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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2003

OR

For the transition period from                      to                     

Commission File Number No. 0-23930

TARGETED GENETICS CORPORATION

(Exact name of Registrant as specified in its charter)

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  ¨

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

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

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TARGETED GENETICS CORPORATION

Quarterly Report on Form 10-Q

For the quarter ended March 31, 2003

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PART I    FINANCIAL INFORMATION

Item 1.    Financial Statements

TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.    Basis of Presentation

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

Our results of operations for the three months ended March 31, 2003 include a $2.6 million termination settlement that we recognized as revenue and $1.3 million of deferred revenue recognized upon termination of the Wyeth agreement. We do not believe that our results of operations for the three months ended March 31, 2003 are necessarily indicative of the results to be expected for the full year.

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

2.    Long-Term Obligations

Long-term obligations consisted of the following:

Future aggregate principal payments related to long-term obligations are $1.4 million for the remainder of 2003, $800,000 in 2004, $9.9 million in 2005 and $10.0 million in 2006.

In addition to the $7.95 million convertible loans payable to Elan, unpaid interest to Elan totaling $733,000 is outstanding at March 31, 2003 and is included in other long-term obligations. Elan has the option to convert principal and interest outstanding under the loan facility, on a per-draw basis, into shares of our common stock. If Elan had elected to convert the convertible loans and the related interest into our common stock as of March 31, 2003, the conversion prices would have ranged from $0.49 to $3.70, and would have resulted in Elan receiving a total of 3,390,961 shares of our common stock.

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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

3.    Redeemable Preferred Stock and Shareholders’ Equity

Series B Convertible Exchangeable Preferred Stock

In July 1999, we issued shares of our Series B convertible exchangeable preferred stock, valued at $12 million, to Elan in exchange for our 80.1% interest in Emerald. The Series B preferred stock is convertible until July 2005, at Elan’s option, into shares of our common stock, at an initial conversion price of $3.32 per share. The Series B preferred stock and accrued dividends were convertible into 4,604,348 shares of our common stock at March 31, 2003 and 4,448,645 shares of our common stock at December 31, 2002. Alternatively, Elan was entitled to exchange the Series B preferred stock for all shares of preferred stock that we hold in Emerald until this exchange right expired on April 21, 2003. As a result of the expiration of the exchange right, we will reclassify the Series B preferred stock to shareholders’ equity beginning in April 2003.

At March 31, 2003, warrants to purchase 5,358,474 shares of our common stock were outstanding. During April 2003, warrants to purchase 3,333,333 shares of our common stock expired.

Stock Compensation

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

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

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

4.    Net Loss per Common Share

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

5.    Collaborative Agreements

International AIDS Vaccine Initiative Agreement

In March 2003, we extended our three-year collaboration agreement with the International Aids Vaccine Initiative, or IAVI, and Children’s Research Institute at Children’s Hospital in Columbus, Ohio, to develop a vaccine, for use in developing countries, to protect against the progression of HIV infection to acquired immune deficiency syndrome, or AIDS. Under the terms of the extension, IAVI will provide up to $5.6 million in funding during 2003 to support efforts that we expect to result in a regulatory filing to support initiation of clinical trials in the second half of 2003 for the first vaccine candidate developed in this collaboration.

Wyeth/Genetics Institute Agreement

In February 2003, we entered into a termination agreement with Wyeth and in March 2003, we received a $3.2 million cash payment from Wyeth. Upon receipt of the $3.2 million settlement payment, we recognized $2.6 million as first quarter 2003 research and development revenue with the remaining $637,000 representing collection of accounts receivable. Additionally, upon termination of this collaboration, we no longer have any performance obligations to Wyeth, and as a result, we recognized revenue totaling $1.3 million in the first quarter of 2003 relating to deferred revenue from up-front payments we received from Wyeth in November 2000. All rights that we granted or otherwise extended to Wyeth related to hemophilia were returned to us and we were granted an option to acquire a right and license to certain hemophilia patent rights controlled by Wyeth.

6.    Accrued Restructure Expenses

During December 2002, we restructured our operations to reduce expenses and focus our resources on our cystic fibrosis, arthritis and AIDS vaccine product development programs. In connection with this restructuring, we reduced our research and administrative staff by approximately 40 personnel (30%) effective February 14, 2003 and accrued $3.4 million for employee termination benefits and contract termination costs related to facility lease commitments.

