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Drugstore.com Inc. (NASDAQ:DSCM)

Q4 2005 Earnings Conference Call

February 1st 2006, 5:00 PM.

Executives:

Dawn Lepore, President, Chief Executive Officer, and Chairman

Bob Barton, Vice President of Finance and Chief Financial Officer

Brinlea Johnson, Investor Relations

Analysts:

Brian Fitzgerald, Morgan Stanley

Kevin Sonich, RK Capital

Ryan Randall, Randall Capital

Operator

Good afternoon ladies and gentlemen, and welcome to the drugstore.com quarterly results conference call. At this time, all participants are in a listen-only mode. Following today’s presentation, instructions will be given for the question-and-answer session. As a reminder, this conference is being recorded Wednesday, February 1, 2006. I would now like to turn the conference over to Brinlea Johnson of the Blue Shirt Group. Please go ahead, Ms. Johnson.

Brinlea Johnson, Investor Relations

Good afternoon. Welcome to the drugstore.com fourth quarter and fiscal year 2005 earnings call. With me today is Dawn Lepore, Chairman and Chief Executive Officer; and Bob Barton, Chief Financial Officer.

Before we get started, we would like to remind you that the information on this call may include forward-looking statements. Words such as "targets," "expects," "believes," "anticipates," and similar expressions, are intended to identify forward-looking statements which involve risks and uncertainties that could cause drugstore.com’s actual results to differ materially from those discussed in the forward-looking statements. In particular, comments about drugstore.com’s anticipated future revenues, earnings, and growth rates are forward looking. Factors that could cause actual results to differ materially from anticipated results are detailed in our periodic filings with the SEC. I would also like to point out that during the call we do mention certain non-GAAP financial measures which will be explained during the call. A reconciliation of these non-GAAP measures and most comparable GAAP measures can be found in our earnings press release which was made available prior to today’s call. Adjusted EBITDA is an example of a non-GAAP measure used in this call. Adjusted EBITDA is defined as earnings before interest, taxes, depreciation, and amortization of intangible assets, non-cash marketing, and soft based compensation and adjusted to exclude non-cash charges for impairment of goodwill and other intangible assets and non-cash litigation settlement.

I would also like to note that as previously disclosed, drugstore.com operates on 52/53-week retail calendar year with each quarter and a 52-week fiscal year representing a 13-week period. Fiscal year 2004 was a 53-week fiscal year, with the fourth quarter representing a 14-week period. Fiscal 2005 was a 52-week fiscal year, with the fourth quarter representing a 13-week period. All year-over-year growth rates noted in this call have been adjusted to reflect the extra week including the fourth quarter of 2004 unless stated otherwise. Non-adjusted growth rates can be found in our earnings press release.

Finally, today’s call is being recorded and will be available for replay on drugstore.com’s web site at www.drugstore.com under Corporate Information. In addition, the earnings press release for the fourth quarter and fiscal 2005 including a summary of our financials and supplemental financial information discussed on this call will be available on our web site also under Corporate Information section.

With that, I’ll turn the call over to Dawn Lepore, Chairman and Chief Executive Officer.

Dawn Lepore, President, Chief Executive Officer, and Chairman

Thanks, Brinlea. Good afternoon, everyone, and thank you for joining us. Today I’d like to provide an overview of our fourth quarter results and an update on the important strategic changes we’re making to achieve adjusted EBITDA profitability during 2006. Following my remarks, I’ll turn the call over to Bob to go over the financials in more detail.

Let me start with our results. Total sales for the fourth quarter were an all-time high, up 10% sequentially to $106.4 million, bringing fiscal year 2005 sales to just under 400 million. We reported strong progress in our core growth businesses, with OTC increasing year-over-year by 26%, excluding wholesale, and mail-order pharmacy increasing year-over-year by 19%. OTC is our fasting growing category and we reported our highest ever sales of 50.8 million this quarter, excluding our wholesale OTC business. We continue to see steady growth across our product categories, but in particular we’ve seen strong growth in our natural and nutrition and wellness categories, which are up over 90% year-over-year, and our beauty business which has grown by more than 40% from Q4 of 2004.

Sales growth has continued to cross a broad range of SKUs, ranging from strong sales of the Phillips Heart Start defibrillator which retails for just over $1200 to selling over 30,000 toy marshmallow shooters during the quarter which retail at $19.99. Mail-order pharmacy sales were also an all-time high at $20 million this quarter as we reached a record $151 net revenue per order. We continue to look for ways to improve our Rx mail margin and advance new partnerships and have seen evidence of success with our agreement with Medical Services Corporation, which has grown by 80% from the third quarter of 2005.

