UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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 þ No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ 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 March 31, 2005

TABLE OF CONTENTS

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PART I FINANCIAL INFORMATION

Item 1. Financial Statements

TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)

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, according to the rules and regulations of the Securities and Exchange Commission, or SEC, and according to accounting principles generally accepted in the United States of America, or GAAP, for interim financial statements. The accompanying balance sheet information as of December 31, 2004 is derived from our audited financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted in accordance with the SEC’s rules and regulations. Our condensed consolidated financial statements include the accounts of Targeted Genetics and our inactive, wholly owned subsidiaries, Genovo, Inc. and TGCF Manufacturing Corporation. Our results of operations for the three months ended March 31, 2004 also include the results of CellExSys, Inc., or CellExSys, our majority-owned subsidiary, that was merged into Chromos, Inc. in July 2004. All significant intercompany transactions have been eliminated in consolidation. 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 months ended March 31, 2005 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, 2004.

2.	Long-Term Obligations

     Long-term obligations consisted of the following:

     Future aggregate principal payments related to long-term obligations are $927,000 for the remainder of 2005, $10,156,000 in 2006, $25,000 in 2007, $1,000 in 2008 and zero in 2009.

3.	Accrued Restructure Charges

We apply the provisions of Statement of Financial Accounting Standards, or SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” as it relates to our facility in Bothell, Washington and record restructure charges on the operating lease for the facility in response to our decision to discontinue use of the facility. Accrued restructure charges represent our best estimate of the fair value of the liability as determined under SFAS No. 146 and are computed as the fair value of the difference between the remaining lease payments, net of assumed sub-lease income and expense. We also record accretion expense based upon changes in the accrued liability that results from the passage of time at an assumed discount rate of 10%. Accretion expense is recorded on an ongoing basis as a restructure charge in our consolidated statements of operations.

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     The table below presents a reconciliation of the accrued restructure liability for the three month period ended March 31, 2005:

     During the three months ended March 31, 2005, we recorded accretion expense of $119,000 and a charge of $100,000 for a change in estimate 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. Through March 31, 2005, we have recorded contract termination costs relating to our Bothell facility and our former facility in Sharon Hill, Pennsylvania, which we discontinued using in February 2002, totaling $7.9 million. We expect to incur an additional $2.5 million in accretion expense through the September 2015 expiration of the Bothell lease.

     Further development or commercialization of any of our product candidates may require the use of a portion of our Bothell facility to fulfill our manufacturing requirements. While the application of SFAS No. 146 includes an assumption for sublease income from the facility, we do not currently intend to sublease a portion of the Bothell facility. We ratably expense this assumed net sublease income over the remaining term of the lease and classify this expense as research and development expense. If we decide to utilize this facility, any remaining accrued restructure charges related to the portion of the facility placed into service will be reversed, net of any applicable deferred credits, and recorded as a one-time credit to restructure charges and reflected in the period in which use is resumed. We would base any decision to use this facility 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 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 as necessary. Because restructure charges are estimates based upon 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.

4.	Stock Compensation

     As permitted by the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” we currently follow Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for employee stock option grants. We do not recognize compensation expense for options granted to employees and members of our board of directors because we grant all options at fair market value on the date of grant. The value of 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. No options or warrants have been issued to non-employees during any of the periods presented. As allowed by SFAS No. 123, we do not recognize compensation expense on stock options granted to employees and directors. However, if we had elected to recognize compensation expense based on the fair market value at the grant dates for the stock options granted, the pro forma net loss and net loss per common share would have been as follows:

     In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share Based Payment.” SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based upon their fair values. Pro forma disclosure will no longer be an alternative under SFAS No.

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123R. We are currently required to adopt SFAS No. 123R as of January 1, 2006. We do not expect the adoption of SFAS No. 123R to have a significant effect on our financial condition or cash flows, however its adoption will result in ongoing non-cash stock compensation charges that will increase our reported net loss and our net loss per share.

     We plan to apply the “modified prospective” method of adopting SFAS No. 123R which will result in prospective charges to expense beginning as of the effective date of SFAS No. 123R for options as they vest. Alternatively, we have the option of applying the “modified retrospective” method which, in addition to the prospective charges applicable under the modified prospective approach, would include a one-time cumulative effect of accounting change for options that are vested as of the effective date. At this time we cannot predict the ultimate impact of adopting SFAS No. 123R because the impact will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123R in prior periods, the impact would have approximated the amounts presented above in the disclosure of pro forma net loss and net loss per share.

5.	Investment in Securities of Chromos Molecular Systems, Inc.

     In July 2004, our majority-owned subsidiary, CellExSys Inc., was merged into Chromos Inc., a wholly owned subsidiary of Chromos Molecular Systems Inc., or Chromos. In connection with the merger, Chromos issued 1.5 million shares of its common stock and a secured convertible debenture totaling approximately $3.4 million Canadian. The debenture is repayable at Chromos’ option in either cash or by the issuance of shares of Chromos common stock, assuming certain conditions are met by Chromos, including compliance with all material provisions of the merger agreement, debenture and other related agreements. Our ownership in CellExSys at the time of the merger was approximately 79%. As a result, we received approximately 1.2 million shares of Chromos common stock and a 79% share of any payments made by Chromos under the debenture. We record the common stock and debenture at fair value in our financial statements, which as of December 31, 2004 totaled $453,000. We review the carrying value of the debenture for signs of impairment on a regular basis and record the shares of Chromos common stock at market value.

     On April 1, 2005, Chromos announced its financial results for the year ended December 31, 2004 and restructuring efforts intended to significantly reduce its operating costs. Chromos also reported that its available cash reserves would not fund its operations beyond May 2005 and terminated substantially all of the former employees of CellExSys. As a result of this announcement, the workforce reduction and the diminished financial condition of Chromos, we have reduced the carrying value of the debenture to zero in our financial statements as of March 31, 2005. Investment income in the accompanying statement of operations for the quarter ended March 31, 2005 includes a $63,000 non-cash charge to reduce the carrying value of the debenture as we deemed the impairment in value to be other than temporary. The approximately 1.2 million shares of Chromos common stock that we hold are recorded in the accompanying balance sheet at $390,000 based on the closing market price on March 31, 2005, which decreased substantially on April 1, 2005 as a result of the Chromos restructuring announcement. We will recognize any changes in the market value of this investment in the period of such change. One of the members of our Board of Directors is also a member of Chromos’ Board of Directors.

