UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

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 x No o

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

TARGETED GENETICS CORPORATION
Quarterly Report on Form 10-Q
For the quarter ended September 30, 2004

TABLE OF CONTENTS

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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

2

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 unaudited condensed consolidated financial statements included in this quarterly report have been prepared by Targeted Genetics Corporation, or Targeted Genetics, 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, our wholly owned subsidiaries Genovo, Inc. (inactive) and TGCF Manufacturing Corporation (inactive), and until its sale in July 2004, our majority-owned subsidiary, CellExSys, Inc., or CellExSys. CellExSys was merged into Chromos Molecular Systems, Inc., or Chromos, on July 27, 2004. The condensed consolidated balance sheet as of December 31, 2003, and our results of operations for the three and nine months ended September 30, 2003, do not include the accounts of Emerald Gene Systems, Ltd., or Emerald, our majority-owned research and development joint venture with Elan International Services Ltd., or Elan, because we did not have operating control of Emerald during those periods. In connection with a termination agreement with Elan effective March 31, 2004, we acquired all of Elan’s equity interest in Emerald. As a result, Emerald became a wholly-owned subsidiary as of March 31, 2004, and is consolidated into our financial statements as of that date. The operations of Emerald terminated during 2002; therefore, the impact of consolidating the accounts of Emerald into our financial results is not significant. We are in the process of dissolving Emerald. 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 period results to the current period presentation.

          We do not believe that our results of operations for the three and nine months ended September 30, 2004 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, 2003.

2. Long-Term Obligations

          Long-term obligations consisted of the following:

     Future aggregate principal payments related to long-term obligations are $284,000 for the remainder of 2004, $1,114,000 in 2005, $10,154,000 in 2006, $26,000 in 2007, and $1,000 in 2008.

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3. Accrued Restructure Charges

     We record accrued restructure charges as they relate to the leases on our facilities in Bothell, Washington and Sharon Hill, Pennsylvania. In December 2002, we began to pursue options to sublease or terminate our lease on the Bothell facility and in February 2003, we closed our Sharon Hill facility. Accrued restructure charges represent our best estimate of the fair value of the liability as determined under Statement of Financial Accounting Standards, or SFAS, No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” and is computed as the fair value of the difference between the remaining lease payments due on these leases and the estimated sub-lease market rates. These assumptions are periodically reviewed and updated as appropriate and adjustment is made to the accrued restructure charge. We record accretion expense based upon changes in the accrued restructure liability that result from the passage of time and the assumed discount rate of 10% that we use to determine the accrued liability. Accretion expense is recorded on an ongoing basis and is reflected as a charge in the accompanying statements of operations as a restructuring charge.

     If we proceed with further development or commercialization of any of our product candidates, we may need the use of the Bothell facility to fulfill our manufacturing requirements. As a result, we do not currently intend to sublease a portion of the Bothell facility to accommodate our potential manufacturing needs. Net sublease income as it relates to that portion of the facility is expensed ratably as research and development expense over the remaining term of the lease. Further, if we decide to utilize this facility, any remaining accrued restructure charges related to the manufacturing facility will be reversed and recorded as a one-time credit to restructure charges, reflected in the period in which use is resumed. Any decision to resume use of the facility will be based on a number of factors, including the progress of our product candidates in clinical development, the estimated duration of facility design and construction, the estimated timing of product manufacturing requirements, the ability of our current manufacturing capabilities to meet demand, and the availability of resources. However, unless we resume use of the Bothell facility, we will continue to account for the lease in accordance with SFAS No. 146 and will periodically evaluate the assumptions and record additional restructure charges if necessary. Because we compute restructure charges using estimates and assumptions regarding the timing and amounts of future events, significant adjustments to the accrual may be necessary in the future based on the actual outcome of events and as we become aware of new facts and circumstances.

     The tables below present our total estimated restructure charges and a reconciliation of the associated liability:

     Charges incurred in 2004 represent accretion expense of $385,000 and additional charges of $136,000 due to a change in estimate related to the Sharon Hill facility to reflect our belief that we can not secure a sublease tenant prior to the expiration of the lease and $276,000 related to additional time that we believe it may require to identify a sublease tenant for the portion of our Bothell facility that we intend to sublease. Estimated future charges represent our estimate of the accretion expense throughout the remainder of the lease term.

4. Shareholders’ Equity

     Stock Compensation

          As permitted by the provisions of 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. In addition, we follow the disclosure requirements of SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS No. 123,” which require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We do not recognize any compensation expense for options

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granted to employees because we grant all options at fair market value on the date of grant. Options and warrants to purchase common stock granted to non-employees are recorded as an expense over their service period based on their fair value, which is determined using the Black-Scholes method. No such options or warrants have been issued during any of the periods presented.