In our other business segments, sales from local pickup pharmacy and vision were relatively flat when adjusted to the extra week in the fourth quarter of 2004, at 23.8 million and 11.3 million, respectively. The fourth quarter is our seasonally strongest sales quarter and we reported a number of impressive key metrics. During the quarter, we acquired 351,000 new customers, our largest ever volume of new customers acquired in a single quarter and had over 2 million customers active within the last 12 months. Repeat customers drove 80% of sales this quarter and repeat OTC revenue increased by 35% year-over-year. Gross margins were 21.4%, our best performance in almost two years.

That brings me to the bottom line. Adjusted EBITDA loss was better than we expected at 1.8 million and reflected both 2.6 million in brand spend and a $560,000 write-off of internally developed software. Clearly you can see that we are close to being profitable and I believe we will be profitable on an adjusted EBITDA basis for the second half of 2006. I am particularly pleased to be talking about profitability on this call. We are absolutely committed to achieving adjusted EBITDA profitability during 2006. When I started a little over a year ago, the Company was very focused on a topline story. We were focused on getting profitable through obtaining additional scale and in order to get that scale we felt we had to be competitive across as many markets and as many products as possible. We are still focused on our topline. Make no mistake about that, and our OTC business will be one of the key drivers of our growth. We will continue to targeting OTC growth rates of 25% or more, and I believe that growth rate is sustainable.

But in addition to growth, we have increased our focus on the profitability of each and every order going out the door. That analysis has led us to refine our strategy, focusing on our core profitable customers and making sure that we are charging adequately for value-added services. We have made and will continue to make important changes that may modestly impact sales growth which should increase profitability and accelerate us toward our goal of driving positive cash flow. These changes are very consistent with the strong value proposition that our customers have come to expect from us.

During the fourth quarter, we adjusted our shipping policy for hard to reach locations like Alaska, Hawaii, and overseas. We’ve added shipping surcharges to these locations in order to address the high transportation costs associated with serving these loyal customers. The surcharge is modest but allows us to turn unprofitable orders into profitable ones.

Also in the fourth quarter we eliminating three upgraded shipping on orders of $99 or greater. Our customers are very interested in being able to earn free shipping, currently earned at $49, and we’ve seen a positive impact on baskets from the $49 free shipping hurdle, but the return on upgraded, or three-day shipping, has been less compelling and didn’t justify the expense. We believe this change should save us roughly $500,000 in 2006.

As explained in our last call, effective November 9, 2005, we terminated our partnership with Amazon. While this resulted in year-over-year fourth quarter sales impact on $4 million, we eliminated a management distraction and ended a low margin business. In addition, we resolved our dispute and restructured our partnership with Weil Lifestyle, a partner in our customized vitamins business. The new Weil agreement should benefit in a number of ways, including eliminating 500,000 of marketing spending.

Under our new agreement, Weil has taken on responsible to grow and market this business while we will active as an exclusive fulfillment partner. This will allow us to continue to serve our customized vitamin customers profitably. Those are the highlights of the changes we made in the fourth quarter of 2005.

Now I’d like to cover some of the changes we’re making in 2006. First, we will be adjusting our backorder shipping policy to give consumers the opportunity to get the products they want without drugstore.com incurring all the additional packaging and shipping costs. We believe this should save us approximately $400,000 this year. We will also be implementing a surcharge for heavier orders, although only a small percentage of our overall volume of orders, these orders have been very challenging from a profitability and we continue to edit SKUs and refine prices. Over the last month, we have been performing a full profitability analysis of all of the SKUs and have reached the conclusion that as many as 4000 of our more than 25,000 SKUs can be eliminated or price adjusted, providing a benefit to our bottom line without a real impact on our product collection or value proposition.

In addition to reviewing our OTC partnership, we’ve been looking at all of our pharmacy contracts and agreements. In the pharmacy area, Medicare Part D is one of the biggest changes in the industry. After much analysis, we’ve chosen not to participate in Medicare Part D due to the very low margins, high customer contact costs, and complexity around managing this benefit. While some of our customers who are over 65 years of age will migrate to Med D and may have some impact on our revenue growth, this impact has been factored into our 2006 plan and guidance. We believe we will continue to see double-digit growth in our mail-order pharmacy business in 2006 and produce a much stronger bottom line, and we will continue to serve customers who participate in Medicare Part D by providing access to low-cost medications that fall out of the customers Med D coverage.