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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 appropriately modifying 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 gene therapy uses of certain genes, methods of transferring genetic material into cells, processes to manufacture our AAV-based 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 development, 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 genetic material into cells are focused on adeno-associated virus, or AAV, a 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 potential gene therapy products, including each of our product candidates currently under development. Our synthetic vectors deliver genetic material into cells using lipids, which are fatty, water-insoluble organic substances that can promote gene uptake through cell membranes. We believe that synthetic vectors may provide a number of gene delivery advantages for repeated, efficient delivery of therapeutic genetic material into rapidly dividing cells, such as certain types of tumor cells. Although all of 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.

     In March 2005, we announced the results for our second Phase II clinical trial of tgAAVCF, our AAV-based product candidate for the treatment patients with mild to moderate cystic fibrosis. In this study, tgAAVCF failed to meet its primary endpoint of statistically significant improvement in lung function, 30 days following initial administration of tgAAVCF compared to placebo. Based on these results, we have decided not to pursue further development of tgAAVCF and have focused our efforts on other clinical and preclinical stage programs.

     We have two product candidates in Phase I clinical trials. The first is 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 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, IAVI 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. Each participant in this trial received a single injection of the vaccine candidate or

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placebo and was monitored for safety and immune response. Preliminary results from this study were announced in February 2005 and suggest that tgAAC09 was safe and well-tolerated in this trial. Results also showed that at the doses evaluated in this initial trial, a single administration of tgAAC09, did not elicit a significant immune response. These results support further development of tgAAC09 and clinical evaluation at higher dose levels. We will continue to monitor these volunteers in accordance with our clinical trial protocol. The current Phase I clinical trial of tgAAC09 is the initial step in a comprehensive development strategy of this vaccine program. IAVI expanded the single-dose Phase I trial to include sites in India. The purpose of this study is to further evaluate the safety of the vaccine in the population that would participate in subsequent efficacy trials, assuming continued development of the vaccine candidates. Additionally, in a non-human primate study, it was demonstrated that antibody and T cell responses increased after a second dose, or boost, of tgAAC09 vaccine. Based on this preclinical data and upon receiving the necessary regulatory approvals, we plan to expand the European Phase I trial to evaluate the safety and immunogenicity of this vaccine after a second dose. After volunteers who receive a second dose of tgAAC09 have been monitored according to protocol, we will report the data from the entire study. While these clinical trials are underway, we continue to pursue the development of additional vaccine candidates, including vaccines based on different serotypes, or strains, of AAV believed to be more efficient delivery systems for gene-based vaccines to muscle. Preclinical studies of these vaccine approaches have demonstrated an ability to elicit an immune response at lower dose levels.

     Our second product candidate in a clinical trial is an AAV-based product candidate for the treatment of inflammatory arthritis. In March 2004, we initiated a Phase I clinical trial for this product candidate. This dose-escalation safety trial is designed to enroll up to 24 patients with rheumatoid arthritis, psoriatic arthritis or ankylosing spondylitis. This study is primarily designed to evaluate the safety of tgAAC94 of escalating doses. We also expect to collect data on signs and symptoms of disease, molecular markers of disease and gene expression in both a drug-treated and placebo-treated groups of patients. We expect to be able to present data from the trial in mid-2005.

     We have established broad capabilities in applying our gene delivery technologies and have developed an infrastructure that allows us to leverage these capabilities into multiple product opportunities. We have also developed processes to manufacture our potential products 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. This has enabled us to establish collaborations with others. In December 2004, we initiated a collaboration with Celladon Corporation to pursue the development of AAV-based treatments for congestive heart failure. In January 2005, we initiated a collaboration with Sirna Therapeutics, Inc. to pursue the development of an AAV-based treatment for Huntington’s disease. We believe that our development and manufacturing capabilities may enable us to establish additional strategic partnerships or collaborations.

     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, monoclonal antibodies or small molecule drugs. These diseases may be more effectively treated by gene-based therapies that may 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 leverage our proprietary intellectual property and AAV development capabilities into multiple product development programs and collaborations to 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. Currently there are no commercially available gene therapy products in the United States. 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 potential AIDS, inflammatory arthritis, congestive heart failure, and Huntington’s disease product candidates 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” presented below.

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Results of Operations

  Revenue

     Revenue increased to $2.0 million for the three months ended March 31, 2005 from $1.3 million for the same period in 2004. Revenue in 2005 and 2004 primarily reflect amounts earned under our AIDS vaccine collaboration with IAVI. We expect that our revenue for the remainder of 2005 will consist primarily of research and development revenue earned under our collaboration with IAVI and smaller amounts of revenue earned from our collaborations with Celladon and Sirna expected later in 2005. Our revenue for the next several years will depend on the continuation of the current collaborations with IAVI, Celladon and Sirna and our success with entering into and performing under potential new collaborations.

  Operating Expenses

     Research and Development Expenses. Research and development expenses increased to $4.5 million for the three months ended March 31, 2005 from $4.2 million for the same period in 2004. This increase generally reflects higher costs in our AIDS vaccine and inflammatory arthritis programs. Research and preclinical development program expenses in 2004 include costs associated with CellExSys, which were eliminated in July 2004 following the merger of CellExSys into Chromos. We expect that our research and development expenses for the remainder of 2005 will vary depending on the timing of outside services necessary to support our clinical programs and our newly initiated collaborations with Celladon and Sirna.

     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:

     Research and development costs attributable to programs in clinical development include the costs of salaries and benefits, clinical trial costs, outside services, materials and supplies incurred to support the clinical programs. Indirect costs allocated to clinical programs include facility and occupancy costs, research and development administrative costs, and license and royalty payments. These costs are further allocated between clinical and preclinical programs based on relative levels of program activity. IAVI separately manages and funds the clinical trial costs of our AIDS vaccine program and the Cystic Fibrosis Foundation separately funded the external costs of the Phase II clinical trial of tgAAVCF. As a result, we do not include those costs in our research and development expenses. We discontinued development of our cystic fibrosis product candidate in March 2005.

