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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2003

OR

Commission File Number No. 0-23930

TARGETED GENETICS CORPORATION

1100 Olive Way, Suite 100
Seattle, WA 98101
(Address of principal executive offices, including zip code)

(206) 623-7612
(Registrant’s telephone number, including area code)

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

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

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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TARGETED GENETICS CORPORATION

Quarterly Report on Form 10-Q
For the quarter ended June 30, 2003

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PART I FINANCIAL INFORMATION

Item 1. Financial Statements

TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.

Basis of Presentation

     The condensed consolidated financial statements included in this quarterly report have been prepared by Targeted Genetics Corporation without audit, according to the rules and regulations of the Securities and Exchange Commission, or SEC. Our condensed consolidated financial statements include the accounts of Targeted Genetics Corporation, our wholly-owned subsidiaries Genovo, Inc. and TGCF Manufacturing Corporation (inactive), and our majority-owned subsidiary, CellExSys, Inc. The condensed consolidated financial statements do not include the accounts of Emerald Gene Systems, Ltd., or Emerald, our unconsolidated, majority-owned research and development joint venture with Elan International Services Ltd., or Elan, because we do not have operating control of Emerald. The operations of Emerald terminated during 2002 and we expect to dissolve the joint venture. All significant inter-company transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted in accordance with the SEC’s rules and regulations. The financial statements reflect, in the opinion of management, all adjustments (which consist solely of normal recurring adjustments) necessary to present fairly our financial position and results of operations as of and for the periods indicated. Certain reclassifications have been made to conform prior year results to the current year presentation.

     Our results of operations for the three months ended June 30, 2003, include a $2.9 million restructure charge, which represents our revised estimate of the ongoing lease commitment and associated costs of our Bothell, Washington facility lease. Our results of operations for the three months ended March 31, 2003, include $3.9 million in revenue recognized in connection with the termination of our development collaboration with Wyeth. As a result of these and other factors, we do not believe that our results of operations for the three months and six months ended June 30, 2003 are necessarily indicative of the results to be expected for the full year.

     The unaudited condensed consolidated financial statements included in this quarterly report should be read in conjunction with our audited consolidated financial statements and related footnotes included in our annual report on Form 10-K for the year ended December 31, 2002.

2.

Impact of New Accounting Pronouncements

     In April 2003, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133 and is effective for contracts entered into or modified after June 30, 2003. We do not expect the provisions of SFAS No. 149 to have a significant effect on our financial position or operating results.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity and is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective beginning July 1, 2003. We do not expect the provisions of SFAS No. 150 to have a significant effect on our financial position or operating results.

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

3.

Long-Term Obligations

     Long-term obligations consisted of the following:

     Future aggregate principal payments related to long-term obligations are $1.1 million for the remainder of 2003, $800,000 in 2004, $10.1 million in 2005 and $10.1 million in 2006.

     Elan has the option to convert principal and unpaid interest outstanding under the loan facility, on a per-draw basis, into shares of our common stock. The applicable fixed conversion prices if Elan elects to convert the loans and interest into shares of our common stock range from $0.49 to $6.11. If Elan had elected to convert the convertible loans and the related interest into our common stock as of June 30, 2003, Elan would have received 3,726,518 shares of our common stock.

     We have the option to prepay principal and interest outstanding under our Elan loan facility, in either cash or shares of our common stock. If we elect to prepay outstanding loan amounts with our common stock, the conversion price will equal the lesser of the average closing price of our common stock for a specified period of time before the date of prepayment and the applicable conversion price for each draw. Unless we obtain shareholder approval, we are limited in our ability to issue shares of our common stock to repay amounts outstanding under the loan facility to the extent the repayment caused Elan’s ownership in our common stock to exceed 19.9% of our then total common shares outstanding. If we elect to prepay the outstanding amounts in cash, we must pay the greater of the amount of principal and interest outstanding or the value of our common stock that Elan would receive upon conversion at the applicable conversion price for each draw, at the then current market price of those shares. In accordance with the terms of the loans payable to Elan, to date, we have elected not to make any cash payments of interest to Elan.

4.

Shareholders’ Equity

   Common Stock Offering

     In June 2003, we issued 7,777,778 shares of our common stock in a public offering to institutional investors at a price of $2.25 per share. We expect to use the proceeds from this financing of approximately $16.1 million to fund our ongoing research and development activities and general corporate purposes.

   Series B Convertible Preferred Stock

     In July 1999, we issued shares of our Series B convertible exchangeable preferred stock, valued at $12 million, to Elan in exchange for our 80.1% interest in Emerald. The Series B preferred stock is convertible until July 2005, at Elan’s option, into shares of our common stock, at an initial conversion price of $3.32 per share. Compounding dividends accrue semi-annually at 7% per year on the $1,000 per share face value of the preferred stock. Dividends are not paid in cash, but rather result in an increase in the number of shares of common stock issuable upon conversion. The Series B preferred stock and accrued dividends were convertible into 4,604,348 shares of our common stock at June 30, 2003, and unless converted earlier, will automatically convert into approximately 5.5 million shares of our common stock in July 2005. Elan was entitled to exchange the Series B preferred stock for all shares of preferred stock that we hold in Emerald until this exchange right expired on April 21, 2003. As a result of the expiration of the exchange right, we have reclassified the Series B preferred stock from mezzanine equity to shareholders’ equity.

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Stock Compensation

     As permitted by the provisions of Statement of Financial Accounting Standard (SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for employee stock option grants, and we apply the disclosure-only provisions to account for our stock option plans. We do not recognize any compensation expense for options granted to employees because we grant all options at fair market value on the date of grant. Options granted to consultants are recorded as an expense over their vesting term based on their fair value, which is determined using the Black-Scholes method.

     If we had elected to recognize compensation expense based on the fair market value at the grant dates for stock options granted, the pro forma net loss and net loss per common share would have been as follows:

Warrants

     During April 2003, warrants to purchase 3,333,333 shares of our common stock expired. At June 30, 2003, warrants to purchase 2,025,141 shares of our common stock were outstanding as follows:

	•		In connection with a technology license agreement with Alkermes, Inc., we issued a warrant to Alkermes to purchase 1,000,000 shares of our common stock at an exercise price of $2.50, expiring in June 2007, and a warrant to purchase 1,000,000 shares at an exercise price of $4.16 per share, expiring in June 2009.
	•		We have outstanding warrants to purchase a total of 25,141 shares of our common stock related to equipment financing and consulting agreements. These warrants have a weighted average price of $5.46 per share and expire between December 2003 and March 2004.

5.

Net Loss per Common Share

     Net loss per common share is based on the weighted average number of common shares outstanding during the period. Our diluted net loss per common share is the same as our basic net loss per common share because all stock options, warrants and other potentially dilutive securities are antidilutive and therefore excluded from the calculation of diluted net loss per common share.

6.

Accrued Restructure Expenses

     During 2002, we restructured our operations to focus our resources on our cystic fibrosis, arthritis and AIDS vaccine product development programs. In connection with this restructuring, we reduced our head count and operating expenses and began to pursue options to sublease, or terminate, the lease on our facility in Bothell, Washington. We had leased the facility in 2000 to accommodate commercial-scale manufacturing of our product candidates. As part of our collaborative development agreements with Celltech and Wyeth, we had financing commitments in place to fund a substantial portion of the construction of this facility. Both of these collaborative development relationships have ended and, as a result, the funding commitments have terminated