In addition to looking at each order, and each partnership, we have been carefully scrutinizing our marketing expenses. In 2005, we tested a number of marketing vehicles to accelerate our growth and gain valuable insight into which program drive customer behavior. As part of our 2006 budgeting process, we did a very careful analysis of each and every marketing program examining the effectiveness, return, and relative performance of each. Our goal was to identify programs that provide the greatest growth at the lowest cost, to identify which programs help us drive to profitability, and which will be deferred until we have the cash to self-fund.

Our analysis confirmed that search both free and paid is a cornerstone of our new customer acquisition and continues to show very high ROI. In addition, the changes we’re making to our site and shopping experience has driven significant changes to customer conversion and our personalization effort both on the site and in e-mail shows very strong returns.

By comparison, catalog, direct mail, and in-box inserts have proven to be more expensive. Our primary goal in 2006 is profitability; therefore, I’ve made the decision to wind down our brand campaign and eliminate our catalogs, direct mail, and in-box marketing spends. I believe that we can still deliver strong topline growth in our OTC business in 2006 and making these adjustments should allow us to reduce our marketing expense as a percent of sales to a 6% to 7% range by midyear.

In addition, our customer acquisition costs should return to the $19 to low $20 range. Once we are profitable, we will look at increasing our investment in marketing and will be well positioned to spend those dollars effectively. Of course, one of our biggest initiatives in 2005 was our brand campaign. We launched the campaign on September 1, 2005, and as promised we’ve taken a detailed look at the results of the campaign over the last four months of the year and here are the highlights of our results. We saw incremental new customer orders in all three cities, New York, San Francisco, and Chicago.

In addition, when customers were aware of the advertising it positively improved their perception of drugstore.com and made them more likely to shop drugstore. For example, brand consideration increased from 49% to 68% in those customers who aware of our advertising. These results tell us that the ads were effective vehicles of communicating the brand position and persuading customers. Lastly, both aided brand awareness and aided advertising awareness saw a statistically significant increase. There were some metrics, however, that were not as strong as I would have liked. For example, the increase in new customer traffic was not consistent over the four-month period. In addition, there was no improvement to repeat customer behavior due to the campaign and no apparent improvement in new customer order size.

The bottom line of our analysis is that our core brand positioning and strategy resonates with customers and once they are aware of the ads they are effective at convincing customers to purchase from us. The ads were effective and advertising can drive growth in our business. But in my mind the real issue is about speed of payback. Four months is a relatively short duration for a campaign and the indications are that with time we would see additional lift. However, when we started the campaign we targeted a greater lift and a faster payback than we achieved. So given the results, and our focus on profitability, I’ve made the decision to defer our campaign until we are generating cash. This will reduce our brand spend during Q1 to about 1.7 million and we are not forecasting any brand spend in Q2, Q3, or Q4 of this year.

To summarize, we had a strong quarter. Solid growth in our key businesses, record new customers, record baskets, and progress on the bottom line. Most importantly, as I said at the beginning of my remarks, I am very pleased to be talking about profitability. During the last quarter, we’ve made some important strategic shifts in our basic model, and I believe we can make each order profitable while continuing to grow our topline. We expect to continue to see strong 25% to 30% growth in our OTC business and double-digit growth in our mail-order pharmacy. And we are targeting adjusted EBITDA profitability for the second half of the year. We have established a clear path to the goal I outlined when I joined the Company, sustainable profitability.

Of course, I look forward to answering any questions that you may have, but first Bob is going to review the details financially. So, go ahead, Bob.

Bob Barton, Vice President of Finance and Chief Financial Officer

Thanks, Dawn. As reported, fourth quarter net sales are our seasonally strongest and were an all-time high at $106.4 million, bringing fiscal year 2005 sales to 399.4 million, just short $400 million. Over the next few minutes I’ll walk you through some of the details driving our fourth quarter sales and then I’ll review expenses, provide an update on the balance sheet and review our guidance for 2006. I’ll also discuss the results including our wholesale OTC business, which we terminated, effective November 9, 2005, and have adjusted growth percentages to reflect the extra week in 2004, as Brinlea noted in the opening. With that as an outline, let’s get started.