     As allowed by SFAS No. 123, we do not recognize compensation expense on stock options or warrants granted to employees and directors. 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:

On March 31, 2004 the Financial Accounting Standards Board, or FASB, issued an Exposure Draft, “Share-Based Payment — An Amendment of FASB Statements No. 123 and 95,” or Proposed SFAS No. 123R, which currently is expected to be effective for public companies in periods beginning after June 15, 2005. Under Proposed SFAS No. 123R we would be required to implement the proposed standard no later than the quarter that begins July 1, 2005. Proposed SFAS No. 123R would eliminate our ability to account for share-based compensation transactions using Accounting Principles Board Opinion No. 25, and generally would require us to account for these transactions using a fair-value based method. As proposed, companies would be required to recognize an expense for compensation cost related to share-based payment arrangements including stock options and employee stock purchase plans. The FASB expects to issue a final standard by December 31, 2004. We are currently evaluating option valuation methodologies and assumptions in light of the Proposed SFAS No. 123R related to employee stock options. Current estimates of option values using the Black-Scholes method (as shown above) may not be indicative of results from valuation methodologies ultimately adopted in the final rules.

5. Merger Agreement Between CellExSys, Inc. and Chromos Molecular Systems, Inc.

     On July 27, 2004, Chromos acquired all of the outstanding shares of CellExSys through a merger between CellExSys and Chromos Inc., a wholly owned subsidiary of Chromos. Under the terms of the merger agreement, Chromos has issued to CellExSys shareholders 1,500,000 shares of Chromos common stock and a secured convertible debenture totaling approximately $2.5 million ($3.4 million Canadian). The debenture bears annual interest of 2% and is payable in two annual installments on the first and second anniversary of the closing.

     Each shareholder of CellExSys will receive a pro rata distribution of Chromos common stock and principal and interest payments received on the debenture, based on the shareholder’s equity interest in CellExSys as of July 27, 2004, the date of closing. We owned approximately 79% of CellExSys at the time of the merger. The debenture is repayable by Chromos at its option in either cash or by the issuance of shares of Chromos common stock, assuming certain limited conditions are met by Chromos. In combination with the shares of Chromos common stock issued at closing, if the debenture is fully paid in shares of Chromos common stock, the shareholders of CellExSys would receive up to a total of 3.5 million shares, which represent approximately 17.2 percent of Chromos, based on issued and outstanding shares of Chromos as of the date of closing. Chromos had funded certain of CellExSys’ operational costs through the closing of the merger in the form of deposits totaling $502,000.

     As a result of the merger, we recorded a gain during the quarter ended September 30, 2004 which is comprised of the following.

     In accordance with the Merger Agreement, the purchase price is subject to limited adjustment. For a limited period of time, we have agreed to provide certain transition services and assistance to CellExSys, which Chromos will for pay on a monthly basis. We will continue to evaluate the merger consideration received from Chromos for value impairment and will record a reduction in the carrying value if we determine that there is an impairment in value that is deemed to be other than temporary. This evaluation will be based on several factors including the market price of Chromos common stock and the financial condition of Chromos. As of September 30, 2004, we do not believe that there is evidence of an impairment in value that warrants adjustment to our carrying value of the merger consideration.

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     The following table presents pro forma results assuming the sale of CellExSys occurred at the beginning of each period presented:

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

     This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. Forward-looking statements include statements about our product development and commercialization goals and expectations, potential market opportunities, our plans for and anticipated results of our clinical development activities and the potential advantage of our product candidates, and other statements that are not historical facts. Words such as “may,” “will,” “believes,” “estimates,” “expects,” “anticipates,” “plans” and “intends,” or statements concerning “potential” or “opportunity” and other words of similar meaning or the negative thereof, may identify forward-looking statements, but the absence of these words does not mean that the statement is not forward-looking. In making these statements, we rely on a number of assumptions and make predictions about the future. Our actual results could differ materially from those stated in, or implied by, forward-looking statements for a number of reasons, including the risks described in the section entitled “Factors Affecting Our Operating Results, Our Business and Our Stock Price” in Part I, Item 2 of this quarterly report.

     You should not unduly rely on these forward-looking statements, which speak only as of the date of this quarterly report. We undertake no obligation to publicly revise any forward-looking statement after the date of this quarterly report to reflect circumstances or events occurring after the date of this quarterly report or to conform the statement to actual results or changes in our expectations. You should, however, review the factors, risks and other information we provide in the reports we file from time to time with the SEC.