     Costs attributed to research and preclinical programs represent our earlier-stage development activities, including costs incurred for the Huntington’s disease and congestive heart failure programs as well as other programs prior to their transition into clinical trials. Research and preclinical program expense also includes costs that are not allocable to a clinical development program, such as unallocated manufacturing infrastructure costs. Because we conduct multiple research projects and utilize resources across several programs, our research and preclinical development costs are not directly assigned to individual programs.

     For purposes of reimbursement from our collaboration partners, we capture the level of effort expended on a program through our project management system, which is based primarily on human resource time allocated to each program, supplemented by an allocation of indirect costs and other specifically identifiable costs, if any. As a result, the costs allocated to a program do not necessarily reflect the actual costs of the program.

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     General and Administrative Expenses. General and administrative expenses increased to $1.9 million for the three months ended March 31, 2005, from $1.8 million for the same period in 2004. This increase primarily reflects higher professional service costs related to patent issuances in the current year, offset by lower personnel costs due to the merger of CellExSys into Chromos in July 2004.

     Restructure Charges. Restructure charges increased to $219,000 for the three months ended March 31, 2005, from $195,000 for the same period in 2004. Restructuring charges in 2005 consist of accretion expense totaling $119,000 and a charge related to updated sublease rental assumptions that may be achieved from our Bothell facility totaling $100,000. We record accretion expense based upon changes in the accrued restructure liability that results from the passage of time at an assumed discount rate of 10%. Accretion expense is recorded on an ongoing basis and is reflected as a charge in the accompanying statements of operations as a restructuring charge.

  Other Income and Expense

     Investment Income. Investment income decreased to $100,000 for the three months ended March 31, 2005, from $124,000 for the same period in 2004. The decrease reflects a $63,000 non-cash charge to reduce the carrying value of our share of the Chromos debenture received as part of the CellExSys merger. This non-cash charge, which reduced the debenture carrying value to zero, was partially offset by higher investment income.

     Interest Expense. Interest expense relates to interest on outstanding loans from our collaborative partners, notes and obligations under equipment financing arrangements that we use to finance purchases of laboratory and computer equipment, furniture and leasehold improvements. Interest expense increased to $129,000 for the three months ended March 31, 2005, from $120,000 for the same period in 2004, reflecting an increase of the London Interbank Offered Rate, or LIBOR, used to calculate interest on a $10 million loan owed to Biogen offset by lower interest charges on decreased principal amounts outstanding under our equipment financing arrangements.

Liquidity and Capital Resources

     Our combined cash and cash equivalents decreased to $30.4 million at March 31, 2005, compared to $34.1 million at December 31, 2004 and our net working capital decreased to $26.8 million at March 31, 2005, compared to $31.2 million at December 31, 2004. Our principal use of cash was $3.3 million to fund our operations during the period. Our shareholders’ equity decreased to $45.1 million at March 31, 2005, compared to $49.8 million at December 31, 2004 due to our net loss of $4.7 million for the quarter ended March 31, 2005.

     We have financed our product development activities and general corporate functions primarily through proceeds from public and private sales of our equity securities, through cash payments received from our collaborative partners and proceeds from the issuance of debt. To a lesser degree, we have also financed our operations through interest earned on cash and cash equivalents, loan funding under equipment leasing agreements and research grants. These financing sources have historically allowed us to maintain adequate levels of cash and investments.

     Our AIDS vaccine candidate and our inflammatory arthritis product candidate are both in Phase I clinical trials. We expect to continue incurring significant expense in advancing our product candidates toward commercialization. As a result, we do not expect to generate sustained positive cash flow from our operations for at least the next several years and only then if we can successfully develop and commercialize our product candidates. We will require substantial additional financial resources to fund the development and commercialization of our product candidates and expand research and development of our product candidates for treating additional diseases.

     We have an ongoing collaboration with IAVI and CCRI to develop an AIDS vaccine for use in non-industrialized countries. We are developing our product candidate for Huntington’s disease under a collaboration with Sirna where we share the development costs, and any potential revenues with Sirna. Under our collaboration with Celladon to develop products to treat congestive heart failure, we have agreed to contribute up to $2 million to support development activities under the collaboration. This contribution will consist primarily of internal development and manufacturing efforts at rates agreed to by the parties. We are entitled to receive payments from Celladon for our research and development efforts above $2 million.

We had previously expected that our cash requirements for 2005 would range from $22 million to $24 million. As a result of discontinuing our cystic fibrosis program, we have eliminated certain operating activities previously planned to occur during 2005. We have also recently completed the preparation of development plans under our new collaborations with Celladon and Sirna, under which we expect to receive additional sources of funding during 2005. As a result, we now expect that our cash requirements for 2005 will range from $20 million to $22 million and that our cash and cash equivalents at March 31, 2005, plus the funding from our partners will be sufficient to fund our operations until approximately mid-2006. This estimate is based on

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our ability to perform planned research and development activities and the receipt of planned funding from our collaborators. Although our development collaboration with IAVI has been extended through the end of 2006, the development plan and budget under the collaboration is established on an annual basis. While we expect this program to continue through at least the duration of the current collaboration term, we have not established the work plan and budget for 2006 with IAVI and have therefore not yet made an assumption as to the level of funding that we may receive from IAVI in 2006. We have a $650,000 loan from Biogen that is due in September 2005. We have a $10 million note payable to Biogen that is due in August 2006, which will require that we raise additional capital, or seek an alternative arrangement to repay the note.

     Our near-term financing strategy has included leveraging our development capabilities and intellectual assets into additional capital raising opportunities, advancing our clinical development programs and accessing the public and private capital markets at appropriate times. During 2004, we raised approximately $30 million in new equity capital and have recently entered into new strategic collaborations with Celladon and Sirna that leverage our development capabilities. In March 2005, we announced the initial results of a Phase II clinical trial of tgAAVCF and our decision to discontinue the development of the product candidate based on those results. The results of this trial and the discontinuance of the program have impacted our ability to raise additional capital and have caused us to focus our financing strategy around advancement of our two other programs in clinical development and our new development collaborations and leveraging value out of our other intellectual assets and capabilities. We expect the level of our future operating expenses to be driven by the needs of our product development programs, offset by the availability of funds through partner-funded collaborations, equity offerings or other financing activities. The size, scope and pace of our development activities depend on the availability of these resources. Our future cash requirements will depend on many factors, including:

	•	the rate and extent of scientific progress in our research and development programs;
	•	the timing, costs and scope of, and our success in, clinical trials, obtaining regulatory approvals and filing, prosecuting and enforcing patents;
	•	competing technological and market developments;
	•	the timing and costs of, and our success in, any product commercialization activities and facility expansions, if and as required; and
	•	the expense and outcome of any litigation or administrative proceedings involving our intellectual property, or access to third-party intellectual property through licensing agreements.