On a segment basis, OTC sales for the fourth quarter, excluding wholesale OTCs, grew by an adjusted 26% year-over-year to $50.8 million. Wholesale OTC revenue, which are net sales generated by our December 2003 agreement to provide fulfillment services to Amazon.com, was down 89% year over year to 468,000, impacting our overall growth rate. We terminated this agreement effective November 9, 2005, and you should no longer anticipate any revenue in 2006 from this relationship.

Mail-order pharmacy net sales grew 19% year over year to a record $20.0 million. Local pick-up pharmacy sales through our Rite Aid partnership and our Vision segment were relatively flat year-over-year at $23.8 million and $11.3 million, respectively. Now, I’ll walk you through some of the key customer metrics that drove our fourth quarter sales. Starting with overall order volume, which was 1.3 million and grew by 8% year-over-year and 16% when excluding the impact from the termination of the Amazon fulfillment agreement. Average net sales per order was a record $80, up from $78 in the fourth quarter in 2004. On a segment basis, average net sales per order for the fourth quarter in our OTC segment increased to $60 and when excluding wholesale OTC average net sales per order for OTC was $61. Mail-order pharmacy baskets grew by 7% to $151. Local pick-up pharmacy grew by 5% to $112 and finally average net sales for order for the vision segment were up 3% to $83.

Repeat revenue in the fourth quarter made up 80% of total sales and 79% for the fiscal year ending 2005. We saw repeat revenue in our OTC segment grow by 35% year over year for the fourth quarter, 33% for the full fiscal year. During the quarter, we added a record 351,000 new customers bringing our total life to date customer base to approximately 7.2 million unique customers since inception. And in 2006 we look forward to reaching important milestone of fulfilling our 25 million customer order. Importantly, our trailing 12-month active customer base grew by 10% year over year to over 2 million, while the trailing 12-month spend for active customer grew by $10, or 6% year over year to approximately $192 and reflect both growth in basket size and increased order frequency.

Please note that both the active customer base and average annual spend numbers exclude net sales and orders associated with our wholesale OTC fulfillment relationship with amazon.com and reflect only the activity of customers making purchases through web sites owned by drugstore.com and our subsidiaries.

Now we’ll move on to gross margin. As Dawn had mentioned, gross margin was our best in almost two years at 21.4% for the fourth quarter, an increase of 150-basis points over the third quarter of 2005, and was up 120-basis points from the fourth quarter of 2004. On the year, gross margin was 20.5% and grew by 20-basis points. Absolute gross profit dollars for the fourth quarter increased by 17% year-over-year to 22.8 million. For fiscal year 2005, gross profit increased 14% year-over-year to 82.1 million. We’ll move on to expenses and we’ll start with marketing and sales. Marketing and sales expense for the fourth quarter as a percentage of net sales was 9.4% reflecting an increase from the fourth quarter of 2004, and as expected up from 9.1% of net sales in the third quarter of 2005. In absolute dollars, marketing and sales expenses for the quarter increased to $9.9 million and reflected 2.6 million associated with our brand campaign. For the fiscal year 2005, sales and marketing expenses were about 8.2% of net sales.

As Dawn mentioned earlier, we are winding down our brand campaign and plan to spend approximately 1.7 million on continued out-of-home and magazine brand activities during the first quarter. We do not have plans to continue to spend in the quarters that follow. Marketing and sales expense per new customer was $28 for the quarter, up from $19 in the fourth quarter of 2004, but down from $31 in the third quarter of 2005. A significant amount of the annual increase reflected money spent during the quarter on a brand development efforts. We anticipate that marketing and sales expense will remain around 8% to 9% of net sales in the first quarter but improve and decline to 6% to 7% in the remainder of 2006.

Next, fulfillment and order processing expense, which includes customer care and credit card fees. For the fourth quarter of 2005, fulfillment, and order processing expenses were 9.8% of net sales, which is down from 10.6% in the fourth quarter of 2004, and down from 10.1% as reported in the third quarter of 2005. For the fiscal year 2005, these expenses were 10%. We expect fulfillment and order processing expensing in 2006 to show continued improvement with volume and anticipate expenses to run in the 9.5% to 10% range.

With that, we’ll move on to other operating expenses. Technology and content expenses for the fourth quarter 2005 were $3.5 million and general and administrative expenses were $2.7 million. For fiscal year 2005, these expenses represented 3.2% and 3.5%, respectively, of net sales.