Business Overview

     Targeted Genetics Corporation develops gene therapy products and technologies for treating both acquired and inherited diseases. Our gene therapy product candidates are designed to treat disease by regulating cellular function at a genetic level. This involves introducing genetic material into target cells and expressing it in a manner that provides the desired effect. We have assembled a broad base of proprietary intellectual property that we believe gives us the potential to address the significant diseases that are the primary focus of our business. Our proprietary intellectual property includes genes, methods of transferring genes into cells, processes to manufacture our lead gene delivery product candidates and other proprietary technologies and processes. In addition, we have established expertise and development capabilities focused in the areas of preclinical research and biology, manufacturing and manufacturing process scale-up, quality control, quality assurance, regulatory affairs and clinical trial design and implementation. We believe that our focus and expertise will enable us to develop products based on our proprietary intellectual property.

     Gene therapy products involve the use of delivery vehicles, called vectors, to place genetic material into target cells. Our proprietary vector technologies include both viral and synthetic vectors. Our viral vector development activities, which use modified viruses to deliver genes into cells, focus primarily on adeno-associated virus, or AAV, a common virus that has not been associated with any human disease or illness. We believe that AAV provides a number of safety and gene delivery advantages over other viruses for several of our potential gene therapy products. Our synthetic vectors deliver genes into cells using lipids, which are fatty, water-insoluble organic substances that can promote gene uptake through cell membranes. We believe that

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synthetic vectors may provide a number of gene delivery advantages for repeated, efficient delivery of therapeutic genes into rapidly dividing cells, such as certain types of tumor cells. Although our current product development candidates utilize AAV as the delivery vector, we believe that possessing capabilities in both viral and synthetic approaches provides advantages in our corporate partnering efforts and increases the range of our potential products that may reach the market.

     We have an AAV-based product candidate under development for treating cystic fibrosis that is being evaluated in a second Phase II clinical trial that was initiated in July 2003. We designed this trial to enroll up to 100 patients and are conducting it in collaboration with the Cystic Fibrosis Foundation, or CF Foundation. In June 2004, we announced that an independent data monitoring committee, or DMC, met for a scheduled interim analysis of this Phase II clinical trial. Based upon its review, the DMC recommended continuation of the study as planned. The DMC provided its recommendation based upon safety parameters and an analysis of whether or not there was a chance that, upon full patient enrollment, the study could show a statistically significant positive impact on lung function measurements in patients treated with tgAAVCF compared to placebo. We expect to complete patient accrual and dosing by the end of 2004 and to present data from the trial in the first half of 2005. This second Phase II trial follows an initial repeat dosing trial for which we announced final data in June 2003. Data from this trial showed a good safety profile and indicated a statistically significant improvement in lung function at day 30 and a decrease in levels of an inflammatory cytokine at day 14 in patients treated with tgAAVCF when compared to placebo.

     We have an AAV-based prophylactic vaccine candidate for high-risk populations in developing nations to protect against the progression of Human Immunodeficiency Virus, or HIV, infection to Acquired Immune Deficiency Syndrome, or AIDS. This program is being developed in a collaboration with the International AIDS Vaccine Initiative, or IAVI, a non-profit organization, and The Columbus Children’s Research Institute at Children’s Hospital in Columbus, Ohio, or CCRI. In December 2003, we initiated a Phase I initial dose escalation safety trial in humans for our AIDS vaccine product candidate in Europe. This dose-escalation safety trial is designed to enroll up to 50 volunteers who are uninfected with HIV and in good health. In September 2004, we announced the completion of enrolment and dosing of the 50 volunteers planned for this study. Each participant in this trial received a single injection of the vaccine candidate or placebo and will be monitored for safety and immune response. We will continue to monitor these volunteers in accordance with our clinical trial protocol. After the required follow-up, we will complete analysis of the safety and immune response data and expect to present results in the first half of 2005. As part of the clinical development of the tgAAC09 vaccine, we are also assessing the evaluation of this vaccine in other non-industrialized countries for which this vaccine is designed. In addition, we continue to pursue a multi-component AIDS vaccine strategy that will include AAV-mediated delivery of multiple HIV genes.

     We have an AAV-based product candidate for the treatment of rheumatoid arthritis. In March 2004, we initiated a Phase I clinical trial for this product candidate for treating rheumatoid arthritis. This dose-escalation safety trial is designed to enroll up to 32 patients with rheumatoid arthritis and is being conducted at multiple sites in the United States and Canada. Patients will be monitored for safety and secondarily for improvements in arthritis signs and symptoms. We expect to complete patient accrual and dosing in this trial and to be able to present data from the trial in the first half of 2005.

