Drugstore.com (DSCM)

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drugstore.com, Inc., (DSCM), is a leading provider of online health, beauty, wellness, personal care, vision, and pharmacy solutions. The company believes its online stores, including drugstore.com, beauty.com, and visiondirect.com, offer a better way for consumers to shop for these products. Customer loyalty is strong. Repeat customers represent approximately 82% of sales. The company operates primarily in the U.S. and Canada, but its products are available to consumers worldwide. Following the acquisition of International Vision Direct Corp. in November 2003, the company organized its operations into four segments: over-the-counter (OTC), mail-order and local pick-up pharmacy, and vision. In 2006, OTC accounted for 48% of net sales, pharmacy 40%, and vision 12%. The OTC segment offers non-prescription health, beauty, wellness, and personal care products. Many of the products found in specialty stores, such as Dr. Weil Recommends, GNC Live Well, and the Natural Store are also available through drugstore.com. The mail-order pharmacy segment delivers prescription drugs and supplies to customers. The company is a mail-order prescription provider for several pharmacy benefit management (PBM) companies and is working to expand this distribution channel. One attractive feature that drugstore.com offers is an innovative online tracking and substantiation system, which allows participating consumers to automatically track and submit expenses for products eligible for reimbursement under corporate flexible spending accounts without attaching receipts. Like Amazon, the PBM companies also provide marketing support. The local pick-up pharmacy segment offers prescriptions that can be picked up at Rite Aid stores. The vision segment offers prescription contact lenses and other vision products through Vision Direct.

We are reiterating our Buy rating and $4.50 target price on DSCM shares. We are positive on the stock, due to the company's improving profitability, Auto Delivery program, and strategic relationships. We expect these three factors to enable the company to deliver profitable growth in the years ahead.

While the company's sales growth was just 6.7% in the third quarter, we think investors should focus on what the company is doing to become profitable. For example, drugstore.com's third quarter contribution margin dollars improved by 18% thanks its gross margin expanding 170 basis points to 23.2%, which is the highest in the company's history. Moreover, the company again delivered positive EBITDA, which is defined as a non-GAAP financial measure of earnings before interest, taxes, depreciation, and amortization of intangible assets and non-cash marketing expense, adjusted to exclude the impact of stock-based compensation expense. What's more, we think that drugstore.com has set the stage to more than triple its adjusted EBITDA in 2007 and report break-even EPS in the fourth quarter of 2007. Another facet of the company's improvement comes from its stable customer base. This should enable the company's business model to generate stable revenue and cash flow thanks to the large percentage of repeat customer orders, which accounted for 82% of its third quarter sales. Part of this success comes from its Auto Delivery program, which provides automatic delivery for its repeat customers. This program was launched in the first quarter of 2006 with less than 100 products. The program is now available for approximately 2,000 products. The increase in available products was driven by customer demand, which is a clear positive. Lastly, drugstore.com has ended unprofitable relationships and negotiating more profitable deals with partners that it keeps. This is causing some near-term pressure on its sales growth. It is important to notes that the company is willing to endure slower sales growth but sales are still growing in the short term in order to improve its profit margins. All told, we are positive on the company's plan to become profitable. We believe the stock is a Buy and has the potential to reach $4.50 per share, which represents a price-to-sales ratio of 1.0x.

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