On a net loss, on a GAAP basis, net loss for the fourth quarter was 4.5 million, or $0.5 per share, which was better than our previous guidance of a net loss range of 6.4 million to 7.4 million. For fiscal year 2005, net loss was better than expected at a loss of 20.9 million, declining drastically by 56% year over year. On an adjusted EBITDA basis, we reported a $1.8 million net loss which was also better than our EBITDA than our guidance of an adjusted EBITDA loss in the range of 3.7 million to 4.7 million. Of importance, during the quarter we spent $2.6 million on our brand campaign and we wrote off $560,000 associated with internally developed software. For the year, our adjusted EBITDA loss was 9.6 million and included 5.5 million of brand and personalization spend. Adjusted EBITDA is defined as earning before interest, taxes, depreciation, and amortization of intangible assets, non-cash marketing and stock-based compensation and it is adjusted to exclude non-cash charges for impairment of goodwill and other intangible assets and a non-cash litigation settlement.

Head count. In regards to head count, we ended the fourth quarter with an employee based at approximately 800 full time equivalents. On to the balance sheet, with regard to our cash position, we ended Q4 with approximately $46.5 million in cash, cash equivalents, and marketable securities, which is up slightly from Q3 as we generated cash from operating activities this quarter. Net of planned capital expenditures and applicable lease financing, we expect to end 2006 with at least $35 million in cash, cash equivalents, and marketable securities. In regards to inventory, our annualized turn rate for the quarter was approximately 14.

With that, we’ll move on to our outlook for the first quarter and fiscal year 2006. For the fiscal year 2006, we are targeting a net sales range of 440 million to 460 million. We believe this will reflect continued strong growth from our OTC and mail order pharmacy segments, even with our strategic decision to focus on only the more profitable sales opportunities. We also believe this focus on long-term sustainable profitability will allow us to reach adjusted EBITDA profitability in the second half of the year.

For the full year, we are targeting an adjusted EBITDA loss of $4 million to an adjusted EBITDA profit of $1 million. From a GAAP basis, we are targeting a net loss range of $15 million to $20 million. Please note that this GAAP net loss range reflects stock option expense associated with the adoption of statement of financial accounting standards 123R which we anticipate will result in stock-based compensation expense approximating $5.5 million.

For the first quarter of 2006, drugstore.com is targeting a net sales range of $102 million to $107 million, a net loss range of 7.2 million to 8.2 million and an adjusted EBITDA loss range of 3.5 million to 4.5 million, which reflects $1.7 million in brand campaign expenses during Q1. That concludes our prepared remarks for today’s call. At this point, we’ll open the call up to questions.

Question-and-Answer Session

Operator

Operator Instructions

Our first question comes from the line of Brian Fitzgerald with Morgan Stanley.

Q - Brian Fitzgerald

Thanks. A couple questions. On the surcharge for heavier orders, you guys had mentioned that your backorder shipping policy would save about 400 K. Would the surcharge for heavier orders, is that included in that 400 K or have you done some analysis about what that would save you and then I have a couple follow-ups.

A - Dawn Lepore

No. The $400,000 was just for the backorder change policy and on the weight based shipping, those heavier orders, we are completing, we are finalizing the plans for that as we speak and are doing that analysis right now. But the $400,000 was just for the backorder the policy change.

Q - Brian Fitzgerald

Okay. And then on the Part D, you mentioned that you more participate in it that would possibly some orders but you would be filling orders for ones that sell out of the Part D schema. Is your assessment kind of neutral to your business going forward impact wise?

A - Dawn Lepore

Well there is some impact to our business but my point about there are some drugs that are not covered by Medicare Part D and there is some coverage that people don’t get from Med Part D and that’s where we would continue to fill those orders. That was my point. In terms of the adoption of Med D, I think it’s too early for any of us to tell. We’ll obviously give you an update as the year goes on.

Q - Brian Fitzgerald

Okay. Very good. Thanks.

Operator

Our next question comes from the line of Kevin Sonich with RK Capital

Q - Kevin Sonich

Thanks. Aside from maybe being a little conservative to take away the write-off this quarter and the brand spend relative to the quarter we’re in now, Q1, it would seem like you’d have an opportunity to do nicely better in terms of your adjusted EBITDA in Q1. I’m just curious if you can explain the guidance for the loss of 3.5 and 4.5 million relative to the 1.8 million adjusted EBITDA loss in Q4?

A - Bob Barton

Thanks for the question. I think the first thing you have to remember is the brand campaign is winding down in the first quarter. So we’re still anticipating, we are still planning to spend just under $2 million in brand expenses during Q1 and that will have, we believe, a fairly significant impact on our guidance and our loss impact during that quarter. You know, obviously going forward we’re removing the brand expense and that’s where we’re very optimistic in how the year can shape up for us.

Q - Kevin Sonich

Okay. But you’re spending less in terms of the brand marketing in Q1 than you did in Q4, right?

A - Bob Barton

We are spending a bit less in Q1 than we are in Q4, that’s correct.

Q - Kevin Sonich

Okay. And just, I’m not too familiar with the business but I wonder if you could help me out here a little bit. The $2 million customers that have been active over the past year. I think you said that was a record number. That sounds great. Excluding the relationship with Amazon and any customers that may have gone away from that, what happens to the other customers that don’t come back? Where do they typically end up?

A - Dawn Lepore

Well, let me give you some context and Bob can add in some answer as well. There are some number of customers who will go out and search for a product, a particular product, come to drugstore and quite honestly maybe not even realize who they’re buying the product from. Buying that one particular problem and not feel that they have an ongoing relationship with drugstore and don’t come back. When we go out and do customer research and we have done that with those customers, they do not report any dissatisfaction with our pricing, with our service, with anything. They just say, gosh, I didn’t think of you guys. That’s why we have some personalized e-mail campaigns going on specifically targeted at those ones – we call them the 1x purchasers to get them to 2x, to remind them about drugstore. It’s a very personalized message. It takes into account what they bought from us, what their characteristics are and tries to convert them into an ongoing long-term customers. And we’ve seen some good early results but we will continue to monitor that throughout this year. We just started with that a few months ago. So it’s not dissatisfaction. Most of the time it’s just people just don’t think of us and that is what we have to continue to move the needle on.

Q - Kevin Sonich

Okay. So it’s a little bit of a combination of I guess just awareness, which you’re getting out through the e-mail campaigns but maybe also is it kind of for customers the switching costs are relatively low and if you can find a way to develop customer loyalty beyond just the brand but whether it’s – I don’t know, you get points for a number of orders or something like that. Just some sort of program to develop a little bit more loyalty it would seem like you’d –

A - Dawn Lepore

And I absolutely agree. We in fact have a program called drugstore dollars which is very, very successful which gives people 5% credit back on their purchases that then they can use in a particular month during the quarter. January was a drugstore dollar month, for instance, and that program has been very successful. I think when, what we hear from customers when they don’t come back more often they’re just stopping at the drugstore on the way home, so our competition is the brick and mortar companies and everything we can do to make it easier for customers to order online, to think of us before they stop at home to click through an e-mail to do auto-replenishment. There are a whole lot of things that we are implementing that we think will make it easier and easier for customers to come back to us and remember us.

Q - Kevin Sonich

Okay. Thank you very much for the answers.

Operator

Operator Instructions

Kevin Sonich, please go ahead with your follow-up.

Q - Kevin Sonich

I figured I would jump back here in the queue. On the, how much capacity do you guys have on the fulfillment side now that you’re not helping out Amazon anymore?

A - Bob Barton

That’s a great question. In fact, we’re spending quite a bit of uptime right now re-evaluating what that’s going to do for us. You know, I would say right now initial estimates would suggest we’re probably a year to two years away from a meeting a new one, but we’ll be able to give you an update as we get farther long in the year.

A - Dawn Lepore

So we have quite a bit of capacity left in order to grow our business and not have to add another distribution center.

Q - Kevin Sonich

So you could maybe grow like 100 million a quarter run rate, you can maybe take that volume up 50% and still be okay on capacity, although at that point starting to get kind of tapped out?

A - Bob Barton

Well, again, I think, you know, I’m going to defer on any exact numbers until we finalize the analysis in terms of what the additional capacity Amazon is going to give us versus what we were planning. What I would tell you is, what we have to manage to are the peaks. So right now on an ongoing basis we’re probably at 60 to maybe as much as 65% utilization of the distribution center and what we’re taking a hard look at again is there’s a couple week time period during the December month that we get spikes pretty hard from holiday sales and so again it looks like we’ll make it through another year at least. You know, the question is it two years or is it three years that we can survive and again we’re in the middle of finalizing that analysis now.

Q - Kevin Sonich

Okay. Great. And just one more, if I could, since there don’t seem to be too many questions, maybe I can ask kind of a real basic one.

A - Dawn Lepore

Sure.

Q - Kevin Sonich

Who do you view as your sort of primary competition I guess, and I understand that it’s sort of everyone but when you’re really going after new customers. Take that 2 million active customer list to 3 million, who do you really intend to kind of grab customers from?

A - Dawn Lepore

There is a wide range and, the brick and mortar companies, so the customers who shop at the Walgreens and SafeWays, etc., on the way home. So that is a piece. But with changing that customer behavior and moving the customers online for these purchases. In addition, it varies a little bit by segment. So for in our beauty business, sephora.com would be a competitor for example. So it’s pretty wide range but a lot of it is about changing customer behavior and getting more people to think of purchasing these things online.

Q - Kevin Sonich

Okay. Okay. Great. Thank you.

Operator

Our next question comes from the line of Brian Fitzgerald with Morgan Stanley.

Q - Brian Fitzgerald

I had one other follow-up. In terms of you mentioned that out of 25,000 SKUs you’d be eliminating or refining prices on 4000…..

A - Dawn Lepore

4000. Yes.

Q - Brian Fitzgerald

Are those, do you have any sense of what verticals those are in?

A - Dawn Lepore

They’re across the board, although there are some areas where we’ve looked particularly closely to make sure that we understand the profitability of each item. So as you can imagine, things like incontinence and diapers and formula and laundry detergent and things like that are more challenging from a shipping perspective, so you have to look very carefully at the total cost to understand. In addition, there are a number of areas where it’s just a matter of having more assortment than we need whereas maybe a six-pack of toilet paper is great and we don’t necessarily need to carry the eight-pack as well. So a lot of it is about looking at assortment as well as some of those categories that are more challenging to ship.

Q - Brian Fitzgerald

Okay. Great. Thank you.

Operator

Our next question comes from the line of Ryan Randall with Randall Capital.

Q - Ryan Randall

Hey. Thanks for taking my question. A couple quick things. You said, Bob I think you said that you were cash flow positive fourth quarter. Could you quantify that amount?

A - Bob Barton

Yes. So we were actually, we ended Q3 at 46.2 million and we ended Q4 at 46, just under 46.5 million.

Q - Ryan Randall

Okay. So it was just slightly cash flow positive.

A - Bob Barton

Yes.

Q - Ryan Randall

So as you guys look out over ’06, I mean, obviously, there’s some seasonality in here in your business. Do you think that Q2 is going to be cash flow break even or should we look at EBITDA?

A - Bob Barton

You know, I think what, the guidance, what you should follow is the guidance that we’ve given today and from an EBITDA perspective what we’re very focused on is the second half of 2006, and that’s where we believe we’ll start to drive positive adjusted EBITDA number and I think from a cash perspective again, I think what I shared on the call, is that we believe we’ll end the year with at least $35 million in cash. You know, what I would tell you is as you think through the process as a profitability, we are very, you know, we don’t plan on stopping in terms of we reach EBITDA, adjust EBITDA profitability and we’ve succeeded. It’s how do we get to the point where we’re earning free cash flow and that’s the next piece of the agenda, if you will, and again, right now our current focus is reaching the first step and achieving positive EBITDA.

Q - Ryan Randall

Okay. That’s helpful. And then just one other thing real quick. You had a nice improvement in your gross margin in the fourth quarter. Would you expect to see kind of continued year-over-year improvement as you get more volume across your distribution center?

A - Bob Barton

Well, you know, gross margin is going to be largely impacted by a mix of our OTC business and if you actually run the numbers for Q4, we saw a nice lift in the mix of our OTC business relative to where it’s been in the past and the OTC business is actually our highest margin segment. So where we will have upside as we continue to accelerate the growth of that business relative to the other segments in our business. So, you know, that’s where the upside could reside.

Q - Ryan Randall

Okay. Great. Thanks very much.

Operator

Management, this does conclude the question-and-answer session. Please continue with your presentation.

Dawn Lepore, President, Chief Executive Officer, and Chairman

Thank you all very much for joining us today, and we’ll look forward to talking to you next quarter.

Operator

Ladies and gentlemen, this does conclude the drugstore.com quarterly results conference call. You may disconnect, and thank you for using AT&T teleconferencing.

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Source: Drugstore.com Q4 2005 Earnings Conference Call Transcript (DSCM)
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