     IAVI has the right to terminate our collaboration and its obligation to provide research funding at any time for any reason with 90 days’ notice. If we were to lose the collaborative funding expected from IAVI and were unable to obtain alternative sources of funding for the AIDS vaccine product candidate, we may be unable to continue our research and development program for that product candidate. Our other development collaborations contain similar termination provisions which if terminated would result in the loss of funding and may cause us to terminate development efforts on the program.

     Additional sources of financing could involve one or more of the following:

	•	entering into additional product development and funding collaborations or other strategic transactions, or extending or expanding our current collaborations;
	•	selling or licensing our technology or product candidates;
	•	borrowing under loan or equipment leasing arrangements;
	•	issuing equity in the public or private markets; or
	•	issuing debt.

     Additional funding may not be available to us on reasonable terms, if at all. Depending on our ability to successfully access additional funding, we may be forced to implement significant cost reduction measures. These adjustments may include scaling back, delaying or terminating one or more research and development programs, curtailing capital expenditures or reducing other operating activities. We may also be required to relinquish some rights to our technology or product candidates or grant licenses on unfavorable terms, either of which would reduce the ultimate value to us of the technology or product candidates.

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Factors Affecting Our Operating Results, Our Business and Our Stock Price

     In addition to the other information contained in this quarterly report, you should carefully read and consider the following risk factors. If any of these risks actually occur, our business, operating results or financial condition could be harmed. This could cause the trading price of our stock to decline, and you could lose all or part of your investment.

Risks Related to Our Business

We expect to continue to operate at a loss and may never become profitable.

     Substantially all of our revenue has been derived under collaborative research and development agreements relating to the development of our potential product candidates. We have incurred, and will continue to incur for the foreseeable future, significant expense to develop our research and development programs, conduct preclinical studies and clinical trials, seek regulatory approval for our product candidates and provide general and administrative support for these activities. As a result, we have incurred significant net losses since inception, and we expect to continue to incur substantial additional losses in the future. As of March 31, 2005, we had an accumulated deficit of approximately $235.5 million. We may never generate profits and, if we do become profitable, we may be unable to sustain or increase profitability.

All of our product candidates are in early-stage clinical trials or preclinical development, and if we are unable to successfully develop and commercialize our product candidates we will be unable to generate sufficient capital to maintain our business.

     In December 2003, IAVI initiated a Phase I trial for our AIDS vaccine product candidate in Europe. In March 2004, we initiated a Phase I trial for our inflammatory arthritis product candidate in the United States and Canada. We will not generate any product revenue for at least several years and then only if we can successfully develop and commercialize our product candidates. Commercializing our potential products depends on successful completion of additional research and development and testing, in both preclinical development and clinical trials. Clinical trials may take several years or more to complete. The commencement, cost and rate of completion of our clinical trials may vary or be delayed for many reasons, including the risks discussed elsewhere in this section. If we are unable to successfully complete preclinical and clinical development of some or all of our product candidates in a timely manner, we may be unable to generate sufficient product revenue to maintain our business.

     Even if our potential products succeed in clinical trials and are approved for marketing, these products may never achieve market acceptance. If we are unsuccessful in commercializing our product candidates for any reason, including greater effectiveness or economic feasibility of competing products or treatments, the failure of the medical community or the public to accept or use any products based on gene delivery, inadequate marketing and distribution capabilities or other reasons discussed elsewhere in this section, we will be unable to generate sufficient product revenue to maintain our business.

If we are unable to raise additional capital when needed, we will be unable to conduct our operations and develop our potential products.

     Because internally generated cash flow will not fund development and commercialization of our product candidates, we will require substantial additional financial resources. Our future capital requirements will depend on many factors, including:

	•	the rate and extent of scientific progress in our research and development programs;
	•	the timing, costs and scope of, and our success in, conducting clinical trials, obtaining regulatory approvals and pursuing patent prosecutions;
	•	competing technological and market developments;
	•	the timing and costs of, and our success in, any commercialization activities and facility expansions, if and as required; and
	•	the existence and/or outcome of any litigation or administrative proceedings involving intellectual property.

     We expect that our cash and cash equivalents at March 31, 2005, plus the funding from IAVI for 2005 work under our AIDS vaccine collaboration and funding from our other partners will be sufficient to fund our operations until approximately

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mid-2006. This estimation is based on our ability to perform planned research and development activities and the receipt of planned funding from our collaborators. In August 2006, our $10 million note payable to Biogen is due, which will require that we raise additional capital to repay the note or seek an alternative arrangement to repay the note. We also have a $650,000 loan from Biogen that is due in September 2005. Although our development collaboration with IAVI has been extended through the end of 2006, the development plan and budget under the collaboration is established on an annual basis. While we expect this program to continue through at least the duration of the current collaboration term, we have not established the work plan and budget for 2006 with IAVI and have therefore not yet made an assumption as to the level of funding that we may receive from IAVI in those years. Additional sources of financing could involve one or more of the following:

	•	extending or expanding our current collaborations;
	•	entering into additional product development collaborations;
	•	selling or licensing our technology or product candidates;
	•	borrowing under loan or equipment leasing arrangements;
	•	issuing equity in the public or private markets; or
	•	issuing debt.

     Additional funding may not be available to us on reasonable terms, if at all.

     The funding that we expect to receive from IAVI depends on continued scientific progress under the collaboration and IAVI’s ability and willingness to continue or extend the collaboration. If we are unable to successfully access additional capital, we may need to scale back, delay or terminate one or more of our development programs, curtail capital expenditures or reduce other operating activities. We may also be required to relinquish some rights to our technology or product candidates or grant or take licenses on unfavorable terms, either of which would reduce the ultimate value to us of our technology or product candidates.

The regulatory approval process for our product candidates is costly, time-consuming and subject to unpredictable changes and delays, and our product candidates may never receive regulatory approval.

