We at The Motley Fool are perfectly happy to exploit "sex" in a headline, especially when it actually relates to a company we're writing about. So, I'm not just using this headline to signal a new direction for our site this week. Though the pictures are fun. (Hi, Mom!)

Back to business. Even in 1999 and 2000, when smitten with the possibilities for e-commerce, I laughed at the idea that so many new companies chased the virtual drugstore market. PlanetRx, drugstore.com, mybasics.com, and Soma.com (cutely named after the drug in Aldous Huxley's Brave New World, and later a top tranquilizer made by Carter Wallace in the 1950s and 1960s) were just a few. Wouldn't the bricks-and-mortar discounters such as Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) win either in their stores or via existing or projected online operations?

Some agreed; others did not. Back then, the usual suspects -- Forrester Research (NASDAQ:FORR) and then Jupiter Media Metrix -- forecast billions (beelyuns) in online prescription fulfillment by 2004, but not from the online drugstores attacked as lacking a human touch. Researchers opined that payer organizations, such as prescription benefits managers (PBMs) and managed care organizations (HMOs), would lead the charge.

The survivor
Today, we know that almost all online drugstores did die, though not because the PBMs or HMOs were any more successful, nor because, as some suggested, online drugstores lacked a human touch. But rather because, for a large part of our repeat everyday purchases (and especially repeat prescriptions), cost is everything. But one company made a lot of smart purchases and partnerships. One company survived: drugstore.com (NASDAQ:DSCM)

Why? Let's talk about cost. From age 15 and extending through college vacations, I worked at a local independent drugstore and learned one big thing: Despite all the talk about individual service, independents lost the war to chains. Chains have the scale to win on cost and selection. How many of you have, like me, walked into one of the last independents and noticed the character of the shelves -- poorly organized and sparsely populated with clearly aging merchandise (yellow and dusty)?

So why haven't Walgreen's (NYSE:WAG), CVS (NYSE:CVS) (which bought Soma.com), or Rite Aid (NYSE:RAD) become the online drugstore rulers, while instead drugstore.com has outlasted its competitors? Most likely because of two key deals.

The first: Amazon (NASDAQ:AMZN) bought 19% of the company in its Web-investing heyday and made it Amazon's Health & Beauty center. The deal was for three years, reduced by six months and quickly renegotiated to reduce drugstore.com's cash payments. Now extended for another year, the deal is key to the company's health: 10% to 15% of drugstore.com's customers reportedly come through Amazon.

The second: The drugstore bought inventory from major investor Rite Aid, in exchange for which Rite Aid handled third-party claims reimbursement and allowed customers to pick up online orders at its pharmacies. Thus bolstered, drugstore.com managed its IPO cash well and didn't overpay for acquisitions of complementary online businesses like Beauty.com.

But while these were important, I didn't pay any attention until two highly anecdotal and irrational things caught my eye. First, I noticed a few people fill repeat prescriptions through drugstore.com. Second, the company spiffed up and relaunched its romantic and sexual products (marital aids, they used to be called) website, sexualwellbeing.com.

It's almost always this kind of anecdotal evidence that first attracts me to a consumer products company, and then to its financials. So, I checked into drugstore.com, only to find it selling in the $2 range -- a number below $5 and within the dreaded universe of the penny stock.

Penny company, but...
A penny stock sells for less than $5 a share, but we like to use the better definition of a penny company. A penny company sells both for less than $5 a share and has a market capitalization of less than $250 million -- so Lucent (NYSE:LU), though its shares currently sell for about $1.62, has a market capitalization of $6.4 billion. A penny stock, but not a penny company.

The stocks of penny stocks are often very easy to manipulate, and their low price and market cap usually indicate a weak business. That's why we don't keep discussion boards open for stocks in this category. Alas, drugstore.com closed yesterday at $2.80, with a market cap of $192 million, making it a penny company.

Only break the rules for a good reason. In a three-year bear market, more stocks have been relegated to the penny company universe, and some actually aren't failing. Far from it. I think drugstore.com is a forgotten Web retailer that offers a certain kind of value.

Not a weak business
A review of the latest quarterly report and the 2001 annual report (the 2002 report will be out sometime before March 31) reveals drugstore.com's five business segments and sample products -- health (Advil, Metamucil), beauty (Revlon, Cover Girl), wellness (GNC, Centrum), personal care (Gillette, Pampers, Rogaine), specialty shops (pet store, home spa, sexualwellbeing.com), and the pharmacy business (mostly drugs for chronic illnesses).

Four new partnerships involve FTD Inc. (NASDAQ:FTDI) for flowers, AC Lens for contact lenses, 1-800-Wheelchair.com for medical equipment, and Comerxia for international sales of non-prescription products from drugstore.com.

What caught my eye among the specialty shops was the relaunched sexualwellbeing.com. Given workplace Internet monitoring, be careful! But it's a tasteful site. It also points to an advantage of online drugstores: People aren't comfortable ordering these products in person, and I'm told that most online options don't present as pleasant and inviting a Web atmosphere as sexualwellbeing.com.

Think only of the condom, a perennial subject of adolescent male humor and angst and the cause of many embarrassed voyages through labyrinthine pharmacy aisles. Any number of factors might lead one to order this and other items in privacy.

Sex good, drugs better
The margins might be good for sexual products, but the prescription business offers even better ones. Prescriptions made up 55% of drugstore.com's 2002 revenues, projected to fall between 55% and 60% in 2003.

The annual and quarterly reports tell you something very interesting: The company's online pharmacy attracts primarily customers with chronic conditions for which they need drugs regularly, often for the rest of their lives. For these people, the pharmacist matters less, while price, convenience, and dependability matter more. Anecdotally, this segment should increase with an aging population.

On its way?
That's the overview. When we check under the hood at the numbers, drugstore.com looks like an improving business with consistently increasing revenue from skillful acquisitions, partnerships, customer acquisition, rising gross margins (a relative decline in cost of goods sold), reduced expenses of all kinds, declining cash burn and Flow Ratio, and a negative cash conversion cycle (as you'd expect from an online retailer). Please join me next Tuesday, when I crunch the numbers and provide a wild-eyed guess at valuation.

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Have a most Foolish week!

Tom Jacobs ( TMF Tom9 ) and the team of Motley Fool investment analysts give you the best investment ideas every month in The Motley Fool Select. He owns shares of drugstore.com, which you would know if you read his profile.The Motley Fool has adisclosure policy.