     We have developed processes to manufacture our potential products using methods and at a scale amenable to clinical development and expandable to large-scale production for advancing our potential products to commercialization. These methods are similar to the methods used to manufacture other biologics. As a result, we evaluated and continue to evaluate opportunities to utilize excess capacity to manufacture biologics for other companies. In March 2003, we entered into a manufacturing services agreement with GenVec, Inc., or GenVec, to manufacture clinical supply of GenVec’s cancer product candidate, an adeno-viral-based gene therapy product. Earlier in 2004, we completed our manufacturing work for GenVec. We also believe that we have established broad capabilities in applying our gene delivery technologies and our development infrastructure into several potential new areas that are beyond the scope of our three core programs under development. We believe that this may enable us to establish new strategic or collaborative relationships with others.

     We believe that a wide range of diseases may potentially be treated, or prevented, with gene-based products, including cancer, genetic diseases and infectious diseases. We believe that there is also a significant opportunity to treat diseases that are currently treated using proteins and monoclonal antibodies, or small molecule drugs. These diseases may be more effectively treated by gene-based therapies due to their ability to provide a long-term or a localized method of treatment. Additionally, we believe that there are potential therapeutic applications where a gene-based approach to delivering a therapeutic protein may be preferred due to inherent difficulties in delivering the therapeutic protein itself. Our business strategy is to develop multiple gene delivery systems, which we believe will maximize our product opportunities. Using AAV gene delivery systems, we are developing product candidates across multiple diseases with the belief that gene-based therapies may provide a means to treat diseases not fully treatable with current biologic and pharmaceutical drugs. We believe that, if successful, we can establish significant market potential for our product candidates. There currently are no commercially available gene therapy products in the United States.

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We intend to pursue product development programs to enable us to demonstrate proof of concept and eventually commercialize gene-based therapeutics to address currently unmet medical needs in treating disease.

     The development of pharmaceutical products, including our possible cystic fibrosis, AIDS and rheumatoid arthritis products discussed above, involves extensive preclinical development followed by human clinical trials that take several years or more to complete. The length of time required to completely develop any product candidate varies substantially according to the type, complexity and novelty of the product candidate, the degree of involvement by a development partner, and the intended use of the product candidate. Our commencement and rate of completion of clinical trials may vary or be delayed for many reasons, including those discussed in the section entitled “Factors Affecting Our Operating Results, Our Business and Our Stock Price” in Part I, Item 2 of this quarterly report.

Results of Operations

Revenue

          Revenue. Revenue decreased to $2.4 million for the three months ended September 30, 2004 from $5.0 million for the same period in 2003 and decreased to $6.5 million for the nine months ended September 30, 2004 from $12.7 million for the same period in 2003. Revenues in 2004 primarily reflect revenues earned under our AIDS vaccine collaboration with IAVI and to a lesser degree, revenues earned under our contract manufacturing relationship with GenVec that was completed during the second quarter of 2004. Revenue for the three months ended September 30, 2003 includes $3.4 million of previously deferred payments received under our former collaboration with Biogen that ended in September 2003. Revenue for the nine months ended September 30, 2003 includes $3.9 million of revenue related to the termination of our collaboration with Wyeth Pharmaceuticals, in February 2003 and $5.1 million under our Biogen collaboration.

          We expect that our revenue for the remainder of 2004 will consist primarily of research and development revenue from our collaboration with IAVI. As a result of the conclusion of our former collaborations with Biogen and Wyeth in 2003, we expect total revenue in 2004 to be less than 2003. Our revenue for the next several years will depend on the continuation of the current collaboration with IAVI and our success with entering into and performing under potential new collaborations.

Operating Expenses

          Research and Development Expenses. Research and development expenses increased to $4.3 million for the three months ended September 30, 2004 from $3.9 million for the same period in 2003, and increased to $13.3 million for the nine months ended September 30, 2004 from $12.8 million for the same period in 2003. These increases generally reflect higher costs in our AIDS vaccine and rheumatoid arthritis programs, which moved out of preclinical development and into clinical testing in late 2003 and early 2004. These increases are partially offset by lower research and pre-clinical development costs as a result of our July 2004 sale of CellExSys. As a result, the costs associated with these programs are included in the costs of programs in clinical development, which increased in 2004 compared to 2003.

          The following is an allocation of our total research and development costs between our programs in clinical development and those that are in research or preclinical stages of development: