10, 2007 between DS Distribution, Inc. and U.S. Industrial REIT II (incorporated by reference to Exhibit 10.18 to
drugstore.com, inc.s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2008 (SEC File No. 000-26137)).                                                                  
|           | 
|10.16      |  | Second Amendment to Industrial Building Lease dated November 18, 2010 between drugstore.com, inc. and U.S. Industrial REIT II                                                                                                                                                                                                                                         
|           | 
|10.17      |  | Sublease effective as of June 1, 2003 between Nova Scotia Power Incorporated and International Vision Direct Ltd. (incorporated by reference to Exhibit 10.25 to drugstore.com
inc.s Annual Report on Form 10-K for the Fiscal Year Ended December 28, 2003 (SEC File No. 000-26137)).                                                                               
|           | 
|10.18      |  | Office Lease Agreement dated August 16, 2004, between EOP-Northwest Properties, L.L.C. and drugstore.com, inc. (incorporated by reference to Exhibit 10.2 to drugstore.com,
inc.s Quarterly Report on Form 10-Q for the quarter ended September 26, 2004 (SEC File No. 000-26137)).                                                                                  
|           | 
|10.19      |  | Loan and Security Agreement dated March 5, 2009 (incorporated by reference to Exhibit 10.24 to drugstore.com, inc.s Annual Report on Form 10-K for the fiscal year ended
December 28, 2008 (SEC File No. 000-26137)).                                                                                                                                                



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|           |  |                                                                                                                                                                                                                                 
|---------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Exhibit Description                                                                                                                                                                                                             
|10.20      |  | Settlement Agreement dated May 8, 2009 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Quarterly Report on Form 10-Q for the quarter ended
June 28, 2009 (SEC File No. 000-26137)).                         
|           | 
|10.21      |  | Offer letter of Dawn Lepore dated September 21, 2004 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Current Report on Form 8-K/A filed
November 3, 2004 (SEC File No. 000-26137)).                         
|           | 
|10.22      |  | Letter agreement with Dawn Lepore dated December 28, 2006 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Current Report on Form 8-K filed
December 29, 2006 (SEC File No. 000-26137)).                     
|           | 
|10.23      |  | Letter agreement with Dawn Lepore dated December 31, 2008 (incorporated by reference to Exhibit 10.27 to drugstore.com, inc.s Annual Report on Form 10-K for the
Fiscal Year Ended December 28, 2008 (SEC File No. 000-26137)).
|           | 
|10.24      |  | Letter agreement with Dawn Lepore, dated January 26, 2009 (incorporated by reference to Exhibit 10.1 to drugstore.com, inc.s Current Report on Form 8-K dated
January 26, 2009)(SEC File No. 000-26137)).                      
|           | 
|10.25      |  | Amendment dated December 31, 2010 to Letter Agreement with Dawn Lepore                                                                                                                                                          
|           | 
|10.26      |  | Offer letter of Yukio Morikubo dated November 10, 2006 (incorporated by reference to Exhibit 10.2 to drugstore.com, inc.s Current Report on Form 8-K filed December 4,
2006 (SEC FileNo. 000-26137)).                          
|           | 
|10.27      |  | Offer letter of Robert Potter, dated May 23, 2008                                                                                                                                                                               
|           | 
|10.28      |  | Offer letter of Tracy Wright, dated May 23, 2008                                                                                                                                                                                
|           | 
|10.29      |  | Form of Change in Control Agreement with Executive Officers                                                                                                                                                                     
|           | 
|21.1       |  | List of Subsidiaries.                                                                                                                                                                                                           
|           | 
|23.1       |  | Consent of Independent Registered Public Accounting Firm.                                                                                                                                                                       
|           | 
|24.1       |  | Powers of Attorney (included on the signature page of this Annual Report on Form 10-K).                                                                                                                                         
|           | 
|31.1       |  | Certification of Dawn G. Lepore, Chairman of Board, President and Chief Executive Officer of drugstore.com, inc., pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.                                                    
|           | 
|31.2       |  | Certification of Robert P. Potter, Vice President, Chief Accounting Officer of drugstore.com, inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                  
|           | 
|32.1       |  | Certification of Dawn G. Lepore, Chairman of Board, President and Chief Executive Officer of drugstore.com, inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.     
|           | 
|32.2       |  | Certification of Robert P. Potter, Vice President, Chief Accounting Officer of drugstore.com, inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.                   



57



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##### Table of Contents

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

drugstore.com, inc.

We have audited the accompanying consolidated balance sheets
of drugstore.com, inc. as of January 2, 2011 and January 3, 2010, and the related consolidated statements of operations, stockholders equity, and cash flows for each of the three years in the period ended January 2, 2011. Our
audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.

We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial
statements referred to above present fairly, in all material respects, the consolidated financial position of drugstore.com, inc. at January 2, 2011 and January 3, 2010, and the consolidated results of its operations and its cash flows for
each of the three years in the period ended January 2, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As
discussed in Note 1 to the consolidated financial statements, in 2009, the Company changed its method of accounting for instruments indexed to an entitys own stock

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), drugstore.com, inc.s internal control over financial reporting as of
January 2, 2011, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 18, 2011 expressed an unqualified
opinion thereon.

/s/ Ernst & Young LLP

Seattle, Washington

March 18, 2011



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##### Table of Contents

DRUGSTORE.COM, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | -------- | - | -------------- | - | -------- | -
|                                                                                                                                                                                        |  | January 2,2011 |          |   | January 3,2010 |  
|Assets                                                                                                                                                                                  |  |                |          |   |                |   |          |  
|Current assets:                                                                                                                                                                         |  |                |          |   |                |   |          |  
|Cash and cash equivalents                                                                                                                                                               |  | $              | 20,437   |   |                | $ | 22,175   |  
|Marketable securities                                                                                                                                                                   |  |                | 13,094   |   |                |   | 14,678   |  
|Accounts receivable, net of allowances                                                                                                                                                  |  |                | 13,916   |   |                |   | 13,275   |  
|Inventories                                                                                                                                                                             |  |                | 48,977   |   |                |   | 39,300   |  
|Other current assets                                                                                                                                                                    |  |                | 3,701    |   |                |   | 2,406    |  
|Assets of discontinued operations                                                                                                                                                       |  |                | 2,440    |   |                |   | 2,832    |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Total current assets                                                                                                                                                                    |  |                | 102,565  |   |                |   | 94,666   |  
|Fixed assets, net                                                                                                                                                                       |  |                | 25,181   |   |                |   | 24,104   |  
|Other intangible assets, net                                                                                                                                                            |  |                | 14,503   |   |                |   | 3,398    |  
|Goodwill                                                                                                                                                                                |  |                | 57,593   |   |                |   | 32,202   |  
|Other long-term assets                                                                                                                                                                  |  |                | 530      |   |                |   | 159      |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Total assets                                                                                                                                                                            |  | $              | 200,372  |   |                | $ | 154,529  |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Liabilities and Stockholders Equity                                                                                                                                                    |  |                |          |   |                |   |          |  
|Current liabilities:                                                                                                                                                                    |  |                |          |   |                |   |          |  
|Accounts payable                                                                                                                                                                        |  | $              | 49,540   |   |                | $ | 34,408   |  
|Accrued compensation                                                                                                                                                                    |  |                | 3,433    |   |                |   | 5,707    |  
|Accrued marketing expenses                                                                                                                                                              |  |                | 4,108    |   |                |   | 5,247    |  
|Other current liabilities                                                                                                                                                               |  |                | 2,397    |   |                |   | 1,542    |  
|Current portion of long-term debt obligations                                                                                                                                           |  |                | 581      |   |                |   | 195      |  
|Liabilities of discontinued operations                                                                                                                                                  |  |                |         |   |                |   | 4,581    |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Total current liabilities                                                                                                                                                               |  |                | 60,059   |   |                |   | 51,680   |  
|Long-term debt obligations, less current portion                                                                                                                                        |  |                | 13,985   |   |                |   | 3,011    |  
|Deferred income taxes                                                                                                                                                                   |  |                | 4,079    |   |                |   | 959      |  
|Other long-term liabilities                                                                                                                                                             |  |                | 920      |   |                |   | 1,213    |  
|                                                                                                                                                                                        |  |               
|Commitments and contingencies                                                                                                                                                           |  |                |          |   |                |   |          |  
|                                                                                                                                                                                        |  |               
|Stockholders equity:                                                                                                                                                                   |  |                |          |   |                |   |          |  
|Preferred stock, $.0001 par value, 10,000,000 shares authorized, no shares issued and outstanding                                                                                       |  |                |         |   |                |   |         |  
|Common stock, $.0001 par value, stated at amounts paid in: 250,000,000 shares authorized, 106,108,096 and 100,362,285 shares
issued, and 105,897,847 and 100,256,729 shares outstanding |  |                | 896,378  |   |                |   | 869,146  |  
|Treasury stock, at cost, 210,249 and 105,556 shares                                                                                                                                     |  |                | (344     | ) |                |   | (151     | )
|Accumulated other comprehensive income (loss)                                                                                                                                           |  |                | 76       |   |                |   | (98      | )
|Accumulated deficit                                                                                                                                                                     |  |                | (774,781 | ) |                |   | (771,231 | )
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Total stockholders equity                                                                                                                                                              |  |                | 121,329  |   |                |   | 97,666   |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  
|Total liabilities and stockholders equity                                                                                                                                              |  | $              | 200,372  |   |                | $ | 154,529  |  
|                                                                                                                                                                                        |  |                |          |   |                |   |          |  

See accompanying notes to consolidated financial statements.



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##### Table of Contents

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except share and per share data)



|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|------------------------------------------------------------- |  | ------------------ | ----------- | - | -------------- | - | ---------- | ---------------- |  | - | ---------- | -
|                                                              |  | For the year ended |            
|                                                              |  | January 2,2011     |             |   | January 3,2010 |   |            | December 28,2008 | 
|Net sales                                                     |  | $                  | 456,507     |   |                | $ | 375,574    |                  |  | $ | 322,214    |  
|Costs and expenses:                                           |  |                    |             |   |                |   |            |                  |  |   |            |  
|Cost of sales                                                 |  |                    | 322,011     |   |                |   | 263,350    |                  |  |   | 227,531    |  
|Fulfillment and order processing                              |  |                    | 49,604      |   |                |   | 41,891     |                  |  |   | 38,896     |  
|Marketing and sales                                           |  |                    | 46,550      |   |                |   | 37,727     |                  |  |   | 32,464     |  
|Technology and content                                        |  |                    | 27,303      |   |                |   | 24,864     |                  |  |   | 22,995     |  
|General and administrative                                    |  |                    | 20,221      |   |                |   | 17,642     |                  |  |   | 19,866     |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Total costs and expenses                                      |  |                    | 465,689     |   |                |   | 385,474    |                  |  |   | 341,752    |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Operating loss                                                |  |                    | (9,182      | ) |                |   | (9,900     | )                |  |   | (19,538    | )
|Interest (expense) income, net                                |  |                    | (432        | ) |                |   | 46         |                  |  |   | 631        |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Loss from continuing operations                               |  |                    | (9,614      | ) |                |   | (9,854     | )                |  |   | (18,907    | )
|Gain from discontinued operations, net of tax                 |  |                    | 6,064       |   |                |   | 8,477      |                  |  |   | 10,620     |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Net loss                                                      |  | $                  | (3,550      | ) |                | $ | (1,377     | )                |  | $ | (8,287     | )
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Basic and diluted loss from continuing operations per share   |  | $                  | (0.09       | ) |                | $ | (0.10      | )                |  | $ | (0.20      | )
|Basic and diluted gain from discontinued operations per share |  | $                  | 0.06        |   |                | $ | 0.09       |                  |  | $ | 0.11       |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Basic and diluted net loss per share                          |  | $                  | (0.03       | ) |                | $ | (0.01      | )                |  | $ | (0.09      | )
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  
|Weighted average shares outstanding                           |  |                    | 102,217,033 |   |                |   | 96,950,189 |                  |  |   | 96,481,787 |  
|                                                              |  |                    |             |   |                |   |            |                  |  |   |            |  



See accompanying notes to
consolidated financial statements.



F-3



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##### Table of Contents

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands, except share data)



|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  
|----------------------------------------------------------------- |  | ------------ | ----------- | - | -------------- | - | ------- | ------------------------------------------ |  |  | ------------------ |  |  | ----- | ---- | - |  | - | ---- | - |  | - | -------- | - |  | - | ------- | -
|                                                                  |  | Common Stock |             |   | Treasury Stock |   |         | Accumulatedothercomprehensiveincome (loss) |  |  | Accumulateddeficit |  |  | Total |     
|                                                                  |  | Shares       |             |   | Amount         |   |         | Shares                                     |  |  | Amount             |  |  |       |     
|Balance at December 30, 2007                                      |  |              | 96,296,687  |   |                | $ | 856,193 |                                            |  |  |                   |  |  | $     |     |   |  | $ | 27   |   |  | $ | (761,852 | ) |  | $ | 94,368  |  
|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  
|Exercise of stock options and warrants                            |  |              | 158,345     |   |                |   | 336     |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 336     |  
|Employee stock purchase plan                                      |  |              | 92,047      |   |                |   | 189     |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 189     |  
|Stock-based compensation                                          |  |              |            |   |                |   | 7,564   |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 7,564   |  
|Net loss and comprehensive loss                                   |  |              |            |   |                |   |        |                                            |  |  |                   |  |  |       |     |   |  |   | 30   |   |  |   | (8,287   | ) |  |   | (8,257  | )
|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  
|Balance at December 28, 2008                                      |  |              | 96,547,079  |   |                |   | 864,282 |                                            |  |  |                   |  |  |       |     |   |  |   | 57   |   |  |   | (770,139 | ) |  |   | 94,200  |  
|Exercise of stock options and warrants                            |  |              | 55,546      |   |                |   | 122     |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 122     |  
|Employee stock purchase plan                                      |  |              | 106,500     |   |                |   | 94      |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 94      |  
|Restricted stock issued, net of 5,262 cancelled shares            |  |              | 3,547,604   |   |                |   |        |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   |        |  
|Treasury stock purchases                                          |  |              |            |   |                |   |        |                                            |  |  | 105,556            |  |  |       | (151 | ) |  |   |     |   |  |   |         |   |  |   | (151    | )
|Stock-based compensation                                          |  |              |            |   |                |   | 5,055   |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 5,055   |  
|Cumulative effect of change in accounting principle               |  |              |            |   |                |   | (407    | )                                          |  |  |                   |  |  |       |     |   |  |   |     |   |  |   | 285      |   |  |   | (122    | )
|Net loss and comprehensive loss                                   |  |              |            |   |                |   |        |                                            |  |  |                   |  |  |       |     |   |  |   | (155 | ) |  |   | (1,377   | ) |  |   | (1,532  | )
|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  
|Balance at January 3, 2010                                        |  |              | 100,256,729 |   |                |   | 869,146 |                                            |  |  | 105,556            |  |  |       | (151 | ) |  |   | (98  | ) |  |   | (771,231 | ) |  |   | 97,666  |  
|Exercise of stock options                                         |  |              | 355,650     |   |                |   | 820     |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 820     |  
|Common stock issued for acquisition of Salu                       |  |              | 5,425,678   |   |                |   | 17,271  |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 17,271  |  
|Stock and restricted stock issued, net of 88,668 cancelled shares |  |              | (35,517     | ) |                |   |        |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   |        |  
|Treasury stock purchases                                          |  |              | (104,693    | ) |                |   |        |                                            |  |  | 104,693            |  |  |       | (193 | ) |  |   |     |   |  |   |         |   |  |   | (193    | )
|Stock-based compensation                                          |  |              |            |   |                |   | 9,141   |                                            |  |  |                   |  |  |       |     |   |  |   |     |   |  |   |         |   |  |   | 9,141   |  
|Net loss and comprehensive loss                                   |  |              |            |   |                |   |        |                                            |  |  |                   |  |  |       |     |   |  |   | 174  |   |  |   | (3,550   | ) |  |   | (3,376  | )
|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  
|Balance at January 2, 2011                                        |  |              | 105,897,847 |   |                | $ | 896,378 |                                            |  |  | 210,249            |  |  | $     | (344 | ) |  | $ | 76   |   |  | $ | (774,781 | ) |  | $ | 121,329 |  
|                                                                  |  |              |             |   |                |   |         |                                            |  |  |                    |  |  |       |      |   |  |   |      |   |  |   |          |   |  |   |         |  

See accompanying notes to consolidated financial statements.