     No gene therapy products have received regulatory approval for marketing from the U.S. Food and Drug Administration, or FDA. Because our product candidates involve new and unproven technologies, we believe that the regulatory approval process may proceed more slowly compared to clinical trials involving traditional drugs. The FDA and applicable state and foreign regulators must conclude at each stage of clinical testing that our clinical data suggest acceptable levels of safety in order for us to proceed to the next stage of clinical trials. In addition, gene therapy clinical trials conducted at institutions that receive funding for recombinant DNA research from the U.S. National Institutes of Health, or NIH, are subject to review by the NIH’s Office of Biotechnology Activities Recombinant DNA Advisory Committee, or RAC. Although NIH guidelines do not have regulatory status, the RAC review process can impede the initiation of the trial, even if the FDA has reviewed the trial and approved its initiation. Moreover, before a clinical trial can begin at an NIH-funded institution, that institution’s Institutional Biosafety Committee must review the proposed clinical trial to assess the safety of the trial.

     The regulatory process for our product candidates is costly, time-consuming and subject to unpredictable delays. The clinical trial requirements of the FDA, NIH and other agencies and the criteria these regulators use to determine the safety and efficacy of a product candidate vary substantially according to the type, complexity, novelty and intended use of the potential products. In addition, regulatory requirements governing gene and cell therapy products have changed frequently and may change in the future. Accordingly, we cannot predict how long it will take or how much it will cost to obtain regulatory approvals for clinical trials or for manufacturing or marketing our potential products. Some or all of our product candidates may never receive regulatory approval. A product candidate that appears promising at an early stage of research or development may not result in a commercially successful product. Our clinical trials may fail to demonstrate the safety and efficacy of a product candidate or a product candidate may generate unacceptable side affects or other problems during or after clinical trials. Should this occur, we may have to delay or discontinue development of the product candidate, and the corporate partner that supports development of that product candidate may terminate its support. Delay or failure to obtain, or unexpected costs in obtaining, the regulatory approval necessary to bring a potential product to market could decrease our ability to generate sufficient product revenue to maintain our business.

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If we are unable to obtain or maintain licenses for necessary third-party technology on acceptable terms or to develop alternative technology, we may be unable to develop and commercialize our product candidates.

     We have entered into exclusive and nonexclusive license agreements that give us and our partners rights to use technologies owned or licensed by commercial and academic organizations in the research, development and commercialization of our potential products. For example, we have a gene transfer technology license agreement with Amgen Inc., or Amgen, as the successor to Immunex Corporation, or Immunex, under which we have license rights to certain Immunex proprietary technology specifically applicable to gene therapy applications. In a February 2004 letter, Amgen took the position that we are not licensed, either exclusively or non-exclusively, to use Immunex intellectual property covering TNFR:Fc or therapeutic uses for TNFR:Fc. We have responded with a letter confirming our confidence that the gene transfer technology license agreement provides us with an exclusive worldwide license to use the gene construct coding for TNFR:Fc for gene therapy applications. We have had and continue to have further communications with Amgen regarding our differences. Notwithstanding our confidence, it is possible that a resolution of those differences, through litigation or otherwise, could cause delay or discontinuation of our development of tgAAC94 or our inability to commercialize any resulting product.

     We believe that we will need to obtain additional licenses to use patents and unpatented technology owned or licensed by others for use, compositions, methods, processes to manufacture compositions, processes to manufacture and purify gene delivery product candidates and other technologies and processes for our present and potential product candidates. If we are unable to maintain our current licenses for third-party technology or obtain additional licenses on acceptable terms, we may be required to expend significant time and resources to develop or license replacement technology. If we are unable to do so, we may be unable to develop or commercialize the affected product candidates. In addition, the license agreements for technology for which we hold exclusive licenses typically contain provisions that require us to meet minimum development milestones in order to maintain the license on an exclusive basis for some or all fields of the license. We also have license agreements for some of our technologies, which may require us to sublicense certain of our rights. If we do not meet these requirements, our licensor may convert all or a portion of the license to a nonexclusive license or, in some cases, terminate the license.

     In many cases, patent prosecution of our licensed technology is controlled solely by the licensor. If our licensors fail to obtain and maintain patent or other protection for the proprietary intellectual property we license from them, we could lose our rights to the intellectual property or our exclusivity with respect to those rights, and our competitors could market competing products using the intellectual property. Licensing of intellectual property is of critical importance to our business and involves complex legal, business and scientific issues and is complicated by the rapid pace of scientific discovery in our industry. Disputes may arise regarding intellectual property subject to a licensing agreement, including:

	•	the scope of rights granted under the license agreement and other interpretation-related issues;
	•	the extent to which our technology and processes infringe on intellectual property of the licensor that is not subject to the licensing agreement;
	•	the sublicensing of patent and other rights under our collaborative development relationships;
	•	the ownership of inventions and know-how resulting from the joint creation or use of intellectual property by our licensors and us and our partners; and
	•	the priority of invention of patented technology.

     If disputes over intellectual property that we have licensed prevent or impair our ability to maintain our current licensing arrangements on acceptable terms, we may be unable to successfully develop and commercialize the affected product candidates.

Failure to recruit patients could delay or prevent clinical trials of our potential products, which could delay or prevent the development of potential products.

     Identifying and qualifying patients to participate in clinical trials of our potential products is critically important to our success. The timing of our clinical trials depends on the speed at which we can recruit patients to participate in testing our product candidates. We have experienced delays in some of our clinical trials, and we may experience similar delays in the future. If patients are unwilling to participate in our gene therapy trials because of negative publicity from adverse events in the biotechnology or gene therapy industries or for other reasons, including competitive clinical trials for similar patient populations, the timeline for recruiting patients, conducting trials and obtaining regulatory approval of potential products will be delayed. These delays could result in increased costs, delays in advancing our product development, delays in testing the effectiveness of our technology or termination of the clinical trials altogether.

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Litigation involving intellectual property, product liability or other claims and product recalls could strain our resources, subject us to significant liability, damage our reputation or result in the invalidation of our proprietary rights.

     As our product development efforts progress, especially in potentially significant markets such as AIDS or inflammatory arthritis therapies, the risk increases that others may claim that our processes and potential products infringe on their intellectual property rights. In addition, administrative proceedings, litigation or both may be necessary to enforce our intellectual property rights or determine the rights of others. Defending or pursuing these claims, regardless of their merit, would be costly and would likely divert management’s attention and resources away from our operations. If there were to be an adverse outcome in litigation or an interference proceeding, we could face potential liability for significant damages or be required to obtain a license to the patented process or technology at issue, or both. If we are unable to obtain a license on acceptable terms, or to develop or obtain alternative technology or processes, we may be unable to manufacture or market any product or potential product that uses the affected process or technology.

     Clinical trials and the marketing of any potential products may expose us to liability claims resulting from the testing or use of our products. Gene therapy treatments are new and unproven, and potential known and unknown side effects of gene therapy may be serious and potentially life-threatening. Product liability claims may be made by clinical trial participants, consumers, healthcare providers or other sellers or users of our products. Although we currently maintain liability insurance, the costs of product liability and other claims against us may exceed our insurance coverage. In addition, we may require increased liability coverage as additional product candidates are used in clinical trials and commercialized. Liability insurance is expensive and may not continue to be available on acceptable terms. A product liability or other claim or product recall not covered by or exceeding our insurance coverage could significantly harm our financial condition. In addition, adverse publicity resulting from a product recall or a liability claim against us, one of our partners or another gene therapy company could significantly harm our reputation and make it more difficult to obtain the funding and collaborative partnerships necessary to maintain our business.

If we lose IAVI as a partner, we may be unable to develop our AIDS vaccine product candidate.

     We have a collaborative development agreement with IAVI, which expires in December 2006, that we expect to provide us with funding to reimburse research and development and manufacturing expenses we incur in connection with the collaboration. As a result, a significant portion of our operating expenses are funded through our collaborative agreements with IAVI. Additionally, IAVI directly funds the Phase I clinical trial for our AIDS vaccine product candidate.

     IAVI has the right to terminate the collaboration or its obligation to provide funding at any time for any reason with 90 days notice, which would significantly affect our operating activities. The loss of significant amounts of collaborative or clinical trial funding could cause the delay, reduction or termination of the related research and development programs, and a reduction in capital expenditures and other operating activities necessary to support general operations. Such a reduction could further impede our ability to develop our product candidates.

If we do not attract and retain qualified personnel, we may be unable to develop and commercialize some of our potential products.

     Our future success depends in large part on our ability to attract and retain key technical and management personnel. All of our employees, including our executive officers, can terminate their employment with us at any time. We have programs in place designed to retain personnel, including competitive compensation packages and programs to create a positive work environment. Other companies, research and academic institutions and other organizations in our field compete intensely for employees, however, and we may be unable to retain our existing personnel or attract additional qualified employees and consultants. If we experience significant turnover or difficulty in recruiting new personnel, our research and development of product candidates could be delayed and we could experience difficulty in generating sufficient revenue to maintain our business.

If our partners or scientific consultants terminate, reduce or delay our relationships with them, we may be unable to develop our potential products.

     Our partners provide funding, manage regulatory filings, aid and augment our internal research and development efforts and provide access to important intellectual property and know-how. Their activities include, for example, support in processing the regulatory filings of our product candidates and funding clinical trials. Our outside scientific consultants and contractors perform research, develop technology and processes to advance and augment our internal efforts and provide access to important intellectual property and know-how. Their activities include, for example, clinical evaluation of our product candidates, product development activities performed under our research collaborations, research under sponsored research agreements and contract manufacturing services. Collaborations with established pharmaceutical and biotechnology companies and academic, research and public health organizations often provide a measure of validation of our product development efforts in the eyes of securities

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analysts, investors and the medical community. The development of certain of our potential products, and therefore the success of our business, depends on the performance of our partners, consultants and contractors. If they do not dedicate sufficient time, regulatory or other technical resources to the research and development programs for our product candidates or if they do not perform their obligations as expected, we may experience delays in, and may be unable to continue, the preclinical or clinical development of those product candidates. Each of our collaborations and scientific consulting relationships concludes at the end of the term specified in the applicable agreement unless we and our partners agree to extend the relationship. Any of our partners may decline to extend the collaboration, or may be willing to extend the collaboration only with a significantly reduced scope, for a number of scientific or business reasons. Competition for scientific consultants and partners in gene therapy is intense. We may be unable to successfully maintain our existing relationships or establish additional relationships necessary for the development of our product candidates on acceptable terms, if at all. If we are unable to do so, our research and development programs may be delayed or we may lose access to important intellectual property or know-how.

The success of our clinical trials and preclinical studies may not be indicative of results in a large number of patients of either safety or efficacy.

     The successful results of our technology in preclinical studies using animal models may not be predictive of the results that we will see in our clinical trials. In addition, results in early-stage clinical trials are based on limited numbers of patients and generally test for drug safety rather than efficacy. Our reported progress and results from our early phases of clinical testing of our product candidates may not be indicative of progress or results that will be achieved from larger populations, which could be less favorable. Moreover, we do not know if the favorable results we have achieved in clinical trials will have a lasting effect. If a larger group of patients does not experience positive results, or if any favorable results do not demonstrate a beneficial effect, our product candidates that we advance to clinical trials, may not receive approval from the FDA for further clinical trials or commercialization. For example, in March 2005, we discontinued the development of tgAAVCF following the analysis of Phase II clinical trial data in which tgAAVCF failed to achieve the efficacy endpoints of the trial.

We may be unable to adequately protect our proprietary rights domestically or overseas, which may limit our ability to successfully market any product candidates.

     Our success depends substantially on our ability to protect our proprietary rights and operate without infringing on the proprietary rights of others. We own or license patents and patent applications, and will need to license additional patents, for genes, processes, practices and techniques critical to our present and potential product candidates. If we fail to obtain and maintain patent or other intellectual property protection for this technology, our competitors could market competing products using those genes, processes, practices and techniques. The patent process takes several years and involves considerable expense. In addition, patent applications and patent positions in the field of biotechnology are highly uncertain and involve complex legal, scientific and factual questions. Our patent applications may not result in issued patents and the scope of any patent may be reduced both before and after the patent is issued. Even if we secure a patent, the patent may not provide significant protection and may be circumvented or invalidated.

     We also rely on unpatented proprietary technology and technology that we have licensed on a nonexclusive basis. While we take precautions to protect our proprietary unpatented technology, we may be unable to meaningfully protect this technology from unauthorized use or misappropriation by a third party. Our competitors could also obtain rights to our nonexclusively licensed proprietary technology. In any event, other companies may independently develop equivalent proprietary information and techniques. If our competitors develop and market competing products using our unpatented or nonexclusively licensed proprietary technology or substantially similar technology, our products, if successfully developed, could suffer a reduction in sales or be forced out of the market.

If we do not develop adequate development, manufacturing, sales, marketing and distribution capabilities, either alone or with our business partners, we will be unable to generate sufficient product revenue to maintain our business.

     Our potential products require significant development of new processes and design for the advancement of the product candidate through manufacture, preclinical and clinical testing. We may be unable to continue development or meet critical milestones with our partners due to technical or scientific issues related to manufacturing or development. We currently do not have the physical capacity to manufacture large-scale quantities of our potential products. This could limit our ability to conduct large clinical trials of a product candidate and to commercially launch a successful product candidate. In order to manufacture product at such scale, we will need to expand or improve our current facilities and staff or supplement them through the use of contract providers. If we are unable to obtain and maintain the necessary manufacturing capabilities, either alone or through third parties, we will be unable to manufacture our potential products in quantities sufficient to sustain our business. Moreover, we are unlikely to become profitable if we, or our contract providers, are unable to manufacture our potential products in a cost-effective manner.

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     In addition, we have no experience in sales, marketing and distribution. To successfully commercialize any products that may result from our development programs, we will need to develop these capabilities, either on our own or with others. We intend to enter into collaborations with other entities to utilize their mature marketing and distribution capabilities, but we may be unable to enter into marketing and distribution agreements on favorable terms, if at all. If our current or future collaborative partners do not commit sufficient resources to timely marketing and distributing our future products, if any, and we are unable to develop the necessary marketing and distribution capabilities on our own, we will be unable to generate sufficient product revenue to sustain our business.

Post-approval manufacturing or product problems or failure to satisfy applicable regulatory requirements could prevent or limit our ability to market our products.

     Commercialization of any products will require continued compliance with FDA and other federal, state and local regulations. For example, our current manufacturing facility, which is designed for manufacturing our AAV vectors for clinical and development purposes, is subject to the Good Manufacturing Practices requirements and other regulations of the FDA, as well as to other federal, state and local regulations such as the Occupational Health and Safety Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and the Environmental Protection Act. Any future manufacturing facilities that we may construct for large-scale commercial production will also be subject to regulation. We may be unable to obtain regulatory approval for or maintain in operation this or any other manufacturing facility. In addition, we may be unable to attain or maintain compliance with current or future regulations relating to manufacture, safety, handling, storage, record keeping or marketing of potential products. If we fail to comply with applicable regulatory requirements or discover previously unknown manufacturing, contamination, product side effects or other problems after we receive regulatory approval for a potential product, we may suffer restrictions on our ability to market the product or be required to withdraw the product from the market.

Risks Related to Our Industry

Adverse events in the field of gene therapy could damage public perception of our potential products and negatively affect governmental approval and regulation.

     Public perception of our product candidates could be harmed by negative events in the field of gene therapy. For example, in 2003, fourteen patients in a French academic clinical trial being treated for x-linked severe combined immunodeficiency in a gene therapy trial using a retroviral vector showed correction of the disease, although three of the patients subsequently developed leukemia. Serious adverse events, including patient deaths have occurred in clinical trials. Adverse events and the resulting publicity, as well as any other adverse events in the field of gene therapy that may occur in the future, could result in a decrease in demand for any products that we may develop. The commercial success of our product candidates will depend in part on public acceptance of the use of gene therapy for preventing or treating human diseases. If public perception is influenced by claims that gene therapy is unsafe, our product candidates may not be accepted by the general public or the medical community. The public and the medical community may conclude that our technology is unsafe.

     Future adverse events in gene therapy or the biotechnology industry could also result in greater governmental regulation, unfavorable public perception, stricter labeling requirements and potential regulatory delays in the testing or approval of our potential products. Any increased scrutiny could delay or increase the costs of our product development efforts or clinical trials.

Our use of hazardous materials exposes us to liability risks and regulatory limitations on their use, either of which could reduce our ability to generate product revenue.

     Our research and development activities involve the controlled use of hazardous materials, including chemicals, biological materials and radioactive compounds. Our safety procedures for handling, storing and disposing of these materials must comply with federal, state and local laws and regulations, including, among others, those relating to solid and hazardous waste management, biohazard material handling, radiation and air pollution control. We may be required to incur significant costs in the future to comply with environmental or other applicable laws and regulations. In addition, we cannot eliminate the risk of accidental contamination or injury from hazardous materials. If a hazardous material accident were to occur, we could be held liable for any resulting damages, and this liability could exceed our financial resources. Accidents unrelated to our operations could cause federal, state or local regulatory agencies to restrict our access to hazardous materials needed in our research and development efforts, which could result in delays in our research and development programs. Paying damages or experiencing delays caused by restricted access could reduce our ability to generate revenue and make it more difficult to fund our operations.

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The intense competition and rapid technological change in our market may result in pricing pressures and failure of our potential products to achieve market acceptance.

     We face increasingly intense competition from a number of commercial entities and institutions that are developing gene therapy technologies. Our competitors include early-stage and more established gene delivery companies, other biotechnology companies, pharmaceutical companies, universities, research institutions and government agencies developing gene therapy products or other biotechnology-based therapies designed to treat the diseases on which we focus. We also face competition from companies using more traditional approaches to treating human diseases, such as surgery, medical devices and pharmaceutical products. As our product candidates become commercial gene therapy products that may affect commercial markets of the analogous protein or traditional pharmaceutical therapy, disputes including lawsuits, demands, threats or patent challenges may arise in an effort to slow our development. In addition, we compete with other companies to acquire products or technology from research institutions or universities. Many of our competitors have substantially more financial and infrastructure resources and larger research and development staffs than we do. Many of our competitors also have greater experience and capabilities than we do in:

	•	research and development;
	•	clinical trials;
	•	obtaining FDA and other regulatory approvals;
	•	manufacturing; and
	•	marketing and distribution.

     In addition, the competitive positions of other companies, institutions and organizations, including smaller competitors, may be strengthened through collaborative relationships. Consequently, our competitors may be able to develop, obtain patent protection for, obtain regulatory approval for, or commercialize new products more rapidly than we do, or manufacture and market competitive products more successfully than we do. This could limit the prices we could charge for the products that we are able to market or result in our products failing to achieve market acceptance.

     Gene therapy is a rapidly evolving field and is expected to continue to undergo significant and rapid technological change and competition. Rapid technological development by our competitors, including development of technologies, products or processes that are more effective or more economically feasible than those we have developed, could result in our actual and proposed technologies, products or processes losing market share or becoming obsolete.

Healthcare reform measures and the unwillingness of third-party payors to provide adequate reimbursement for the cost of our products could impair our ability to successfully commercialize our potential products and become profitable.

     Sales of medical products and treatments depends substantially, both domestically and abroad, on the availability of reimbursement to the consumer from third-party payors. Our potential products may not be considered cost-effective by third-party payors, who may not provide coverage at the price set for our products, if at all. If purchasers or users of our products are unable to obtain adequate reimbursement, they may forego or reduce their use of our products. Even if coverage is provided, the approved reimbursement amount may not be high enough to allow us to establish or maintain pricing sufficient to realize a sufficient return on our investment.

     Increasing efforts by governmental and third-party payors, such as Medicare, private insurance plans and managed care organizations, to cap or reduce healthcare costs will affect our ability to commercialize our product candidates and become profitable. We believe that third-party payors will attempt to reduce healthcare costs by limiting both coverage and level of reimbursement for new products approved by the FDA. There have been and will continue to be a number of federal and state proposals to implement government controls on pricing, the adoption of which could affect our ability to successfully commercialize our product candidates. Even if the government does not adopt any such proposals or reforms, their announcement could impair our ability to raise capital.

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Risks Related to Our Common Stock

If we are unable to comply with the minimum requirements for quotation on the NASDAQ SmallCap Market and we lose our quotation on NASDAQ, the liquidity and market price of our common stock would decline.

     Our stock is listed on the NASDAQ SmallCap Market. In order to continue to be listed on the NASDAQ SmallCap Market, we must meet specific quantitative standards, including maintaining a minimum bid price of $1.00 for our common stock. The closing bid price of our common stock has been below the $1.00 requirement for extended periods of time on multiple occasions in March and April 2005. If at any time we can not maintain this minimum standard for 30 consecutive trading days, the delisting process may be initiated. Ultimately, if we are unable to comply with the minimum bid price requirement and the other current or future listing requirements, we would lose our quotation on the NASDAQ SmallCap Market. Delisting of our common stock from the NASDAQ SmallCap Market would likely result in a substantial loss in liquidity of our common stock and in a decline in its market price, and you could lose all or part of your investment. In addition, our ability to raise capital through the issuance of debt or equity securities may be impaired if our common stock is delisted.

Concentration of ownership of our common stock may give certain shareholders significant influence over our business.

     A small number of investors own a significant number of shares of our common stock. As of March 31, 2005, Biogen held approximately 12.1 million and Elan (together with its affiliates) held approximately 11.6 million shares of our common stock. Together these holdings represent approximately 27.7% of our common shares outstanding as of March 31, 2005. This concentration of stock ownership may allow these shareholders to exercise significant control over our strategic decisions and block, delay or substantially influence all matters requiring shareholder approval, such as:

	•	election of directors;
	•	amendment of our charter documents; or
	•	approval of significant corporate transactions, such as a change of control of Targeted Genetics.

     The interests of these shareholders may conflict with the interests of other holders of our common stock with regard to such matters. Furthermore, this concentration of ownership of our common stock could allow these shareholders to delay, deter or prevent a third party from acquiring control of Targeted Genetics at a premium over the then-current market price of our common stock, which could result in a decrease in our stock price.

Market fluctuations or volatility could cause the market price of our common stock to decline and limit our ability to raise capital.

     The stock market in general and the market for biotechnology-related companies in particular have experienced extreme price and volume fluctuations, often unrelated to the operating performance of the affected companies. The market price of the securities of biotechnology companies, particularly companies such as ours without earnings and product revenue, has been highly volatile and is likely to remain so in the future. Any report of clinical trial results that are below the expectations of financial analysts or investors could result in a decline in our stock price. We believe that in the past, similar levels of volatility have contributed to the decline in the market price of our common stock, and may do so again in the future. Trading volumes of our common stock can increase dramatically, resulting in a volatile market price for our common stock. In addition, the trading price of our common stock could decline significantly as a result of sales of a substantial number of shares of our common stock, or the perception that significant sales could occur.

     For example, at March 31, 2005, Elan held approximately 11.6 million shares of our common stock. Between December 31, 2004 and January 5, 2005, Elan reported the sale of 395,000 shares of our common stock. In accordance with the termination agreement that we entered into in Elan with in March 2004, Elan is permitted to sell quantities of stock our equal to 175% of the volume limitation set forth in Rule 144(e)(1) promulgated under the Securities Act of 1933, as amended. The sale of significant quantities of stock by Elan, or other holders of significant shares of our stock, could adversely impact the price of our common stock.

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Item 3.	Quantitative and Qualitative Disclosures About Market Risk

     Notes payable: Our results of operations are affected by changes in short-term interest rates as a result of a loan from Biogen that contains a variable interest rate. Interest payments on this loan are determined by the LIBOR plus a margin of 1%. The carrying amount of the note payable approximates fair value because the interest rate on this instrument changes with, or approximates, market rates. The following table provides information as of March 31, 2005, about our obligations that are sensitive to changes in interest rate fluctuations:

Item 4.	Controls and Procedures

     Evaluation of disclosure controls and procedures. Based on our management’s evaluation, with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in ensuring that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms.

     Changes in internal control over financial reporting. There was no change in our internal control over financial reporting, that occurred during the period covered by this quarterly report that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II OTHER INFORMATION

Item 1.	Legal Proceedings

     None.

Item 2.	Unregistered Sales of Securities and Use of Proceeds

     Certain of our loan agreements contain financial covenants establishing limits on our ability to declare or pay cash dividends.

Item 3.	Defaults Upon Senior Securities

     None.

Item 4.	Submission of Matters to a Vote of Security Holders

     None.

Item 5.	Other Information

     None.

Item 6.	Exhibits

     See the Index to Exhibits included in this quarterly report.

SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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TARGETED GENETICS CORPORATION

INDEX TO EXHIBITS

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