F-4



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##### Table of Contents

DRUGSTORE.COM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|------------------------------------------------------------------------------------------------------ |  | ------------------ | ------- | - | -------------- | - | ------- | ---------------- |  | - | ------- | -
|                                                                                                       |  | For the year ended |        
|                                                                                                       |  | January 2,2011     |         |   | January 3,2010 |   |         | December 28,2008 | 
|Operating Activities:                                                                                  |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net loss                                                                                               |  | $                  | (3,550  | ) |                | $ | (1,377  | )                |  | $ | (8,287  | )
|Less gain from discontinued operations                                                                 |  |                    | 6,064   |   |                |   | 8,477   |                  |  |   | 10,620  |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Loss from continuing operations                                                                        |  |                    | (9,614  | ) |                |   | (9,854  | )                |  |   | (18,907 | )
|Adjustments to reconcile loss from continuing operations to net cash provided by operating activities: |  |                    |         |   |                |   |         |                  |  |   |         |  
|Depreciation                                                                                           |  |                    | 13,733  |   |                |   | 12,682  |                  |  |   | 10,912  |  
|Amortization of intangible assets                                                                      |  |                    | 434     |   |                |   | 477     |                  |  |   | 867     |  
|Stock-based compensation                                                                               |  |                    | 8,949   |   |                |   | 5,400   |                  |  |   | 7,564   |  
|Other                                                                                                  |  |                    | 57      |   |                |   | (33     | )                |  |   | (59     | )
|Changes in, net of amounts acquired:                                                                   |  |                    |         |   |                |   |         |                  |  |   |         |  
|Accounts receivable                                                                                    |  |                    | 445     |   |                |   | (5,448  | )                |  |   | (444    | )
|Inventories                                                                                            |  |                    | (5,157  | ) |                |   | (7,733  | )                |  |   | (1,743  | )
|Other assets                                                                                           |  |                    | (784    | ) |                |   | (348    | )                |  |   | 1,425   |  
|Accounts payable, accrued expenses and other liabilities                                               |  |                    | 7,897   |   |                |   | 7,237   |                  |  |   | 704     |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net cash provided by continuing operations                                                             |  |                    | 15,960  |   |                |   | 2,380   |                  |  |   | 319     |  
|Net cash provided by (used in) discontinued operations                                                 |  |                    | (2,394  | ) |                |   | 1,420   |                  |  |   | 9,594   |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net cash provided by operating activities                                                              |  |                    | 13,566  |   |                |   | 3,800   |                  |  |   | 9,913   |  
|                                                                                                       |  |                    |        
|Investing Activities:                                                                                  |  |                    |         |   |                |   |         |                  |  |   |         |  
|Purchases of marketable securities                                                                     |  |                    | (22,358 | ) |                |   | (15,910 | )                |  |   | (46,926 | )
|Sales and maturities of marketable securities                                                          |  |                    | 23,911  |   |                |   | 14,130  |                  |  |   | 51,705  |  
|Purchases of fixed assets                                                                              |  |                    | (13,019 | ) |                |   | (8,323  | )                |  |   | (13,197 | )
|Proceeds from the sale of discontinued operations                                                      |  |                    | 4,969   |   |                |   | 5,946   |                  |  |   | 3,964   |  
|Purchase of Salu, less cash acquired                                                                   |  |                    | (17,977 | ) |                |   |        |                  |  |   |        |  
|Purchases of intangible assets                                                                         |  |                    | (64     | ) |                |   | (145    | )                |  |   |        |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net cash used in continuing investing activities                                                       |  |                    | (24,538 | ) |                |   | (4,302  | )                |  |   | (4,454  | )
|Net cash used in discontinued investing activities                                                     |  |                    | (1,073  | ) |                |   |        |                  |  |   |        |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net cash used in investing activities                                                                  |  |                    | (25,611 | ) |                |   | (4,302  | )                |  |   | (4,454  | )
|                                                                                                       |  |                    |        
|Financing Activities:                                                                                  |  |                    |         |   |                |   |         |                  |  |   |         |  
|Proceeds from exercise of stock options, warrants, and employee stock purchase plan                    |  |                    | 820     |   |                |   | 216     |                  |  |   | 525     |  
|Proceeds from line of credit and term loan                                                             |  |                    | 10,000  |   |                |   | 2,986   |                  |  |   | 5,000   |  
|Principal payments on capital leases, line of credit and term loan obligations                         |  |                    | (320    | ) |                |   | (5,571  | )                |  |   | (4,359  | )
|Purchase of treasury stock                                                                             |  |                    | (193    | ) |                |   | (151    | )                |  |   |        |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net cash provided by (used in) financing activities                                                    |  |                    | 10,307  |   |                |   | (2,520  | )                |  |   | 1,166   |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Net increase (decrease) in cash and cash equivalents                                                   |  |                    | (1,738  | ) |                |   | (3,022  | )                |  |   | 6,625   |  
|Cash and cash equivalents at beginning of year                                                         |  |                    | 22,175  |   |                |   | 25,197  |                  |  |   | 18,572  |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|Cash and cash equivalents at end of year                                                               |  | $                  | 20,437  |   |                | $ | 22,175  |                  |  | $ | 25,197  |  
|                                                                                                       |  |                    |         |   |                |   |         |                  |  |   |         |  
|                                                                                                       |  |                    |        
|Supplemental Cash Flow Information:                                                                    |  |                    |         |   |                |   |         |                  |  |   |         |  
|Cash paid for interest                                                                                 |  | $                  | 520     |   |                | $ | 215     |                  |  | $ | 360     |  
|Common stock issued for purchase of Salu                                                               |  | $                  | 17,271  |   |                |   |        |                  |  |   |        |  
|Equipment acquired in capital lease agreements                                                         |  | $                  | 1,012   |   |                | $ | 226     |                  |  | $ | 524     |  

See accompanying notes
to consolidated financial statements.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Description of Business and Accounting Policies

Description of
Business

drugstore.com, inc. is a leading online retailer of health, beauty, clinical skincare, and vision products.
We provide a convenient, private, and informative shopping experience while offering a wide assortment of products through our web stores located on the Internet as follows:



|                                 |  |                           
|-------------------------------- |  | --------------------------
|Health, Beauty & Pharmacy        |  | OTC Partnerships          
|www.drugstore.com                |  | www.medcohealthstore.com  
|www.Beauty.com                   |  | www.riteaidonlinestore.com
|www.SkinStore.com (1)            |  | www.spalook.com (1)       
|www.DrWeilVitaminAdvisor.com (3) |  |                           



|                          |  |                                 
|------------------------- |  | --------------------------------
|Microsites                |  | Vision and Vision Partnerships  
|www.thenaturalstore.com   |  | www.VisionDirect.com            
|www.athisbest.com         |  | www.LensMart.com                
|www.sexualwellbeing.com   |  | www.Lensworld.com               
|www.allergysuperstore.com |  | www.LensQuest.com               
|www.vitaminemporium.com   |  | www.pearlevisioncontacts.com (2)
|                          |  | www.lenscrafterscontacts.com (2)



|(1) | On February 19, 2010, we completed the acquisition of Salu, Inc., now Salu Beauty, Inc. (Salu), owner of SkinStore.com and operator and fulfillment partner for the
spalook.com web store. See Note 2 of our consolidated financial statements.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | In January 2011, we launched two sites under our partnership with Luxottica Group, S.p.A. (Luxottica), a global leader in the design, manufacturing and distribution of
fashion, luxury, and sport eyewear.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | We act as the exclusive fulfillment provider for customized nutritional supplements sold through www.DrWeilVitaminAdvisor.com, www.DrWeil.com, and other
Dr. Weil-related websites.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Principles of Consolidation and Basis of Presentation

The accompanying consolidated financial statements include those of drugstore.com, inc. and our subsidiaries. All material intercompany
transactions and balances have been eliminated.

We operate using a 52/53-week retail calendar year with each of the fiscal
quarters in a 52-week year representing a 13-week period. Fiscal year 2010 is a 52-week year, fiscal year 2009 is a 53-week year, with the fourth quarter of 2009 representing a 14-week period, and fiscal year 2008 is a 52-week year.

Estimates and Assumptions

The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the amounts of assets and
liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. These estimates include, but are not limited to, revenue recognition, inventories, goodwill and intangible assets,
stock-based compensation, deferred taxes, and commitments and contingencies. Actual results could differ from our estimates, and these differences could be material.

Cash Equivalents

We consider all highly liquid investments with a
maturity of three months or less from the date of purchase to be cash equivalents. Cash equivalents include money market funds and commercial paper.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Marketable Securities

Management determines the appropriate classification of marketable securities at the time of purchase and reevaluates such designation as
of each balance sheet date. The evaluation includes our view that our investments in debt securities are available to support current operations and therefore classified as a current asset. At January 2, 2011 and January 3, 2010,
marketable securities, which are considered available-for-sale and carried at fair value with unrealized gains or losses included in accumulated other comprehensive income in stockholders equity and consisted primarily of U.S. government
agency obligations, corporate notes, and commercial paper. Cost of securities sold is determined using the specific identification method.

We regularly monitor and evaluate the realizable value of our marketable securities. When assessing marketable securities for other-than-temporary declines in value, we consider such factors as, among
other things, how significant the decline in value is as a percentage of the amortized cost, how long the market value of the investment has been less than its amortized cost, the performance of the issuers price in relation to the price of
its competitors within the industry and the market in general, analyst recommendations, any news that has been released specific to the issuer, and the outlook for the overall industry in which the issuer operates. If events and circumstances
indicate that a decline in the value of these assets has occurred and is other than temporary, we record a charge against net earnings. No such charges have been recorded in fiscal years 2010, 2009, and 2008.

Fair Value

GAAP has established a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical
assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurement). This hierarchy requires entities to maximize the use of observable inputs and minimize the use of unobservable inputs. The three levels
of inputs used to measure fair value are as follows:

Level 1Valuations based on quoted prices for
identical assets and liabilities in active markets.

Level 2Valuations based on observable inputs other
than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, or inputs that are observable or can be
corroborated by observable market data.

Level 3Valuations based on observable inputs reflecting
our own assumptions, consistent with reasonably available assumptions made by other market participants. These valuations require significant judgment.

See Note 5 for a summary of our assets and liabilities that we measure at fair value.

Concentration of Credit Risk

Financial instruments, which
potentially subject us to concentrations of credit risk, consist principally of our holdings of cash, cash equivalents, marketable securities, and accounts receivable. Our credit risk is managed by investing our cash equivalents and marketable
securities in high-quality money market instruments and securities of the U.S. government agencies, and high-quality corporate issuers. We manage our credit risk through monitoring the stability of the United States-based financial institutions we
use and the diversification of our financial resources by limiting the investment in any one issuer of not more than 10% of the total portfolio at the time of purchase, except for investments in U.S. treasuries and agencies and investment
advisors money market funds.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Accounts Receivable

Accounts receivable includes amounts due primarily from customers from the sales of products and vendors from promotional funding and
rebates. At January 2, 2011 and January 3, 2010, vendor receivables, net, were $7.2 million and $7.3 million, respectively, and customer receivables, net, were $6.7 million and $6.0 million, respectively. We record accounts receivable net
of allowances for doubtful accounts, which were $55,000 as of January 2, 2011 and $69,000 as January 3, 2010. We determine our allowance for doubtful accounts by considering a number of factors, including the length of time receivables are
past due, previous loss history, our ability to offset our obligations, and the customers ability to pay its obligation. We write off accounts receivable when they become uncollectible, and any payments subsequently received are applied to the
allowance for doubtful accounts.

Inventories

Inventories consist of finished goods and are stated at the lower of cost (using the weighted average cost method) or the current
estimated market value and adjusted for shrinkage, slow moving, damaged, and expired inventory.

Fixed Assets

Fixed assets are stated at cost less accumulated depreciation and amortization, which includes the depreciation of
assets recorded under capital leases. We determine depreciation and amortization using the straight-line method over the estimated useful lives of the related assets, which range from two to ten years. Fixed assets purchased under capital leases and
leasehold improvements are depreciated over the shorter of the lease term or the estimated useful life. Repairs and maintenance costs are expensed as incurred.

Fixed assets include the cost of internally developed software and website development, including software used to upgrade and enhance our websites. We expense all costs related to internally developed
software other than those costs incurred during the application development stage. Costs incurred during the application development stage are capitalized and amortized over the estimated useful life of the software, generally three years. Internal
labor costs, including benefit costs, and third-party consulting costs totaling $10.1 million, $6.6 million, and $12.0 million, were capitalized during the fiscal years ended January 2, 2011, January 3, 2010, and December 28,
2008, respectively.

Leases

We categorize leases at their inception as either operating or capital leases depending on certain defined criteria. We recognize operating lease costs on a straight-line basis without regard to deferred
payment terms and lease incentives are treated as a reduction of our costs over the term of the agreement.

Other
Intangible Assets

Other intangible assets consist of trade names, a service contract, developed technology, domain
names, patents and customer lists acquired in connection with the purchase of Salu, Vision Direct, CNS and our private label de~luxe brand of natural, spa quality personal care products. All definite-lived intangible assets are being amortized
over their expected useful lives, which range from two to ten years.

Goodwill

We test for impairment of goodwill during the fourth quarter of each year and whenever indicators of impairment occur. The first phase of
the test screens for impairment, while the second phase of the test (if



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



necessary) measures the amount of impairment. The first phase is performed by comparing the fair value of the applicable reporting unit to its carrying value. Fair value is determined using
either a discounted cash flow methodology or methodology based on comparable market prices. The second step of the goodwill impairment test compares the implied fair value of reporting unit goodwill with the carrying amount of that goodwill. If the
carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to the excess.

During fiscal 2010, 2009 and 2008 we estimated the fair value of our reporting units by preparing a discounted cash flow analysis using forward looking projections of our estimated future operating
results. Based on the results of the discounted cash flow analysis each year, we concluded that the fair value of our reporting units exceeded the carrying value, and therefore goodwill was not impaired. We also considered as an indicator of market
value the market value of our common stock during the fourth quarter of the respective fiscal years.

The significant
assumptions used in our discounted cash flow analysis included: projected operating results, the discount rate used to present value future cash flows, and capital expenditures. Projected operating results assumptions include sales growth
assumptions which are based on historical trends, and to a lesser extent, future sales growth from new strategic partnerships or initiatives. Also included in projected operating results are gross margin and operating cost growth assumptions which
are based on the historical relationship of those measures compared to sales. Our discount rate is a market participant weighted average cost of capital (WACC). Our capital expenditure assumptions are based on our planned capital
expenditures for existing and new projects. Sensitivity tests were performed on our significant assumptions and determined that a reasonable, negative change in assumptions would not impact our conclusions.

Long-Lived Assets

We review the carrying values of our amortized long-lived assets, including definite-lived intangible assets, whenever an indicator of impairment exists. When facts and circumstances indicate that the
carrying values of long-lived assets may be impaired, we perform an evaluation of recoverability. The determination of whether impairment exists is based on any excess of the carrying value over the expected future cash flows, as estimated through
undiscounted cash flows, excluding interest charges. Any resulting impairment charge would be measured 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.

We review our indefinite-lived intangible assets, other than
goodwill, for impairment annually during the fourth quarter or when an indicator of impairment exists. We compare the carrying value of the asset to its estimated fair value based upon a discounted cash flow analysis and record an impairment charge
when the carrying value of the asset exceeds the estimated fair value. Based upon our review, we recorded no impairment for amortized or unamortized long-lived assets in fiscal 2010, 2009, or 2008.

Net Sales

We recognize revenue from product sales or services rendered (including advertising revenues), net of sales tax, 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. Revenue arrangements
with multiple deliverables are divided into separate units and revenue is allocated using estimated selling prices if we do not have vendor-specific objective evidence or third-party evidence of the selling prices of the deliverables.

Revenues are recorded when the products are shipped and title passes to customers, net of promotional discounts, cancellations, rebates,
and returns allowances. We generally require payment at the point of sale. We



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



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 evaluate whether it is appropriate to record the gross amount of product sales and related costs or the net amounts earned. 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. In addition, when we report revenue from fulfillment partnerships, we
include in revenues, the costs of the products sold and our variable fulfillment costs to fulfill each order that are received from our fulfillment partners.

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.

Cost of Sales

Cost of sales consists primarily of the cost of products sold to our customers, including allowances for shrinkage and damaged, slow-moving, and expired inventory; outbound and inbound shipping costs; and
expenses related to promotional inventory included in shipments to customers. We net against cost of sales payments that we receive from vendors in connection with volume purchases or rebate allowances and payment discount terms.

Shipping Activities

Our revenues from shipping charges to customers are included in net sales and were $15.0 million for the year ending on January 2, 2011, $13.5 million for the year ending on January 3, 2010, and
$13.8 million for the year ending on December 28, 2008. Outbound shipping costs are included in cost of sales and were $34.7 million for the year ending on January 2, 2011, $28.3 million for the year ending on January 3, 2010,
and $25.9 million for the year ending on December 28, 2008. The net cost to us of shipping activities was $19.7 million for the year ending on January 2, 2011, $14.8 million for the year ending on January 3, 2010, and $12.1 million
for the year ending on December 28, 2008.

Fulfillment and Order Processing

Fulfillment and order processing expenses include payroll and related expenses for personnel engaged in purchasing, fulfillment,
distribution, and customer care activities (including warehouse and vision prescription verification personnel), distribution center equipment and packaging supplies, credit card processing fees, and bad debt expenses. These expenses also include
rent and depreciation related to equipment and fixtures in our distribution centers and call center facility. Variable fulfillment costs represent the incremental costs of fulfilling, processing, and delivering the orders that are variable based on
sales volume.

Marketing and Sales

Marketing and sales expenses include advertising expenses, promotional expenditures, web analytic tools, web design, and payroll and related expenses for personnel engaged in marketing and merchandising
activities. Advertising expenses include our obligations under various advertising contracts. Advertising and other



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



promotional costs, which consist primarily of online advertising, and to a lesser extent, royalty and public relations expenditures, are expensed as incurred, and were $34.2 million, $27.3
million, and $22.8 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008.

Technology and Content

Technology and content expenses consist primarily of payroll and related expenses for personnel engaged in developing, maintaining, and making routine upgrades and improvements 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.

Technology and content costs are expensed as incurred, except for certain costs relating to the development of internal-use software and website development, including upgrades and enhancements to our
websites, which are capitalized and depreciated over their estimated useful life.

General and Administrative

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.

Foreign
Currency

Assets and liabilities of our foreign subsidiaries are translated at exchange rates prevailing at the balance
sheet dates. Revenues, costs and expenses are translated into U.S. dollars using average exchange rates for the period. Gains and losses resulting from the translation of our consolidated balance sheet are recorded as a component of accumulated
other comprehensive income. Realized gains and losses from foreign currency transactions are recognized as interest and other income (expense), net.

Interest Income and Expense

Interest income consists of earnings on
our cash, cash equivalents, and marketable securities, and interest expense consists primarily of interest associated with capital leases and debt obligations. Interest income for the years ended January 2, 2011, January 3, 2010, and
December 28, 2008, totaled $0.1 million, $0.3 million, and $1.1 million, respectively. Interest expense was $0.5 million, $0.2 million, and $0.5 million for the years ended January 2, 2011, January 3, 2010, and December 28, 2008,
respectively.

Accumulated Other Comprehensive Income/Loss

Accumulated other comprehensive income/loss consists of the accumulated net unrealized gains and losses on available-for-sale securities
(see note 5) and cumulative translation adjustments from the translation of assets and liabilities of our foreign subsidiaries into U.S. dollars. Our currency translation adjustment included in accumulated other comprehensive income/loss as of
January 2, 2011 was an unrealized gain of $76,000 and as of January 3, 2010, and December 28, 2008, was an unrealized loss of $133,000 and $76,000, respectively.

Income Taxes

We account for income taxes under the liability method. Under the liability method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of
assets and



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. Deferred tax assets are evaluated for future
realization and reduced by a valuation allowance to the extent we believe a portion will not be realized. We consider many factors when assessing the likelihood of future realization of our deferred tax assets, including our recent cumulative
earnings experience and expectations of future taxable income and capital gains by taxing jurisdiction, the carry-forward periods available to us for tax reporting purposes, and other relevant factors. We allocate our valuation allowance to current
and long-term deferred tax assets on a pro-rata basis.

We utilize a two-step approach to recognizing and measuring uncertain
tax positions. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related
appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our
tax positions and tax benefits, which may require periodic adjustments and which may not accurately forecast actual outcomes. We did not have any unrecognized tax benefits. Our policy is to recognize interest and penalties related to the
underpayment of income taxes as a component of income tax expense. To date, we have not incurred charges for interest or penalties in relation to the underpayment of income taxes. The tax years 1998 through the present remain open to examination by
the major taxing jurisdictions to which we are subject.

Stock-Based Compensation

Compensation cost for all stock-based awards is measured at fair value on the date of grant and recognized over the service period for
awards expected to vest. The fair value of stock options and stock appreciation rights is based on the estimated grant date fair value method using the Black-Scholes valuation model. The fair value of restricted stock and restricted stock units is
determined based on the number of shares granted and the quoted price of our common stock. Such value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line method. The estimation of stock awards that
will ultimately vest requires judgment, and to the extent actual results or updated estimates differ from our current estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are revised. We consider many factors
when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results and future estimates may differ substantially from our current estimates.

Net Loss per Share

We compute net income (loss) per share using the two-class method. We compute basic net income (loss) per share by dividing net income (loss) by the weighted-average number of shares outstanding during
the applicable period, including outstanding participating securities when in a net income position. Participating securities include unvested restricted stock awards and restricted stock units, as holders of these securities are entitled to receive
non-forfeitable dividends prior to vesting at the same rate as holders of our common stock. Because we had a net loss for the years ended 2010, 2009 and 2008, none of the loss was allocated to the participating securities. In addition, 816,450
shares of common stock held in escrow in connection with the acquisition of Salu were also excluded from the computation of net income (loss) per share for the year ended January 2, 2011 as these shares were considered contingently issuable
shares. We compute diluted earnings per share using the weighted-average number of shares determined for the basic net income (loss) per share computation plus the dilutive effect of common stock equivalents to the extent it does not create
anti-dilution using the treasury stock method.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



We excluded the following shares from the calculation of diluted net loss per share
because their inclusion would have been anti-dilutive:



|                                                |  |                    |            |  |                |  |            |                  |  |  |            | 
|----------------------------------------------- |  | ------------------ | ---------- |  | -------------- |  | ---------- | ---------------- |  |  | ---------- | 
|                                                |  | For the year ended |           
|                                                |  | January 2,2011     |            |  | January 3,2010 |  |            | December 28,2008 | 
|Stock options and stock appreciation rights (1) |  |                    | 20,064,342 |  |                |  | 16,635,725 |                  |  |  | 16,706,547 | 
|Restricted stock units                          |  |                    | 1,274,672  |  |                |  |           |                  |  |  |           | 
|Non-released restricted stock (2)               |  |                    | 1,671,191  |  |                |  | 2,124,738  |                  |  |  |           | 
|Warrants                                        |  |                    | 700,000    |  |                |  | 400,000    |                  |  |  | 400,000    | 
|Contingently issuable shares                    |  |                    | 816,450    |  |                |  |           |                  |  |  |           | 
|                                                |  |                    |            |  |                |  |            |                  |  |  |            | 
|                                                |  |                    | 24,526,655 |  |                |  | 19,160,463 |                  |  |  | 17,106,547 | 
|                                                |  |                    |            |  |                |  |            |                  |  |  |            | 



|(1) | Fiscal year 2009 excludes approximately 3.4 million shares subject to stock options and stock appreciation rights that were subject to stockholder approval, which
was obtained on June 10, 2010.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Fiscal year 2009 excludes approximately 700,000 shares of restricted stock that were subject to stockholder approval, which was obtained on June 10, 2010.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------

Recently Issued Accounting Standards

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (FASB) or other standard setting
bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, our management believes that the impact of recently issued standards that are not yet effective will not have a material impact on our consolidated
financial statements upon adoption.

In October 2009, the FASB issued Accounting Standards Update (ASU) 2009-13, Revenue
Recognition: Multiple Deliverable Revenue ArrangementsA Consensus of the FASB Emerging Issues Task Force. This update provides application guidance on whether multiple deliverables exist, how the deliverables should be separated and
how the consideration should be allocated to one or more units of accounting. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on
vendor-specific objective evidence, if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific or third-party evidence is available. This guidance is effective
prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. We adopted this guidance on January 3, 2011.

In June 2008, the FASB issued new guidance that clarifies the determination of whether an instrument (or an embedded feature) is indexed
to an entitys own stock, which would qualify as a scope exception under guidance related to certain contracts involving an entitys own equity. We adopted the provisions of this guidance on the first day of our fiscal year 2009 and upon
adoption, we recorded a cumulative change in accounting principle, which resulted in a reduction to common stock of $407,000 and a reduction in our accumulated deficit of $285,000, as well as, we reclassified $285,000 to a long-term liability.
Additionally, we adjust the fair value of the warrants subject to this guidance to fair market value at the end of each reporting period. For the year ended January 2, 2011, we recorded a benefit to stock-based compensation of $192,000 and for
the year ended January 3, 2010, we recorded additional stock-based compensation of $345,000 related to the increase in the fair value of these warrants.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



2. Acquisition of Salu

We account for acquisitions using the acquisition method of accounting. Under the acquisition method, assets acquired and liabilities assumed from acquisitions are recorded at their fair value as of the
acquisition date. Any excess of the purchase price over the fair values of the net assets acquired is recorded as goodwill.

On February 19, 2010, we acquired Salu. The acquisition was made pursuant to an Agreement and Plan of Merger, dated as of
December 27, 2009, by and among drugstore.com, Silk Acquisition Corporation, a Delaware corporation and a wholly owned subsidiary of drugstore.com, Salu, certain stockholders of Salu, and a representative of all stockholders of Salu. As
consideration for their shares of Salu, the stockholders of Salu received $19.4 million in cash (less approximately $1.9 million of Salus transaction expenses and the repayment of Salus outstanding debt obligation of $2.6 million
paid out of the merger consideration) and 5,425,678 shares of drugstore.com common stock with a fair value of $17.3 million. Of this initial consideration, drugstore.com paid approximately $2.7 million in cash and 816,450 shares of our common stock
into escrow to secure post-closing indemnification obligations of Salus stockholders. Additionally, certain employees of Salu are eligible to receive a performance incentive payment payable in cash over a two-year period commencing in fiscal
year 2010 with an aggregate value of $2.5 million if the surviving entity achieves certain financial and other performance targets. On the acquisition date, we recorded a liability of $0.5 million which represented the fair value of the portion of
the performance incentive payment that will be accounted for as additional consideration. Any adjustments to the fair value of our initial estimate of the performance incentive payment may affect our consolidated statements of operations and could
have a material impact on our financial results. In 2010, approximately $0.2 million of the initial purchase price, equal parts of cash and stock, was reimbursed and $0.2 million was due from escrow in connection with adjustments allowed for under
the Agreement and Plan of Merger. Also in 2010, we reduced the performance incentive liability to $0.3 million and recorded a benefit to the statement of operations of $0.2 million.

We financed a portion of the cash payable at the closing of the acquisition described above by borrowing $10.0 million under our
revolving two-year line of credit pursuant to our March 2009 loan and security agreement with our existing bank. In conjunction with the acquisition, we also paid $1.4 million in transaction fees in the first quarter of 2010, which are recorded in
general and administrative expenses in the statement of operations. In 2010, we also incurred integration costs and purchase accounting adjustments of approximately $0.7 million, which are recorded in general and administrative expenses and cost of
sales ($0.1 million) in our statements of operations. Salus results of operations are included in the consolidated statements of operations beginning February 20, 2010, and generated net sales of $42.3 million, and net income of $2.3
million, excluding integration costs and purchase accounting adjustments of $0.3 million.



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following summarizes the fair values of Salus acquired assets and liabilities
assumed based on the total consideration of $36.9 million, which represents $19.4 million of cash, $17.3 million of common stock issued, and $0.5 million of deferred acquisition payments, less $0.2 million of funds due from escrow. The following
table also includes cash acquired of $1.4 million as of the acquisition date (in thousands):



|                                    |  |   |        |  
|----------------------------------- |  | - | ------ | -
|Total current assets                |  | $ | 7,105  |  
|Fixed assets                        |  |   | 406    |  
|Goodwill (1)                        |  |   | 25,347 |  
|Identifiable intangible assets (2): |  |   |        |  
|Trademarks                          |  |   | 8,749  |  
|Service contract                    |  |   | 2,087  |  
|Developed technology                |  |   | 501    |  
|                                    |  |   |        |  
|Total assets acquired               |  |   | 44,195 |  
|                                    |  |   |        |  
|Total current liabilities           |  |   | (4,251 | )
|Long-term deferred tax liabilities  |  |   | (3,070 | )
|                                    |  |   |        |  
|Total liabilities assumed           |  |   | (7,321 | )
|                                    |  |   |        |  
|Total consideration                 |  | $ | 36,874 |  
|                                    |  |   |        |  



|(1) | Goodwill represents the excess of the purchase price over the fair values of the net assets acquired and represents the value of the expected synergies to be realized
by combining Salu with our beauty business to become one of the largest online beauty retailers offering mass beauty products, prestige brands and clinical skincare products.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Purchased definite-lived intangible assets will be amortized on a straight-line basis over their respective useful lives ranging from three to nine years. Trademarks,
identified as indefinite-lived assets, will be tested annually or whenever an indicator of impairment exists. Any resulting impairment charge would be measured 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.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Unaudited Pro Forma Financial Information

The financial information in the table below summarizes the combined results of our operations and Salus on a pro forma basis, as though the companies had been combined as of the beginning of the
year ended January 3, 2010. The 2010 pro forma earnings were adjusted to exclude $2.1 million of acquisition-related costs and the 2009 pro forma earnings were adjusted to include those costs. The pro forma financial information is presented
for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had actually taken place at the beginning of the year ended January 3, 2010 and is not intended to be a projection of
future results or trends.



|          |  |                |         |   |                |   |         |  
|--------- |  | -------------- | ------- | - | -------------- | - | ------- | -
|          |  | January 2,2011 |         |   | January 3,2010 |  
|          |  | (in thousands) |        
|Net sales |  | $              | 463,214 |   |                | $ | 417,871 |  
|Net loss  |  | $              | (3,477  | ) |                | $ | (3,612  | )

3. Discontinued Operations

On July 29, 2010, drugstore.com and DS Pharmacy, Inc., our wholly owned subsidiary, entered into a second amendment
to the asset purchase agreement dated May 5, 2010, as amended July 14, 2010, with BioScrip, Inc., and BioScrip Pharmacy Services, Inc., its wholly owned subsidiary (BioScrip), of which the sale



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



closed on July 30, 2010. Under the terms of the agreement, BioScrip Pharmacy Services purchased substantially all of the assets of DS Pharmacy for a purchase price of $10.5 million, subject
to adjustment for changes in gross profit of the business. Of this initial consideration, BioScrip paid $5.0 million in connection with closing, with $0.5 million accounting for the purchase of inventory and $4.5 million accounting for the purchase
of other assets. BioScrip will pay the remaining $5.5 million of the consideration into escrow in installments, based on the monthly profitability of the business, over the 12 months following the closing. The final amount paid out of escrow will be
determined after the 12-month period based on the profitability of the prescription pharmacy business during that period. For the year ended January 2, 2011, we recognized $1.6 million of the contingent consideration and will continue to earn
all or a portion of the remaining consideration of $3.9 million over the remaining contract period in 2011. Additionally, the parties entered into a 5-year marketing agreement allowing drugstore.com pharmacy customers to continue to order as they
always have through the drugstore.com web store. Under the agreement, 12 months following the closing of July 30, 2010, BioScrip will pay drugstore.com a fee to continue to market the drugstore.com pharmacy, which will be served by BioScrip. We
consider the marketing service fees to be indirect cash inflows of our discontinued mail-order pharmacy segment, as the fees earned are not a significant source of ongoing future revenue.

On September 3, 2008, we entered into an amended and restated main agreement with Rite Aid whereby we transferred to Rite Aid the
rights to our local pick-up pharmacy business (LPU), which included prescription refills sold online through the drugstore.com web store or the Rite Aid online store and picked up by customers at Rite Aid stores, in exchange for $9.9 million, paid
in ten monthly installments beginning in September 2008. We recorded the purchase price as a deferred gain that we recognized over the ten-month contractual payment period ended June 2009. Additionally, Rite Aid paid drugstore.com ongoing marketing
service fees for the continued marketing of Rite Aids LPU offering on the drugstore.com site during the term of the agreement, which terminated in May 2010. In addition, the pharmacy agreement terminated as of July 2010. We considered the
marketing service fees to be indirect cash inflows of our discontinued LPU segment, as the fees earned are not a significant source of ongoing future revenue.

We have classified the results of operations of our mail-order pharmacy and LPU business segments as discontinued operations in the accompanying consolidated financial statements for all periods
presented.

The following table summarizes the results of operations that we have classified as discontinued operations.



|                                                        |  |                    |        |  |                |   |        |                  |  |   |        | 
|------------------------------------------------------- |  | ------------------ | ------ |  | -------------- | - | ------ | ---------------- |  | - | ------ | 
|                                                        |  | For the year ended |       
|                                                        |  | January 2,2011     |        |  | January 3,2010 |   |        | December 28,2009 | 
|Net sales                                               |  | $                  | 16,664 |  |                | $ | 37,258 |                  |  | $ | 44,365 | 
|Income from discontinued operationsmail-order pharmacy |  |                    | 162    |  |                |   | 2,531  |                  |  |   | 2,540  | 
|Net gain from sale of mail-order pharmacy               |  |                    | 5,902  |  |                |   |       |                  |  |   |       | 
|                                                        |  |                    |        |  |                |   |        |                  |  |   |        | 
|Gain from discontinued operationsmail-order pharmacy   |  |                    | 6,064  |  |                |   | 2,531  |                  |  |   | 2,540  | 
|Gain from discontinued operationsLPU pharmacy          |  |                    |       |  |                |   | 5,946  |                  |  |   | 8,080  | 
|                                                        |  |                    |        |  |                |   |        |                  |  |   |        | 
|Gain from discontinued operations, net of tax           |  | $                  | 6,064  |  |                | $ | 8,477  |                  |  | $ | 10,620 | 
|                                                        |  |                    |        |  |                |   |        |                  |  |   |        | 



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



We have classified the assets and liabilities of our mail-order pharmacy segment as net
assets and liabilities from discontinued operations in the accompanying consolidated balance sheets for all periods presented.



|                                                    |  |                |       |  |                |   |        |  
|--------------------------------------------------- |  | -------------- | ----- |  | -------------- | - | ------ | -
|                                                    |  | January 2,2011 |       |  | January 3,2010 |  
|Accounts receivable (1)                             |  | $              | 1,711 |  |                | $ | 1,798  |  
|Inventories                                         |  |                |      |  |                |   | 912    |  
|Other current assets                                |  |                | 10    |  |                |   | 61     |  
|Fixed assets, net                                   |  |                | 719   |  |                |   | 61     |  
|                                                    |  |                |       |  |                |   |        |  
|Assets of discontinued operations                   |  | $              | 2,440 |  |                | $ | 2,832  |  
|                                                    |  |                |       |  |                |   |        |  
|Accounts payable                                    |  | $              |      |  |                | $ | 4,220  |  
|Accrued liabilities                                 |  |                |      |  |                |   | 340    |  
|Other current liabilities                           |  |                |      |  |                |   | 21     |  
|                                                    |  |                |       |  |                |   |        |  
|Liabilities of discontinued operations              |  |                |      |  |                |   | 4,581  |  
|                                                    |  |                |       |  |                |   |        |  
|Net assets (liabilities) of discontinued operations |  | $              | 2,440 |  |                | $ | (1,749 | )
|                                                    |  |                |       |  |                |   |        |  



|(1) | Accounts receivable as of January 2, 2011, primarily represents amounts due from BioScrip.
|--- | ------------------------------------------------------------------------------------------

4. Strategic Agreements

Agreements with Medco

In November 2008, we entered into a five-year web store hosting and fulfillment agreement with Medco Health Services, Inc. (Medco) whereby
drugstore.com provides technical development and operation services, consumer health products and OTC merchandising, fulfillment capabilities and customer care for the non-prescription drug offerings in the Medco-branded online store. In June 2009,
we launched the Medco-branded online store. Under the terms of the original agreement, we retained the revenue collected from the customer order at the Medco-branded online store, and Medco earned a percentage of the contribution margin generated by
the order. We recorded the amount paid to Medco as a marketing and sales expense in our consolidated statements of operations. In August 2010, we entered into an amended web store hosting and fulfillment agreement with Medco, extending the agreement
through 2018. Under the amended agreement, we now receive from Medco the costs of the products sold plus our variable fulfillment costs and a fixed fee on customer orders at the Medco-branded online store. Accordingly, beginning with the third
quarter of 2010, we record the amount received from Medco as revenue and do not incur any marketing and sales expense.

Agreements with Rite Aid

In June 1999, we entered into a ten-year strategic relationship with Rite Aid Corporation (Rite Aid). On September 3, 2008, we amended and restated both the main agreement and the pharmacy supply and
services agreement dated June 17, 1999 between Rite Aid and drugstore.com. In May 2010, the main agreement between Rite Aid and drugstore.com terminated. In July 2010, the pharmacy portions of the agreement were terminated.

Under the amended and restated pharmacy and private label supply and services agreement, Rite Aid had granted drugstore.com, during the
two-year term of the agreement, a nonexclusive, fully paid license to the Rite Aid information and pharmacy systems that were integrated with our systems, subject to third-party rights to such technology. Through this technology integration, Rite
Aid adjudicated and collected insurance reimbursement payments for prescription medications in our mail-order pharmacy segment on behalf of



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



drugstore.com. In addition, we have the right to purchase pharmaceutical inventory and Rite Aid private label over-the-counter products through Rite Aid. As a result of this relationship, Rite
Aid was one of our largest suppliers. On July 30, 2010, we closed the sale of substantially all of our pharmacy assets to BioScrip. As a result, we no longer procure pharmacy inventory or rely on Rite Aids pharmacy systems under these
agreements.

Also on September 3, 2008, we entered into a two-year web store and fulfillment agreement with Rite Aid
whereby drugstore.com provided site design, development, hosting, customer service, and fulfillment for the Rite Aid online store. In December 2008, we launched the Rite Aid online store. In December 2010, this agreement renewed for an additional
one-year term. Under the terms of this agreement, we retain revenues collected from the order at the Rite Aid online store, and Rite Aid earns a percentage of the contribution margin generated by the order. We record the amount paid to Rite Aid as a
marketing and sales expense in our consolidated statements of operations.

Agreements with Luxottica Group, S.p.A.

In November 2009, we entered into a strategic multi-year e-commerce partnership with Luxottica Group, S.p.A.
(Luxottica) whereby our subsidiary Vision Direct, Inc. provides site design, development and hosting services, the purchasing, inventory management, and other fulfillment services, and the marketing, merchandising and related customer services,
including prescription verification, for the Luxottica-branded online stores. In January 2011, we launched two of Luxotticas branded web stores,www.pearlevisioncontacts.comandwww.lenscrafterscontacts.com. Under the
partnership, we receive from Luxottica the costs of the products sold plus our variable fulfillment costs and a fixed percentage of the sales generated through the Luxottica-branded online stores and certain sales generated in the Luxottica-branded
offline stores. We will record the amounts received from Luxottica as revenue.

Agreements with Amazon.com

In June 2009, we entered into a three-year merchant agreement with Amazon.com, a related party, to sell OTC products
through the marketplace on the Amazon.com website. In September 2007, we entered into a three-year merchant agreement with Amazon.com to sell prestige beauty products through the Beauty.com marketplace on the Amazon.com website, and as of early 2011
we continued to sell prestige beauty products through this marketplace. We ship the Amazon.com orders from our distribution facility in exchange for an agreed-upon product price less a referral fee. Product revenue generated by the merchant
agreements totaled $10.8 million in 2010, $3.6 million in 2009, and $1.3 million in 2008, and referral fees paid totaled $1.7 million in 2010, $0.6 million in 2009, and $0.2 million in 2008. As of January 2, 2010, January 3, 2010, and
December 28, 2008, amounts due from Amazon.com totaled $0.4 million, $0.3 million, and $49,000, respectively.

5. Fair Value

We measure the fair value of money market funds based on quoted prices in active markets for identical assets. All other
financial instruments measured at fair value were valued either based on recent trades of securities in inactive markets or based on quoted market prices of similar instruments and other significant inputs derived from or corroborated by observable
market data.

As of January 2, 2011, we had deferred acquisition payments totaling $0.3 million, in conjunction with our
acquisition of Salu on February 19, 2010, that is categorized as a Level 3 liability. We utilized a discounted cash flow model that incorporated several different assumptions of future performance and a discount rate to



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



determine fair value. In the fourth quarter of 2010, we decreased the deferred acquisition payment from $0.5 million and recognized a benefit of $0.2 million in the statement of operations.

The carrying value approximates the fair value for all other financial instruments that we do not measure at fair value on
the balance sheets, including accounts receivable and debt, due to the short-maturities or variable interest rate of the instruments.

Assets and liabilities measured at fair value consist of the following:



|                                                       |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|------------------------------------------------------ |  | -------------------- | ------ |  | --------------------------- | - | - | -------------------------------- |  | - | --------------- |  |  | - | ------ | 
|                                                       |  | January 2, 2011      |       
|                                                       |  | Cost orAmortizedCost |        |  | GrossUnrealizedHoldingGains |   |   | GrossUnrealizedHoldingLosses (1) |  |   | TotalFair Value | 
|                                                       |  | (in thousands)       |       
|Cash                                                   |  | $                    | 11,973 |  |                             | $ |  |                                  |  | $ |                |  |  | $ | 11,973 | 
|Level 1 securities:                                    |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|Money market funds                                     |  |                      | 7,065  |  |                             |   |  |                                  |  |   |                |  |  |   | 7,065  | 
|Level 2 securities:                                    |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|Commercial paper                                       |  |                      | 2,727  |  |                             |   |  |                                  |  |   |                |  |  |   | 2,727  | 
|U.S. government agency obligations                     |  |                      | 8,128  |  |                             |   |  |                                  |  |   | 2               |  |  |   | 8,126  | 
|Corporate notes and bonds (2)                          |  |                      | 3,638  |  |                             |   | 2 |                                  |  |   |                |  |  |   | 3,640  | 
|                                                       |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|Total cash, cash equivalents and marketable securities |  | $                    | 33,531 |  |                             | $ | 2 |                                  |  | $ | 2               |  |  | $ | 33,531 | 
|                                                       |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|Level 3 liabilities:                                   |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 
|Deferred acquisition payment                           |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  | $ | 289    | 
|                                                       |  |                      |        |  |                             |   |   |                                  |  |   |                 |  |  |   |        | 



|                                                       |  |                      |        |  |                             |   |    |                                  |  |   |                 |  |  |   |        | 
|------------------------------------------------------ |  | -------------------- | ------ |  | --------------------------- | - | -- | -------------------------------- |  | - | --------------- |  |  | - | ------ | 
|                                                       |  | January 3, 2010      |       
|                                                       |  | Cost orAmortizedCost |        |  | GrossUnrealizedHoldingGains |   |    | GrossUnrealizedHoldingLosses (1) |  |   | TotalFair Value | 
|                                                       |  | (in thousands)       |       
|Cash                                                   |  | $                    | 12,316 |  |                             | $ |   |                                  |  | $ |                |  |  | $ | 12,316 | 
|Level 1 securities:                                    |  |                      |        |  |                             |   |    |                                  |  |   |                 |  |  |   |        | 
|Money market funds                                     |  |                      | 7,059  |  |                             |   |   |                                  |  |   |                |  |  |   | 7,059  | 
|Level 2 securities:                                    |  |                      |        |  |                             |   |    |                                  |  |   |                 |  |  |   |        | 
|Commercial paper                                       |  |                      | 6,398  |  |                             |   |   |                                  |  |   |                |  |  |   | 6,398  | 
|U.S. government agency obligations                     |  |                      | 9,365  |  |                             |   | 35 |                                  |  |   |                |  |  |   | 9,400  | 
|Corporate notes and bonds (2)                          |  |                      | 1,680  |  |                             |   |   |                                  |  |   |                |  |  |   | 1,680  | 
|                                                       |  |                      |        |  |                             |   |    |                                  |  |   |                 |  |  |   |        | 
|Total cash, cash equivalents and marketable securities |  | $                    | 36,818 |  |                             | $ | 35 |                                  |  | $ |                |  |  | $ | 36,853 | 
|                                                       |  |                      |        |  |                             |   |    |                                  |  |   |                 |  |  |   |        | 



|(1) | As of January 2, 2011, U.S. government agency obligations had unrealized losses totaling $2,000 and as of January 3, 2010, there were no investments with loss
positions. We evaluated the nature of our investments, credit worthiness of the issuer, and the duration of any impairments to determine if an other-than-temporary decline in fair value had occurred.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Corporate notes and bonds include investments in corporate institutions. No single issuer represents a significant portion of the total corporate notes and bonds
portfolio.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



The following table summarizes contractual maturities of marketable securities including
cash equivalents as of January 2, 2011:



|                               |  |                       |        |  |            |   |        | 
|------------------------------ |  | --------------------- | ------ |  | ---------- | - | ------ | 
|                               |  | Cost or AmortizedCost |        |  | Fair Value |  
|Due within one year            |  | $                     | 11,577 |  |            | $ | 11,577 | 
|Due one year through two years |  |                       | 2,916  |  |            |   | 2,916  | 
|                               |  |                       |        |  |            |   |        | 
|                               |  | $                     | 14,493 |  |            | $ | 14,493 | 
|                               |  |                       |        |  |            |   |        | 

6. Fixed Assets

Fixed assets consist of the following:



|                                               |  |                |         |   |                |   |         |  
|---------------------------------------------- |  | -------------- | ------- | - | -------------- | - | ------- | -
|                                               |  | January 2,2011 |         |   | January 3,2010 |  
|                                               |  | (in thousands) |        
|Computers and equipment                        |  | $              | 23,112  |   |                | $ | 22,780  |  
|Purchased and internally developed software    |  |                | 50,659  |   |                |   | 45,000  |  
|Furniture and fixtures                         |  |                | 2,334   |   |                |   | 2,531   |  
|Leased assets                                  |  |                | 5,982   |   |                |   | 6,121   |  
|Leasehold improvements                         |  |                | 10,160  |   |                |   | 10,094  |  
|                                               |  |                |         |   |                |   |         |  
|                                               |  |                | 92,247  |   |                |   | 86,526  |  
|Less accumulated depreciation and amortization |  |                | (75,607 | ) |                |   | (65,973 | )
|                                               |  |                |         |   |                |   |         |  
|                                               |  |                | 16,640  |   |                |   | 20,553  |  
|Construction in progress                       |  |                | 8,541   |   |                |   | 3,551   |  
|                                               |  |                |         |   |                |   |         |  
|Total                                          |  | $              | 25,181  |   |                | $ | 24,104  |  
|                                               |  |                |         |   |                |   |         |  

Depreciation expense on fixed assets was $13.7 million in 2010, $12.7 million in 2009, and $10.9 million in
2008. Accumulated amortization on leased assets was $5.9 million and $5.8 million as of January 2, 2011 and January 3, 2010. Amortization on leased assets is included in depreciation expense.

7. Other Intangible Assets and Goodwill

Intangible Assets

The other intangible assets balances as of
January 2, 2011 were as follows (in thousands):



|                                                   |  |                                 |            |  |                       |   |       |                  |  |   |           |  |  |                         |     |  |                       |   |      |   |  |   |        | 
|-------------------------------------------------- |  | ------------------------------- | ---------- |  | --------------------- | - | ----- | ---------------- |  | - | --------- |  |  | ----------------------- | --- |  | --------------------- | - | ---- | - |  | - | ------ | 
|                                                   |  | WeightedAverageYearsUseful Life |            |  | BalanceJanuary 3,2010 |   |       | Acquisitions (1) |  |   | Other (2) |  |  | AccumulatedAmortization |     |  | BalanceJanuary 2,2011 |  
|Vision Direct trade name                           |  |                                 | indefinite |  |                       | $ | 2,700 |                  |  | $ |          |  |  | $                       |    |  |                       | $ |     |   |  | $ | 2,700  | 
|Salu trademarks                                    |  |                                 | indefinite |  |                       |   |      |                  |  |   | 8,749     |  |  |                         | 138 |  |                       |   |     |   |  |   | 8,887  | 
|Trademarks                                         |  |                                 | indefinite |  |                       |   | 292   |                  |  |   |          |  |  |                         |    |  |                       |   |     |   |  |   | 292    | 
|Salu service contract and developed technology (3) |  |                                 | 7.8        |  |                       |   |      |                  |  |   | 2,588     |  |  |                         |    |  |                       |   | (318 | ) |  |   | 2,270  | 
|Technology license, domain names and other         |  |                                 | 8.2        |  |                       |   | 406   |                  |  |   | 64        |  |  |                         |    |  |                       |   | (116 | ) |  |   | 354    | 
|                                                   |  |                                 |            |  |                       |   |       |                  |  |   |           |  |  |                         |     |  |                       |   |      |   |  |   |        | 
|Total other intangible assets                      |  |                                 | 7.9        |  |                       | $ | 3,398 |                  |  | $ | 11,401    |  |  | $                       | 138 |  |                       | $ | (434 | ) |  | $ | 14,503 | 
|                                                   |  |                                 |            |  |                       |   |       |                  |  |   |           |  |  |                         |     |  |                       |   |      |   |  |   |        | 



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)





|(1) | On February 19, 2010, in conjunction with the acquisition of Salu, we acquired identifiable intangible assets of $11.3 million.
|--- | -------------------------------------------------------------------------------------------------------------------------------

|(2) | Represents the impact of foreign exchange rate differences.
|--- | -----------------------------------------------------------

|(3) | The Salu service contract assumes the five-year renewal period is exercised.
|--- | ----------------------------------------------------------------------------

The other intangible assets balances as of January 3, 2010 were as follows (in thousands):



|                                           |  |                                 |            |  |                             |   |       |              |  |   |                             |  |  |                       |      |   |  |   |       | 
|------------------------------------------ |  | ------------------------------- | ---------- |  | --------------------------- | - | ----- | ------------ |  | - | --------------------------- |  |  | --------------------- | ---- | - |  | - | ----- | 
|                                           |  | WeightedAverageYearsUseful Life |            |  | BalanceDecember 28,2008 (1) |   |       | Acquisitions |  |   | AccumulatedAmortization (1) |  |  | BalanceJanuary 3,2010 |     
|Vision Direct trade name                   |  |                                 | indefinite |  |                             | $ | 2,700 |              |  | $ |                            |  |  | $                     |     |   |  | $ | 2,700 | 
|Trademarks                                 |  |                                 | indefinite |  |                             |   | 252   |              |  |   | 40                          |  |  |                       |     |   |  |   | 292   | 
|Technology license, domain names and other |  |                                 | 8.4        |  |                             |   | 709   |              |  |   | 105                         |  |  |                       | (408 | ) |  |   | 406   | 
|                                           |  |                                 |            |  |                             |   |       |              |  |   |                             |  |  |                       |      |   |  |   |       | 
|Total other intangible assets              |  |                                 | 8.4        |  |                             | $ | 3,661 |              |  | $ | 145                         |  |  | $                     | (408 | ) |  | $ | 3,398 | 
|                                           |  |                                 |            |  |                             |   |       |              |  |   |                             |  |  |                       |      |   |  |   |       | 



|(1) | During 2009, we wrote off $12.3 million of fully amortized intangible assets related to our GNC vendor agreement with a net book value of $0.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------

The following table summarizes our estimated amortization expense for each of the next five fiscal years (in thousands):



|            |  |   |       | 
|----------- |  | - | ----- | 
|Fiscal year |  |   |      
|2011        |  | $ | 529   | 
|2012        |  |   | 502   | 
|2013        |  |   | 355   | 
|2014        |  |   | 256   | 
|2015        |  |   | 236   | 
|            |  |   |       | 
|Total       |  | $ | 1,878 | 
|            |  |   |       | 

Goodwill

The following table summarizes our goodwill by business segment (in thousands):



|                                                 |  |     |        |  |        |   |        |       |  |   |        | 
|------------------------------------------------ |  | --- | ------ |  | ------ | - | ------ | ----- |  | - | ------ | 
|                                                 |  | OTC |        |  | Vision |   |        | Total | 
|Balance at December 28, 2008 and January 3, 2010 |  | $   | 8,404  |  |        | $ | 23,798 |       |  | $ | 32,202 | 
|Acquisitions (1)                                 |  |     | 25,347 |  |        |   |       |       |  |   | 25,347 | 
|Other (2)                                        |  |     | 44     |  |        |   |       |       |  |   | 44     | 
|                                                 |  |     |        |  |        |   |        |       |  |   |        | 
|Balance at January 2, 2011                       |  | $   | 33,795 |  |        | $ | 23,798 |       |  | $ | 57,593 | 
|                                                 |  |     |        |  |        |   |        |       |  |   |        | 



|(1) | On February 19, 2010, we completed our acquisition of Salu resulting in goodwill of $25.3 million from the excess of the purchase price over the fair value of the
net assets acquired.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Represents the impact of foreign exchange rate differences.
|--- | -----------------------------------------------------------



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



8. Long-Term Obligations

Line of Credit

In March 2011, we entered into a loan and security
agreement with our existing bank, which includes a revolving three-year line of credit allowing for borrowings up to $40.0 million, which accrue interest at LIBOR plus 2.5%  3%, or prime plus 0%  0.5%. This agreement
replaced our two-year $25.0 million line of credit scheduled to mature in March 2011. As of January 2, 2011, $13.0 million was outstanding under the line of credit, which was refinanced under the new three-year line of credit maturing in March
2014. As a result we have classified the balance outstanding on the line of credit as long-term. Availability under each line of credit was also reduced by a $541,000 letter of credit we provided to our corporate headquarters landlord. As of
January 2, 2011, the available borrowings under the two-year line of credit were approximately $11.5 million and in March 2011, the available borrowings under the three-year line of credit were approximately $26.5 million. Advances available
under the revolving line of credit are limited, based on eligible inventory, accounts receivable, cash and investment balances, and balances outstanding under our line of credit. The agreement contains certain covenants that are customary in
transactions of this nature, including a prohibition on other debt and liens, requirements regarding the payment of taxes, and certain restrictions on mergers and acquisitions, investments, and transactions with our affiliates, as well as certain
financial covenants. As of January 2, 2011, we exceeded our capital expenditure covenant of $14.0 million by $0.1 million, and as of January 30, 2011 we failed our adjusted quick ratio covenant, which were both waived in conjunction with
the March 2011 loan and security agreement renewal. In our new agreement, the adjusted quick ratio definition was redefined to reduce the possibility of non-compliance in the future. The agreement identifies certain events of default that are
customary for transactions of this nature and subject to materiality provisions and grace periods where appropriate, including failure to pay any principal or interest under this facility or other instruments when due, the occurrence of a material
adverse change, violations of any covenants, a material cross-default to our other debt, or a change of control. As of January 2, 2011, none of these events had occurred.

Capital Leases

We lease equipment and software under non-cancelable
capital leases. Capital lease obligations bear interest ranging from 3% to 8% and mature 24- 36 months from the date of funding. We secured additional funds of $1.7 million during 2010 and $0.2 million during 2009, through capital lease financing
agreements. We are in compliance with all covenants required by these agreements.

Maturities of capital leases at
January 2, 2011 are as follows (in thousands):



|                                                  |  |   |       |  
|------------------------------------------------- |  | - | ----- | -
|Fiscal Year                                       |  |   |      
|2011                                              |  | $ | 625   |  
|2012                                              |  |   | 589   |  
|2013                                              |  |   | 442   |  
|                                                  |  |   |       |  
|Total minimum payments                            |  |   | 1,656 |  
|Less amounts representing interest                |  |   | (76   | )
|                                                  |  |   |       |  
|Present value of minimum payments                 |  |   | 1,580 |  
|Less current portion of capital lease obligations |  |   | (581  | )
|                                                  |  |   |       |  
|Non-current portion of capital lease obligations  |  | $ | 999   |  
|                                                  |  |   |       |  



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



9. Commitments and Contingencies

Operating Leases

We lease office, distribution center, and call center facilities under non-cancelable operating leases. We have the option to extend some of these leases for one or two additional terms of five years.
Total rent expense under operating leases was $3.6 million in 2010 and 2009, and $3.7 million in 2008.

Future minimum
commitments at January 2, 2011 are as follows (in thousands):



|                       |  |                  |        | 
|---------------------- |  | ---------------- | ------ | 
|Fiscal Year            |  | Operating Leases |       
|2011                   |  | $                | 3,120  | 
|2012                   |  |                  | 3,174  | 
|2013                   |  |                  | 2,336  | 
|2014                   |  |                  | 1,582  | 
|2015                   |  |                  | 1,562  | 
|Thereafter             |  |                  | 6,050  | 
|                       |  |                  |        | 
|Total minimum payments |  | $                | 17,824 | 
|                       |  |                  |        | 

Other

In connection with the lease arrangements for our corporate headquarters, we are required to provide a standby letter of credit to our landlord as a security deposit, which will be renewed annually until
the end of the lease term. The standby letter of credit is funded under our revolving line of credit and is not required to be secured with cash. As of January 2, 2011, cash and money market funds include $5.0 million, which serves as
collateral on a contract. The contract is cancelable upon 30-days written notice and therefore the cash equivalent is considered readily available within 30 days and reported as cash and cash equivalents on our consolidated balance sheet. In
December 2010, we entered into an agreement to purchase approximately $5.0 million of hardware and software to automate our primary distribution center.

Legal Proceedings

Class Action Laddering Litigation. A
consolidated amended complaint, which is now the operative complaint, was filed on April 19, 2002 in the U.S. District Court for the Southern District of New York. It names drugstore.com 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 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.

In
general, the complaint alleges that the prospectuses through which we conducted the Offerings were materially false and misleading because they failed 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



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



amount and other relief. The action is being coordinated with approximately 300 other nearly identical actions filed against other companies or their present and former officers and directors.

On October 9, 2002, the District Court dismissed the Individual Defendants from the case without prejudice. On
December 5, 2006, the U.S. Court of Appeals for the Second Circuit vacated a decision by the District Court granting class certification in six of the coordinated cases, which are intended to serve as test, or focus, cases. The
plaintiffs selected these six cases, which do not include us. On April 6, 2007, the Second Circuit denied a petition for rehearing filed by plaintiffs, but noted that plaintiffs could ask the District Court to certify more narrow classes than
those that were rejected.

The parties in the approximately 300 coordinated cases, including the parties in
drugstore.coms case, reached a settlement. The insurers for the issuer defendants in the coordinated cases will make the settlement payment on behalf of the issuers, including drugstore.com. The District Court approved the settlement on
October 5, 2009. Two appeals of the settlement approval are proceeding. Plaintiffs have moved to dismiss both appeals.

Due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of this matter. We are unable to
estimate the potential damages that might be awarded if the appeal is successful and we were found liable, there arose a material limitation with respect to our insurance coverage, or the amount awarded were to exceed our insurance coverage. Because
our liability, if any, cannot be reasonably estimated, no amounts have been accrued for this matter. An adverse outcome in 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, other than those listed above.

10. Income Taxes

No federal tax benefit or expense was recorded in 2010, 2009, and 2008, due to our ongoing operating losses. In addition, no tax benefit or expense related to discontinued operations has been recorded due
to the continuing and historical tax losses related to the LPU and mail-order pharmacy businesses. Our deferred tax assets consist primarily of net operating loss carry-forwards and amortization and impairment of intangible assets. We have provided
a valuation allowance for our deferred tax assets to an amount expected to be realized.

At January 2, 2011, we had
approximately $626.9 million of federal net operating loss carry-forwards that will expire beginning in 2018. Internal Revenue Code Section 382 imposes limitations on our ability to utilize net operating losses if we experience an ownership
change. An ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. The value of the stock at the time of an ownership
change is multiplied by the applicable long-term tax exempt interest rate to calculate the annual limitation. Any unused annual limitation may be carried over to later years. Based upon our cumulative historic ownership activity, it likely results
in a significant limitation on the utilization of our net operating loss carryforwards.



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



At January 2, 2011, we had approximately $77.9 million of state net operating loss
carry-forwards that will expire beginning in 2011.

Approximately $12.0 million of our net loss carry-forwards are related to
tax-deductible stock-based compensation in excess of amounts recognized for financial reporting purposes. To the extent that net operating loss carry-forwards, if realized, relate to stock-based compensation, the resulting tax benefits will be
recorded to stockholders equity, rather than to results of operations.

Deferred income tax balances reflect the effects
of temporary differences between the carrying amount of assets and liabilities and their tax bases and are stated at the enacted tax rates expected to be in effect when taxes are actually paid or recovered. Significant components of our deferred tax
assets and liabilities are as follows:



|                                                               |  |                |          |   |                |   |          |  
|-------------------------------------------------------------- |  | -------------- | -------- | - | -------------- | - | -------- | -
|                                                               |  | January 2,2011 |          |   | January 3,2010 |  
|                                                               |  | (in thousands) |         
|Deferred tax assets:                                           |  |                |          |   |                |   |          |  
|Net operating loss carry-forward (federal)                     |  | $              | 219,408  |   |                | $ | 201,837  |  
|Net operating loss carry-forward (state)                       |  |                | 4,690    |   |                |   | 3,822    |  
|Net operating loss carry-forward (foreign)                     |  |                | 106      |   |                |   |         |  
|Depreciation, amortization and impairment of intangible assets |  |                | 20,937   |   |                |   | 27,537   |  
|Tax credit carry-forwards                                      |  |                | 1,462    |   |                |   | 1,414    |  
|Stock based compensation                                       |  |                | 13,760   |   |                |   | 10,451   |  
|Other temporary differences                                    |  |                | 1,659    |   |                |   | 2,749    |  
|                                                               |  |                |          |   |                |   |          |  
|Total gross deferred tax assets                                |  |                | 262,022  |   |                |   | 247,810  |  
|Less valuation allowance                                       |  |                | (262,022 | ) |                |   | (247,810 | )
|                                                               |  |                |          |   |                |   |          |  
|Net deferred tax assets, net of valuation allowance            |  |                |         |   |                |   |         |  
|Deferred tax liabilities:                                      |  |                |          |   |                |   |          |  
|Indefinite-lived intangible assets                             |  |                | (4,079   | ) |                |   | (959     | )
|                                                               |  |                |          |   |                |   |          |  
|Net deferred tax liability                                     |  | $              | (4,079   | ) |                | $ | (959     | )
|                                                               |  |                |          |   |                |   |          |  

A reconciliation of income taxes from continuing operations computed at the statutory rate to the income tax
amount recorded is as follows:



|                                                                    |  |                |        |   |                |   |        |                  |  |   |        |  
|------------------------------------------------------------------- |  | -------------- | ------ | - | -------------- | - | ------ | ---------------- |  | - | ------ | -
|                                                                    |  | January 2,2011 |        |   | January 3,2010 |   |        | December 28,2008 | 
|                                                                    |  | (in thousands) |       
|Income tax benefit at statutory rate                                |  | $              | 1,244  |   |                | $ | 481    |                  |  | $ | 2,899  |  
|State taxes, net of federal impact                                  |  |                | 394    |   |                |   | 242    |                  |  |   | 2,093  |  
|State net operating loss expiration                                 |  |                | (744   | ) |                |   | (7,569 | )                |  |   | (597   | )
|Prior period adjustment-true up deferred balance                    |  |                | (1,541 | ) |                |   |       |                  |  |   |       |  
|Nondeductible transaction costs                                     |  |                | (494   | ) |                |   |       |                  |  |   |       |  
|Impact of rate changeState                                         |  |                | 3,049  |   |                |   | 430    |                  |  |   | (172   | )
|Other                                                               |  |                | 34     |   |                |   | (188   | )                |  |   | (190   | )
|Decrease (increase) in valuation allowance, net of amounts acquired |  |                | (1,942 | ) |                |   | 6,604  |                  |  |   | (4,033 | )
|                                                                    |  |                |        |   |                |   |        |                  |  |   |        |  
|Total income tax benefit                                            |  | $              |       |   |                | $ |       |                  |  | $ |       |  
|                                                                    |  |                |        |   |                |   |        |                  |  |   |        |  



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



11. Stockholders Equity

Outstanding Warrants

We have the following warrants outstanding as of January 2, 2011, issued in connection with various consulting agreements. The fair value of the warrants was determined using the Black-Scholes option
pricing model and recorded in general and administrative expenses in the consolidated statements of operations as follows:



|              |  |        |         |  |               |   |      |                 |  |                                          |         |   |      |   |  |   |     |  |  |   |     | 
|------------- |  | ------ | ------- |  | ------------- | - | ---- | --------------- |  | ---------------------------------------- | ------- | - | ---- | - |  | - | --- |  |  | - | --- | 
|              |  | Shares |         |  | ExercisePrice |   |      | Expiration Date |  | Stock-compensation expense(in thousands) |        
|Issue Date    |  |        |         |  | FY 2010       |   |      | FY 2009         |  |                                          | FY 2008 |  
|February 2010 |  |        | 300,000 |  |               | $ | 2.00 |                 |  | February 2020                            |         | $ | 727  |   |  | $ |    |  |  | $ |    | 
|June 2008     |  |        | 50,000  |  |               | $ | 2.53 |                 |  | June 2018                                |         |   |     |   |  |   |    |  |  |   | 69  | 
|March 2008    |  |        | 100,000 |  |               | $ | 2.53 |                 |  | March 2018                               |         |   |     |   |  |   |    |  |  |   | 163 | 
|June 2007 (1) |  |        | 200,000 |  |               | $ | 2.50 |                 |  | June 2017                                |         |   | (192 | ) |  |   | 345 |  |  |   |    | 
|July 2007     |  |        | 50,000  |  |               | $ | 2.53 |                 |  | July 2017                                |         |   |     |   |  |   |    |  |  |   |    | 
|              |  |        |         |  |               |   |      |                 |  |                                          |         |   |      |   |  |   |     |  |  |   |     | 
|              |  |        | 700,000 |  |               |   |      |                 |  |                                          |         | $ | 535  |   |  | $ | 345 |  |  | $ | 232 | 
|              |  |        |         |  |               |   |      |                 |  |                                          |         |   |      |   |  |   |     |  |  |   |     | 



|(1) | At the end of each reporting period, we adjust the fair value of the June 2007 warrants as they are considered liability instruments.
|--- | -------------------------------------------------------------------------------------------------------------------------------------

12. Employee Benefit Plans

Defined Contribution Plan

We have a defined contribution retirement
plan under Section 401(k) of the Internal Revenue Code, which covers substantially all of our employees (401(k) Plan). Eligible employees may contribute amounts to the 401(k) Plan via payroll withholding, subject to certain limitations.
Under the 401(k) Plan, employees may elect to reduce their current compensation by up to the statutorily prescribed annual limit and to have the amount of such reduction contributed to the 401(k) Plan. The 401(k) Plan permits us but does not require
us to make additional matching contributions to the 401(k) Plan on behalf of all participants in the 401(k) Plan. Beginning in 2008, we began matching 25% of the employee contributions up to $1,000. We made matching contributions under our 401(k)
Plan of approximately $200,000 in 2010 and 2009 and $180,000 in 2008.

Stock-Based Benefit Plans

1998 Stock PlanUnder the terms of our 1998 Stock Plan, as amended (1998 Stock Plan), our board of directors could grant
incentive and nonqualified stock options to employees, officers, directors, agents, consultants, and independent contractors of drugstore.com. Options under this plan generally vest over four years, as follows: 20% of the shares vest after six
months, and the remaining 80% vest quarterly over the subsequent 42 months. Option grants generally had exercise prices equal to the fair market value of the common stock on the date of grant and expire ten years from the date of grant. The 1998
Stock Plan expired in June 2008 and was replaced with the 2008 Equity Incentive Plan (2008 Equity Plan) and no further awards have been or will be granted under the 1998 Stock Plan. The 1998 Stock Plan, however, will continue to govern awards
previously granted under that plan and any outstanding options will continue to vest and will remain outstanding until they are exercised, are forfeited, or expire.

2008 Equity Incentive PlanUnder the terms of the 2008 Equity Plan, which replaced the 1998 Stock Plan, our board of directors may grant stock options, stock appreciation rights,
restricted stock, restricted stock units,



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



performance shares and performance units, and other stock or cash awards to employees, directors, and consultants who provide services to drugstore.com. The board of directors has reserved
8.0 million shares of our common stock for issuance under the 2008 Equity Plan, as well as up to 15.0 million shares from stock options or similar awards granted under the 1998 Stock Plan that expire or otherwise terminate without having
been exercised in full and shares issued pursuant to awards granted under the 1998 Stock Plan that are forfeited or that we repurchase. The shares may be authorized, but unissued, or reacquired common stock. As of January 2, 2011, there
were 5.5 million shares available for grant under the 2008 Equity Plan.

Under the 2008 Equity Plan, stock appreciation
rights, which are the rights to receive the appreciation in fair market value of common stock between the exercise date and the date of grant, become exercisable at the times and on the terms established by the plan administrator. The plan
administrator has complete discretion to determine the terms and conditions of stock appreciation rights granted under the 2008 Equity Plan; provided, however, that the exercise price may not be less than 100% of the fair market value of a share on
the date of grant. The term of a stock appreciation right may not exceed ten years. Under the 2008 Equity Plan, the plan administrator may issue awards of restricted stock, restricted stock units, and performance units and performance
shares at its sole discretion. Restricted stock awards and restricted stock units generally vest every six-months over a period of four years. In June 2010, the Board of Directors approved the granting of restricted stock units as permitted under
the 2008 Plan.

On March 10, 2010, we notified the staff of the Nasdaq Stock Market that we were in material
noncompliance with Rule 5635(c) of the Corporate Governance Requirements of the NASDAQ listing requirements with respect to certain equity awards granted under the 2008 Plan. The 2008 Plan previously required that any award of restricted stock,
among other securities, be counted against the 2008 Plan share reserve as three shares for every one share subject to the award (the Full Value Award Provision). In the first quarter of 2010, our management became aware that we exceeded
the share limit set forth in the 2008 Plan as a result of the inadvertent incorrect application of the Full Value Award Provision. Because the grant of approximately 700,000 shares of restricted stock and awards of options and stock appreciation
rights with respect to approximately 3.4 million shares of common stock exceeded the share reserve limit after proper application of the Full Value Award Provision, we were deemed to have issued securities pursuant to the 2008 Plan without
stockholder approval. Accordingly, we were not in compliance with Rule 5635(c) of the Nasdaq Corporate Governance Requirements.

We submitted our plan to regain compliance with Rule 5635(c) to NASDAQ on March 10, 2010. Our compliance plan conditioned the
release and delivery of certain shares of restricted stock and unvested options and stock appreciation rights on approval by our stockholders of certain amendments to the 2008 Plan. We included those amendments in our 2010 proxy statement as
proposals which were presented at the annual meeting of stockholders, held on June 10, 2010. We also provided notice to affected award recipients on March 15, 2010. On March 16, 2010, NASDAQ informed us that by providing the foregoing
notice to affected equity award recipients, we had regained compliance with Rule 5635(c). On June 10, 2010, our stockholders approved the release and delivery of the restricted stock and unvested options and stock appreciation rights impacted
by the noncompliance with the 2008 Plan. The stockholders also approved an amendment to our 2008 Plan, retroactive to the inception of the 2008 Plan, to decrease from 3.0 to 1.33 the share ratio applied for purposes of counting full value awards.

Under the codification guidance for stock compensation, a grant date cannot occur before all necessary approvals have been
obtained, including stockholder approval of the reservation of sufficient additional shares under the plan. Accordingly, the restricted stock awards, stock options, and stock appreciation rights to purchase common stock granted under the 2008 Plan
beginning on March 6, 2009 were not considered valid grants. Upon



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DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



stockholder approval, the grants became valid grants and the measurement date for the approximately 700,000 restricted stock awards and the 3.4 million stock options and stock appreciation
rights, originally impacted, was June 10, 2010. On the measurement date, the restricted stock awards, stock options, and stock appreciation rights were valued at the closing stock price of $3.47. The stock options and stock appreciation rights
have exercise prices ranging from $0.85 to $2.44, resulting in the stock options and stock appreciation rights being granted as in-the-money awards for purposes of measuring stock compensation expense. In addition, the vesting terms of the
restricted stock awards, stock options, and stock appreciation rights were accelerated. As a result, we recognized $2.5 million of stock compensation expense in the second quarter of 2010 relating to these awards.

1999 Employee Stock Purchase PlanUnder the terms of our 1999 Employee Stock Purchase Plan, as amended (1999 ESPP), eligible
employees could purchase common stock for a purchase price equal to 85% of the fair market value of our common stock on the first or last day, whichever is less, of the applicable six-month purchase period, which periods end in January and July of
each year, except in 2009, when the period ended in June upon the expiration of the 1999 ESPP. For the years ended January 3, 2010 and December 28, 2008 employees purchased 106,500 and 92,047 shares, respectively, of our common stock under
the 1999 ESPP in exchange for $94,000 and $189,000, respectively.

Determining Fair Value

The following weighted-average assumptions were used in arriving at the fair value of each stock option and stock appreciation right
grant:



|                            |  |                    |      |   |                |   |      |                  |  |   |      |  
|--------------------------- |  | ------------------ | ---- | - | -------------- | - | ---- | ---------------- |  | - | ---- | -
|                            |  | For the year ended |     
|                            |  | January 2,2011     |      |   | January 3,2010 |   |      | December 28,2008 | 
|Expected volatility         |  |                    | 71   | % |                |   | 70   | %                |  |   | 65   | %
|Expected term (in years)    |  |                    | 4.7  |   |                |   | 4.7  |                  |  |   | 4.3  |  
|Risk-free interest rate     |  |                    | 1.8  | % |                |   | 1.8  | %                |  |   | 2.5  | %
|Expected dividend           |  |                    | 0    | % |                |   | 0    | %                |  |   | 0    | %
|Weighted-average fair value |  | $                  | 2.30 |   |                | $ | 0.28 |                  |  | $ | 1.40 |  

Volatility

Our computation of expected volatility is based on our historical volatility, adjusted for changes in capital structure and corporate
changes, information available that may indicate future volatility, and observable mean reversion tendencies of historical volatility.

Expected Term

Our
expected term estimates are based on a comprehensive weighted average life (WAL) analysis. The WAL analysis provides a historical based platform for use in developing expected term estimates for the future based on the historically observed time
periods from grant date through post-vesting activities, such as exercise and cancellation. The historical grant data is segregated into pre-vesting forfeitures, post-vesting forfeitures, outstanding and unvested grants, and outstanding and vested
grants and then data is included or excluded in the WAL depending on the applicable contractual or vesting provisions, differences in other option terms and insufficient elapsed time from grant date or from vesting dates. We also analyze by
homogenous group, which includes employees, executives, our chief executive officer, board members, and other non-employees, the weighted average time from grant date to post-vesting activity. For those grants still outstanding, we developed a
reasonable assumption regarding the expected time of settlement.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Risk-Free Interest Rate and Dividend Yield

We base the risk-free interest rate on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent
remaining term. Where the expected term of our stock-based awards do not correspond with the terms for which interest rates are quoted, we average the periods to determine the rate from the available term maturities. A dividend yield of 0% was
considered appropriate as we have not issued and do not anticipate issuing any dividends in the near future.

Forfeitures

We are required to recognize stock-based compensation expense based on the number of awards expected to vest. Accordingly, we apply a
forfeiture rate of 35% to employee options and stock appreciation rights, a 15% forfeiture rate to employee restricted stock and restricted stock unit awards, except that we use a forfeiture rate of 0% for our chief executive officer and board
members. When estimating forfeitures, we considered historical voluntary termination behavior and turnover, in addition to analyzing actual forfeitures.

Stock Option and Stock Appreciation Rights Activity

The following table summarizes
our stock option and stock appreciation rights activity:



|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 
|---------------------------------------------- |  | --------------- | ---------- | - | -------------------------------------- | - | ---- | ---------------------------------------- |  |  | ---- | 
|                                               |  | Number ofShares |            |   | Weighted-AverageExercisePrice perShare |   |      | Weighted-AverageRemainingContractualTerm | 
|Outstanding at January 3, 2010                 |  |                 | 16,635,725 |   |                                        | $ | 3.16 |                                          |  |  |      | 
|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 
|Options granted (1)                            |  |                 | 4,551,624  |   |                                        | $ | 2.28 |                                          |  |  |      | 
|Options exercised                              |  |                 | (355,650   | ) |                                        | $ | 2.22 |                                          |  |  |      | 
|Options forfeited                              |  |                 | (767,357   | ) |                                        | $ | 6.07 |                                          |  |  |      | 
|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 
|Outstanding at January 2, 2011                 |  |                 | 20,064,342 |   |                                        | $ | 2.86 |                                          |  |  |      | 
|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 
|Vested and expected to vest at January 2, 2011 |  |                 | 17,597,559 |   |                                        | $ | 2.95 |                                          |  |  | 5.36 | 
|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 
|Exercisable at January 2, 2011                 |  |                 | 16,367,193 |   |                                        | $ | 2.98 |                                          |  |  | 5.13 | 
|                                               |  |                 |            |   |                                        |   |      |                                          |  |  |      | 



|(1) | Includes 3.4 million stock options and stock appreciation rights that were subject to stockholder approval, which was obtained on June 10, 2010.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------

The aggregate intrinsic value for stock options and stock appreciation rights was $0.8 million for awards
vested and expected to vest and $0.7 million for awards exercisable at January 2, 2011. The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the market price of our common stock
for the 1.1 million shares subject to options that were in-the-money at January 2, 2011 (i.e., with an exercise price of $2.21 or less). As of January 2, 2011, the total compensation cost related to unvested options and stock
appreciation rights granted totaled $3.2 million, net of estimated forfeitures of approximately $4.9 million. This cost will be amortized on a straight-line basis over a weighted-average period of 2.3 years and will be adjusted for subsequent
changes in estimated forfeitures.

The aggregate intrinsic value of options exercised was $0.4 million, $41,000, and $32,000,
as of January 2, 2011, January 3, 2010, and December 28, 2008.



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



Restricted Stock Awards Activity

The following table summarizes our restricted stock awards activity:



|                            |  |                 |            |   |                                      |   |      | 
|--------------------------- |  | --------------- | ---------- | - | ------------------------------------ | - | ---- | 
|                            |  | Number ofShares |            |   | Weighted-AverageGrant DateFair Value |  
|Unvested at January 3, 2010 |  |                 | 2,130,000  |   |                                      | $ | 0.76 | 
|                            |  |                 |            |   |                                      |   |      | 
|Awards granted (1)          |  |                 | 693,503    |   |                                      | $ | 3.47 | 
|Awards released             |  |                 | (1,063,644 | ) |                                      | $ | 1.66 | 
|Awards forfeited            |  |                 | (88,668    | ) |                                      | $ | 1.79 | 
|                            |  |                 |            |   |                                      |   |      | 
|Unvested at January 2, 2011 |  |                 | 1,671,191  |   |                                      | $ | 1.26 | 
|                            |  |                 |            |   |                                      |   |      | 



|(1) | Includes 0.7 million restricted stock awards that were subject to stockholder approval, which was obtained on June 10, 2010.
|--- | ----------------------------------------------------------------------------------------------------------------------------

The weighted average fair value of restricted stock awards granted during 2009 was $0.78.

Restricted Stock Units Activity

The following table summarizes our restricted stock units activity:



|                            |  |                 |           |   |                                      |   |      | 
|--------------------------- |  | --------------- | --------- | - | ------------------------------------ | - | ---- | 
|                            |  | Number ofShares |           |   | Weighted-AverageGrant DateFair Value |  
|Unvested at January 3, 2010 |  |                 |          |   |                                      | $ |     | 
|                            |  |                 |           |   |                                      |   |      | 
|Units granted               |  |                 | 1,363,646 |   |                                      | $ | 2.26 | 
|Units vested                |  |                 | (53,151   | ) |                                      | $ | 3.47 | 
|Units forfeited             |  |                 | (35,823   | ) |                                      | $ | 3.04 | 
|                            |  |                 |           |   |                                      |   |      | 
|Unvested at January 2, 2011 |  |                 | 1,274,672 |   |                                      | $ | 2.19 | 
|                            |  |                 |           |   |                                      |   |      | 

As of January 2, 2011, the total compensation cost related to unvested restricted stock
awards and restricted stock units granted totaled $3.5 million, net of estimated forfeitures of approximately $1.3 million. This cost will be amortized on a straight-line basis over a weighted-average period of 2.9 years and will be adjusted for
subsequent changes in estimated forfeitures.

Stock Compensation Expense

The following table summarizes stock-based compensation by operating function recorded in the Statements of Operations:



|                                 |  |                     |       |  |                |   |       |                  |  |   |       | 
|-------------------------------- |  | ------------------- | ----- |  | -------------- | - | ----- | ---------------- |  | - | ----- | 
|                                 |  | For the years ended |      
|                                 |  | January 2,2011      |       |  | January 3,2010 |   |       | December 28,2008 | 
|                                 |  | (in thousands)      |      
|Fulfillment and order processing |  | $                   | 949   |  |                | $ | 512   |                  |  | $ | 576   | 
|Marketing and sales              |  |                     | 2,158 |  |                |   | 1,576 |                  |  |   | 1,619 | 
|Technology and content           |  |                     | 1,588 |  |                |   | 1,102 |                  |  |   | 1,265 | 
|General and administrative       |  |                     | 4,254 |  |                |   | 2,210 |                  |  |   | 4,104 | 
|                                 |  |                     |       |  |                |   |       |                  |  |   |       | 
|Total                            |  | $                   | 8,949 |  |                | $ | 5,400 |                  |  | $ | 7,564 | 
|                                 |  |                     |       |  |                |   |       |                  |  |   |       | 



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



13. Segment Information

We have two reporting segments: over-the-counter (OTC) and vision. The OTC segment is comprised of the sales and related costs of selling all non-prescription health, beauty, personal care, household, and
other products, and includes the results of Salu beginning as of February 20, 2010. Our vision segment is comprised of sales and the related costs of selling contact lenses and other contact lens supplies through Vision Direct. On July 30,
2010, we closed our sale of our mail-order pharmacy assets to BioScrip, as discussed in Note 3 of our consolidated financial statements. As a result, we have presented our mail-order pharmacy segment as discontinued operations beginning with the
second quarter of 2010 and for all prior periods presented. We operate and evaluate our business segments based on contribution margin results. We define contribution margin as net sales attributable to a segment, less the direct cost of these sales
and the incremental (variable) costs of fulfilling, processing, and delivering the order (labor, packaging supplies, and credit card fees that are variable based on sales volume). In the second quarter of 2010, our chief operating decision makers
modified our definition of variable order costs to exclude partnership-related royalty costs, which are variable in nature, but are considered more reflective of a marketing cost since we consider our partnerships a marketing channel, thus we have
restated prior periods to reflect this change in the definition of contribution margin. The information presented below for these segments is the information our management uses in evaluating operating performance.



|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|------------------------ |  | ------------------- | ------- |  | -------------- | - | ------- | ---------------- |  | - | ------- | 
|                         |  | For the years ended |        
|                         |  | January 2,2011      |         |  | January 3,2010 |   |         | December 28,2008 | 
|                         |  | (in thousands)      |        
|OTC:                     |  |                     |         |  |                |   |         |                  |  |   |         | 
|Net sales                |  | $                   | 385,234 |  |                | $ | 306,854 |                  |  | $ | 260,794 | 
|Cost of sales            |  |                     | 267,681 |  |                |   | 210,456 |                  |  |   | 180,252 | 
|Variable order costs (a) |  |                     | 32,851  |  |                |   | 26,528  |                  |  |   | 23,408  | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|Contribution margin (b)  |  | $                   | 84,702  |  |                | $ | 69,870  |                  |  | $ | 57,134  | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|                         |  |                     |        
|Vision:                  |  |                     |         |  |                |   |         |                  |  |   |         | 
|Net sales                |  | $                   | 71,273  |  |                | $ | 68,720  |                  |  | $ | 61,420  | 
|Cost of sales            |  |                     | 54,330  |  |                |   | 52,894  |                  |  |   | 47,279  | 
|Variable order costs (a) |  |                     | 3,343   |  |                |   | 3,172   |                  |  |   | 2,899   | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|Contribution margin (b)  |  | $                   | 13,600  |  |                | $ | 12,654  |                  |  | $ | 11,242  | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|                         |  |                     |        
|Consolidated:            |  |                     |         |  |                |   |         |                  |  |   |         | 
|Net sales (c)            |  | $                   | 456,507 |  |                | $ | 375,574 |                  |  | $ | 322,214 | 
|Cost of sales            |  |                     | 322,011 |  |                |   | 263,350 |                  |  |   | 227,531 | 
|Variable order costs (a) |  |                     | 36,194  |  |                |   | 29,700  |                  |  |   | 26,307  | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 
|Contribution margin (b)  |  | $                   | 98,302  |  |                | $ | 82,524  |                  |  | $ | 68,376  | 
|                         |  |                     |         |  |                |   |         |                  |  |   |         | 



|(a) | These amounts include all variable costs of fulfillment and order processing, including labor, packaging supplies, and credit card fees that are variable based on sales
volume. These amounts exclude depreciation, fixed overhead costs, and stock-based compensation.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) | Contribution margin represents a measure of how well each segment is contributing to our operating goals. It is calculated as net sales less the direct cost of these
sales and the incremental (variable) fulfillment and order processing costs of delivering orders to our customers.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(c) | Net sales in 2010, 2009 and 2008 were comprised of 97%, 98% and 99% of sales in the United States of America, respectively.
|--- | ---------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



|                                                         |  |   |        |   |  |   |        |   |  |   |         |  
|-------------------------------------------------------- |  | - | ------ | - |  | - | ------ | - |  | - | ------- | -
|Consolidated contribution margin for reportable segments |  | $ | 98,302 |   |  | $ | 82,524 |   |  | $ | 68,376  |  
|Less:                                                    |  |   |        |   |  |   |        |   |  |   |         |  
|Fixed fulfillment and order processing (d)               |  |   | 13,410 |   |  |   | 12,191 |   |  |   | 12,589  |  
|Marketing and sales                                      |  |   | 46,550 |   |  |   | 37,727 |   |  |   | 32,464  |  
|Technology and content                                   |  |   | 27,303 |   |  |   | 24,864 |   |  |   | 22,995  |  
|General and administrative                               |  |   | 20,221 |   |  |   | 17,642 |   |  |   | 19,866  |  
|                                                         |  |   |        |   |  |   |        |   |  |   |         |  
|Operating loss                                           |  | $ | (9,182 | ) |  | $ | (9,900 | ) |  | $ | (19,538 | )
|                                                         |  |   |        |   |  |   |        |   |  |   |         |  



|(d) | These amounts include all fixed costs of fulfillment and order processing that are not discernable by business segment.
|--- | -----------------------------------------------------------------------------------------------------------------------

The following table presents assets by segment and geographic asset information:



|                             |  |                |         |  |                |   |         | 
|---------------------------- |  | -------------- | ------- |  | -------------- | - | ------- | 
|                             |  | January 2,2011 |         |  | January 3,2010 |  
|                             |  | (in thousands) |        
|Total Assets:                |  |                |         |  |                |   |         | 
|OTC                          |  | $              | 103,268 |  |                | $ | 58,744  | 
|Vision                       |  |                | 37,457  |  |                |   | 36,542  | 
|Discontinued operations      |  |                | 2,440   |  |                |   | 2,832   | 
|Corporate                    |  |                | 57,207  |  |                |   | 56,411  | 
|                             |  |                |         |  |                |   |         | 
|Consolidated                 |  | $              | 200,372 |  |                | $ | 154,529 | 
|                             |  |                |         |  |                |   |         | 
|Property and Equipment, Net: |  |                |         |  |                |   |         | 
|United States of America     |  | $              | 25,120  |  |                | $ | 24,071  | 
|Australia                    |  |                | 54      |  |                |   |        | 
|Canada                       |  |                | 7       |  |                |   | 33      | 
|                             |  |                |         |  |                |   |         | 
|Consolidated                 |  | $              | 25,181  |  |                | $ | 24,104  | 
|                             |  |                |         |  |                |   |         | 



F-32



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##### Table of Contents

DRUGSTORE.COM, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



14. Quarterly Results of Operations (unaudited)

The following tables contain selected unaudited consolidated statement of operations information for each quarter of fiscal years 2010 and
2009. We believe that the following information reflects all normal recurring adjustments necessary for a fair presentation of the information for the periods presented. The operating results for any quarter are not necessarily indicative of results
for any future period.



|                                                |  |                                         |             |   |                  |   |             |              |  |   |               |   |  |              |             |   |               |   |            |              |  |   |                   |   |  |   |            |   |  |   |            |  
|----------------------------------------------- |  | --------------------------------------- | ----------- | - | ---------------- | - | ----------- | ------------ |  | - | ------------- | - |  | ------------ | ----------- | - | ------------- | - | ---------- | ------------ |  | - | ----------------- | - |  | - | ---------- | - |  | - | ---------- | -
|                                                |  | Fiscal Year 2010                        |             |   | Fiscal Year 2009 |  
|                                                |  | FirstQuarter (3)                        |             |   | SecondQuarter    |   |             | ThirdQuarter |  |   | FourthQuarter |   |  | FirstQuarter |             |   | SecondQuarter |   |            | ThirdQuarter |  |   | FourthQuarter (1) |  
|                                                |  | ($ in thousands, except per share data) |            
|Net sales                                       |  | $                                       | 110,933     |   |                  | $ | 113,147     |              |  | $ | 108,791       |   |  | $            | 123,636     |   |               | $ | 89,528     |              |  | $ | 88,880            |   |  | $ | 88,576     |   |  | $ | 108,590    |  
|Cost of sales                                   |  |                                         | 77,753      |   |                  |   | 78,705      |              |  |   | 77,160        |   |  |              | 88,393      |   |               |   | 63,526     |              |  |   | 62,040            |   |  |   | 61,937     |   |  |   | 75,847     |  
|Loss from continued operations                  |  |                                         | (3,116      | ) |                  |   | (2,948      | )            |  |   | (2,335        | ) |  |              | (1,215      | ) |               |   | (2,718     | )            |  |   | (2,530            | ) |  |   | (2,353     | ) |  |   | (2,253     | )
|Gain from discontinued operations               |  |                                         | 500         |   |                  |   | 274         |              |  |   | 4,738         |   |  |              | 552         |   |               |   | 3,572      |              |  |   | 3,556             |   |  |   | 719        |   |  |   | 630        |  
|Net income (loss)                               |  |                                         | (2,616      | ) |                  |   | (2,674      | )            |  |   | 2,403         |   |  |              | (663        | ) |               |   | 854        |              |  |   | 1,026             |   |  |   | (1,634     | ) |  |   | (1,623     | )
|Basic and diluted:                              |  |                                         |             |   |                  |   |             |              |  |   |               |   |  |              |             |   |               |   |            |              |  |   |                   |   |  |   |            |   |  |   |            |  
|Loss from continuing operations per share       |  | $                                       | (0.03       | ) |                  | $ | (0.03       | )            |  | $ | (0.02         | ) |  | $            | (0.01       | ) |               | $ | (0.03      | )            |  | $ | (0.03             | ) |  | $ | (0.02      | ) |  | $ | (0.02      | )
|Gain from discontinued operations per share     |  | $                                       | 0.00        |   |                  | $ | 0.00        |              |  | $ | 0.04          |   |  | $            | 0.00        |   |               | $ | 0.04       |              |  | $ | 0.04              |   |  | $ | 0.01       |   |  | $ | 0.01       |  
|                                                |  |                                         |             |   |                  |   |             |              |  |   |               |   |  |              |             |   |               |   |            |              |  |   |                   |   |  |   |            |   |  |   |            |  
|Net income (loss) per share (2)                 |  | $                                       | (0.03       | ) |                  | $ | (0.03       | )            |  | $ | 0.02          |   |  | $            | (0.01       | ) |               | $ | 0.01       |              |  | $ | 0.01              |   |  | $ | (0.02      | ) |  | $ | (0.02      | )
|                                                |  |                                         |             |   |                  |   |             |              |  |   |               |   |  |              |             |   |               |   |            |              |  |   |                   |   |  |   |            |   |  |   |            |  
|Weighted average shares used in computation of: |  |                                         |             |   |                  |   |             |              |  |   |               |   |  |              |             |   |               |   |            |              |  |   |                   |   |  |   |            |   |  |   |            |  
|Basic net income (loss) per share               |  |                                         | 102,605,614 |   |                  |   | 104,992,447 |              |  |   | 105,628,635   |   |  |              | 103,406,014 |   |               |   | 97,355,613 |              |  |   | 99,727,521        |   |  |   | 96,932,740 |   |  |   | 97,390,984 |  
|Diluted net income (loss) per share             |  |                                         | 102,605,614 |   |                  |   | 104,992,447 |              |  |   | 105,628,635   |   |  |              | 103,406,014 |   |               |   | 97,355,613 |              |  |   | 99,727,521        |   |  |   | 96,932,740 |   |  |   | 97,390,984 |  



|(1) | The fourth quarter of 2009 is a 14-week quarter.
|--- | ------------------------------------------------

|(2) | Net income (loss) per share on a quarterly basis does not sum to the annual net loss per share as a result of the impact of participating securities on the weighted
average number of shares used in the computation in the periods with net income.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(3) | The first quarter of 2010 includes $1.8 million of transaction and integration related costs to the acquisition of Salu, and $0.65 million of vision migration costs
related to our move of our vision fulfillment operations from Ferndale, Washington, to Swedesboro, New Jersey.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

DRUGSTORE.COM, INC.

SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS

(in thousands)



|                                           |  |                                     |         |  |                                                    |  |        |            |  |  |                                |   |  |  |         | 
|------------------------------------------ |  | ----------------------------------- | ------- |  | -------------------------------------------------- |  | ------ | ---------- |  |  | ------------------------------ | - |  |  | ------- | 
|Description                                |  | Balance atbeginning offiscal period |         |  | Charges torevenue, costsand expenses,and additions |  |        | Deductions |  |  | Balance at endof fiscal period |  
|Allowance for doubtful accounts (a)        |  |                                     |         |  |                                                    |  |        |            |  |  |                                |   |  |  |         | 
|Year Ended January 2, 2011                 |  |                                     | 69      |  |                                                    |  | 200    |            |  |  | (214                           | ) |  |  | 55      | 
|Year Ended January 3, 2010                 |  |                                     | 16      |  |                                                    |  | 310    |            |  |  | (257                           | ) |  |  | 69      | 
|Year Ended December 28, 2008               |  |                                     | 41      |  |                                                    |  | 183    |            |  |  | (208                           | ) |  |  | 16      | 
|Allowance for sales returns (b)            |  |                                     |         |  |                                                    |  |        |            |  |  |                                |   |  |  |         | 
|Year Ended January 2, 2011                 |  |                                     | 418     |  |                                                    |  | 4,804  |            |  |  | (4,844                         | ) |  |  | 378     | 
|Year Ended January 3, 2010                 |  |                                     | 320     |  |                                                    |  | 4,642  |            |  |  | (4,544                         | ) |  |  | 418     | 
|Year Ended December 28, 2008               |  |                                     | 493     |  |                                                    |  | 3,633  |            |  |  | (3,806                         | ) |  |  | 320     | 
|Deferred tax asset valuation allowance (c) |  |                                     |         |  |                                                    |  |        |            |  |  |                                |   |  |  |         | 
|Year Ended January 2, 2011                 |  |                                     | 247,810 |  |                                                    |  | 14,212 |            |  |  |                               |   |  |  | 262,022 | 
|Year Ended January 3, 2010                 |  |                                     | 254,414 |  |                                                    |  |       |            |  |  | (6,604                         | ) |  |  | 247,810 | 
|Year Ended December 28, 2008               |  |                                     | 250,381 |  |                                                    |  | 4,033  |            |  |  |                               |   |  |  | 254,414 | 



|(a) | Deductions consist of write-offs of uncollectible accounts, net of recoveries.
|--- | ------------------------------------------------------------------------------

|(b) | Deductions consist of sales credits to customers for product returns.
|--- | ---------------------------------------------------------------------

|(c) | Additions and deductions are the result of changes in our net deferred assets.
|--- | ------------------------------------------------------------------------------



F-34



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##### Table of Contents

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 18, 2011.



DRUGSTORE.COM, INC.By:

/S/    DAWN G.
LEPOREDawn G. Lepore President, Chief Executive Officer and Chairman of the
Board


POWER OF ATTORNEY

Each person whose individual signature appears below hereby authorizes and appoints Dawn G. Lepore and Robert P. Potter, and each of
them, with full power of substitution and resubstitution and full power to act without the other, as his or her true and lawful attorney-in-fact and agent to act in his or her name, place and stead and to execute in the name and on behalf of each
person, individually and in each capacity stated below, and to file, any and all amendments to this report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission,
granting unto such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing, ratifying and confirming all that said attorneys-in-fact and agents or any of them or their or his or her
substitute or substitutes may lawfully do or cause to be done by virtue thereof.

Pursuant to the requirements of the
Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities indicated as of March 18, 2011.



|                                                   |  |                                                                                           
|-------------------------------------------------- |  | ------------------------------------------------------------------------------------------
|Signature                                          |  | Title                                                                                     
|                                                   | 
|/S/    DAWN G.
LEPORE Dawn G. Lepore               |  | President, Chief Executive Officer and Chairman of the Board (Principal Executive Officer)
|                                                   | 
|/S/    ROBERT P.
POTTER Robert P. Potter           |  | Vice President, Chief Accounting Officer (Principal Financial and Accounting Officer)     
|                                                   | 
|/S/    RICHARD W. BENNET
III Richard W. Bennet III |  | Director                                                                                  
|                                                   | 
|/S/    GEOFFREY R.
ENTRESS Geoffrey R. Entress     |  | Director                                                                                  
|                                                   | 
|/S/    JEFFREY M.
KILLEEN Jeffrey M. Killeen       |  | Director                                                                                  
|                                                   | 
|/S/    WILLIAM D.
SAVOY William D. Savoy           |  | Director                                                                                  
|                                                   | 
|/S/    GREGORY S.
STANGER Gregory S. Stanger       |  | Director                                                                                  



F-35