Accrued restructuring expenses in the accompanying Condensed Consolidated Balance Sheets represent estimated costs that will continue to be incurred for the remaining term of the lease, and is computed as the fair value of the remaining lease rentals reduced by estimated sublease rentals. We estimated the fair value of the liability using the discounted cash flow method. During the three months ended March 31, 2003, we incurred $281,000 in additional costs associated the February 2003 exit of our facility in Sharon Hill, Pennsylvania and relocation of certain equipment to Seattle, Washington. These costs are reflected as restructure charges in the accompanying Condensed Consolidated Statement of Operations for the three months ended March 31, 2003. As of March 31, 2003, we have completed the employee terminations, facility closures and relocated certain equipment to Seattle, Washington. We will continue to negotiate an early termination or sublease of the Bothell, Washington and Sharon Hill, Pennsylvania facility leases to further reduce fixed operating costs.

Payment of rent related to these facilities is reflected as a reduction in the amount of the accrued restructure liability. We will recognize accretion expense due to the passage of time as an additional restructure charge and as an increase in the carrying amount of the accrued restructure expenses. Additionally, because certain restructure charges are computed using assumptions, periodic adjustments may be necessary as we obtain additional information.

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TARGETED GENETICS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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

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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 “believes,” “expects,” “anticipates,” “plans,” “intends,” and other words of similar meaning 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 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 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 correcting cellular function at a genetic level. This involves inserting genes into target cells and activating the inserted gene 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 develop therapies or vaccines for 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 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 insert genetic material into target cells. Our proprietary vector technologies include both viral vector technologies and synthetic vector technologies. Our viral vector development activities, which use modified viruses to deliver a DNA sequence, or gene, 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 using lipids, which are fatty, water-insoluble organic substances that can be absorbed through cell membranes. We believe that 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. We believe that using both viral and synthetic approaches provides advantages in our product development efforts and increases the probability of our potential products reaching the market.

We have a lead AAV product candidate under development for treating cystic fibrosis that has been evaluated in a Phase II clinical trial. In October 2002, we announced preliminary results of this Phase II study. Our analysis of the preliminary data indicates that the primary endpoint of safety and tolerability of the drug was achieved. In addition, positive trends in improvement of lung function, levels of inflammatory cytokines and transfer of the correct gene into the cells of the lung were observed. We expect to begin patient recruitment for a larger confirmatory Phase II clinical trial for this cystic fibrosis product candidate in mid-2003. We also have a pipeline of product candidates focused on treating arthritis, hemophilia, and cancer and we are developing a vaccine candidate to protect against the progression of HIV infection to AIDS, which is partnered with a public health organization. Our synthetic vector product candidates for treating cancer have been evaluated in Phase I and Phase II clinical trials, which showed a good safety profile of the drug, efficient transfer of the gene of interest into the targeted cells, a decrease in the level of proteins produced at abnormally high levels by tumor cells and a reduction in tumor burden. Through partnership activities and other internally funded efforts, we have successfully advanced our product candidates into clinical development, including Phase II clinical trials for our lead cystic fibrosis product candidate and Phase I and Phase II clinical trials for our cancer product candidates.

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During 2002, we implemented plans to restructure operations to concentrate resources on key product development programs and business development activities. In connection with these operational changes, we suspended further clinical development of our cancer and hemophilia programs until we can find development partners to help fund development costs, or find other sources of funding for the program. We have focused our efforts on advancing the clinical development of our product candidate to treat cystic fibrosis and on initiating clinical trials for our product development candidate to treat arthritis and our AIDS vaccine.

We have developed processes to manufacture our AAV-based potential products at a scale amenable to clinical development and expandable to large-scale production for commercialization, pending successful completion of clinical trials and regulatory approval. We believe that our successes in assembling a broad platform of proprietary intellectual property for developing and manufacturing potential products, in establishing collaborative relationships and advancing our potential products to clinical evaluation serve to demonstrate the value of our intellectual property and our potential to develop gene therapy product candidates to treat a range of diseases.

A wide range of diseases may potentially be treated with gene-based products, including cancer, genetic diseases and infectious diseases. We believe that there is also a significant opportunity to treat diseases currently treated with proteins using recombinant DNA technology, monoclonal antibodies or small molecules that may be more effectively treated by gene-based therapies due to their ability to provide a long-term or a localized treatment modality. Our business strategy is to develop multiple gene delivery systems, which we believe will maximize our product opportunities. Using these gene delivery systems, we are developing product candidates across multiple diseases with the belief that gene-based therapies may provide a means to treat disease in ways not currently achievable with traditional pharmaceuticals. We believe that, if successful, we can establish significant market potential for our product candidates. Because there are currently no commercially available gene therapy products, 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. If this is achieved, we believe that the value of our assets can be leveraged into multiple product opportunities.

Developing pharmaceutical products 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 this Section entitled “Factors Affecting Our Operating Results, Our Business and Our Stock Price” in Item 2 of this quarterly report.

Results of Operations

Revenue

Revenue.    Revenue for the three months ended March 31, 2003 increased to $5.6 million from $5.4 million for the same period of 2002. This increase reflects higher revenue, which totaled $3.9 million in 2003, attributable to our hemophilia collaboration with Wyeth, which ended during the quarter, partially offset by lower revenue earned under our AIDS vaccine collaboration with IAVI. Further, we did not earn revenue under our former collaborations with Celltech, Inc. and Emerald Gene Systems, Ltd. for the three months ended March 31, 2003, as both collaborations concluded in 2002.

We expect that our revenue for the next few quarters will consist primarily of research and development revenue from our collaborations with Biogen and IAVI. Any revenue that we may generate from new collaborations or manufacturing arrangements is ultimately dependent on our product development success. Both of these collaborations will conclude in 2003 unless extended. If extended, we can not currently predict the nature or scope of activities under such extensions. As a result of the conclusion of our former collaborations with Celltech, Elan and Wyeth, we expect that total revenue in 2003 will be less than 2002. We also intend to pursue opportunities that may generate contract manufacturing revenue in the future.

Operating Expenses

Research and Development Expenses.    Research and development expense for the three months ended March 31, 2003 decreased to $4.5 million from $8.3 million for the same period of 2002. This decrease represents the suspension of our hemophilia and cancer programs and reduced investments in our technology development activities as we focus our resources on advancing the clinical development of our product candidate to treat cystic fibrosis and on initiating clinical trials for our product development candidate to treat arthritis and our AIDS vaccine.

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Our research and development expenses for the three months ended March 31, 2003 and 2002 were as follows:

Research and development costs attributable to clinical programs include costs of salaries, benefits, clinical trial site 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. Costs attributed to research and preclinical programs largely represent our product pipeline-generating activities. Because we conduct multiple research projects and utilize resources across several projects, the majority of our research and preclinical development costs are not directly assigned to individual projects, but are instead allocated among multiple projects. For purposes of reimbursement from our collaboration partners, we capture the level of effort expended on a project through our project management system, which is based primarily on human resource time allocated to each project, supplemented by an allocation of indirect costs and other specifically identifiable costs, if any. As a result, the costs we allocate to a project are not intended to, and do not necessarily, reflect the actual costs of the project.

The size and scope of our research programs depend on the availability of resources, such as funding provided by our partners under our collaborative agreements. We expect our 2003 research and development costs to be lower than in 2002 as a result of cost reductions initiated to focus our resources on advancing clinical development of our potential cystic fibrosis, arthritis and AIDS vaccine products.

General and Administrative Expenses.    General and administrative expenses for the three months ended March 31, 2003 decreased to $1.3 million from $2.4 million for the same period of 2002. The decrease primarily reflects decreased administrative support for our collaborative partnerships, reduced patent costs and the implementation of measures intended to reduce overall operating expenses.

Restructure Charges.    We recorded restructure charges of $281,000 for the three months ended March 31, 2003 primarily related to lease commitment costs associated with the closure of our facility located in Sharon Hill, Pennsylvania.

Equity in Net Loss of Unconsolidated, Majority-Owned Research and Development Joint Venture.    Our net loss in Emerald decreased to zero for the three months ended March 31, 2003 from $778,000 for the same period in 2002 as the joint venture operations were completed in the third quarter of 2002.

Amortization of Acquisition-Related Intangibles.    Amortization expense decreased to zero for the three months ended March 31, 2003 from $126,000 for the same period in 2002. Amortization of intangibles in 2002 represented amortization of non-competition agreements acquired in connection with our acquisition of Genovo, Inc. in 2000, which were fully amortized as of September 30, 2002.

Other Income and Expense

Investment Income.    Investment income for the three months ended March 31, 2003 decreased to $52,000 from $87,000 for the same period of 2002. The decrease resulted from lower average cash balances in 2003 and a decrease in the yield of our short-term bond mutual fund.

Interest Expense.    Interest expense relates to interest on outstanding loans from our collaborative partners, notes and obligations under equipment financing arrangements and installment loans we use to finance purchases of laboratory and computer equipment, furniture and leasehold improvements. Interest expense for the three months ended March 31, 2003 increased to $362,000 from $267,000 for the same period of 2002. This increase is attributable to higher average principal balances outstanding during the three months ended March 31, 2003, as compared to the same period in 2002.

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Liquidity and Capital Resources

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, cash equivalents and short-term investments, loan funding commitments from our collaboration partners and under equipment leasing agreements and research grants. These financing sources have historically allowed us to maintain adequate levels of cash and investments.

A significant portion of our operating expenses have been funded through collaborations with third parties. We have two ongoing strategic partnerships:

Our future cash requirements will depend on many factors, including:

All of our product candidates are in research, preclinical and clinical development and 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, grow our business and expand research and development of our product candidates for treating additional diseases.

Our combined cash and cash equivalents total $12.2 million at March 31, 2003, compared to $12.6 million at December 31, 2002. Our primary source of cash for the three months ended March 31, 2003 was funding from collaboration partners, including a $3.2 million termination payment from Wyeth. We expect to receive additional collaborative funding of $5.6 million in research and development payments under our partnerships with Biogen and IAVI, to reimburse expenses incurred in connection with the applicable development collaboration. We believe that our cash and cash equivalents and the funding anticipated under our collaborations will be sufficient to fund our operations at least through the end of 2003.

The size and scope of our development activities depend on the availability of resources. For example, in December 2002, we implemented plans to restructure our operations to reduce expenses and concentrate resources on key product development programs and business development activities. As part of these plans, we suspended further clinical development of our cancer and hemophilia programs and implemented a reduction in headcount of approximately 30%, consisting of approximately 40 positions in operations, scientific and administrative functions that were not required to support our AIDS vaccine, cystic fibrosis and arthritis development programs. We implemented these operational changes to reduce expenses and to concentrate our resources with advancing these programs, pursuing corporate strategic initiatives and accessing additional capital.

IAVI has the right to terminate our collaboration with it or its obligation to provide research funding at any time for scientific or business reasons 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 covered by the collaboration, we may be unable to continue our research and development program for that product candidate.

We are seeking partners for our hemophilia and cancer programs and are pursuing other opportunities to obtain additional capital to fund our operations. Additional sources of financing could involve one or more of the following:

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Our common stock is listed on the NASDAQ SmallCap Market, which requires that we maintain compliance with certain minimum listing standards including minimum shareholders’ equity and stock bid price. Our stock price is currently below the $1.00 minimum bid price, however we have been provided 180 days, or until September 15, 2003, to comply with the minimum bid price requirement provided that we continue to comply with the other initial listing requirements of the NASDAQ SmallCap Market, including maintaining minimum shareholders’ equity of $5 million. Loss of our stock listing would impair our ability to raise equity capital necessary to support our operations.

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 take further 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.

The following are our contractual commitments associated with our debt and lease obligations:

We are negotiating with the landlords of the Bothell, Washington and Sharon Hill, Pennsylvania facilities to terminate our leases or to sublease the facilities in an effort to reduce fixed operating costs, to preserve our cash and to concentrate resources on our key product development programs.

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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, which could result in a decline in the value of our common stock and a loss of your investment.

Substantially all of our revenue has been earned 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, 2003, we had an accumulated deficit of approximately $203 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.

Our product candidate for cystic fibrosis has been evaluated in a Phase II clinical trial. In October 2002, we announced the preliminary results of the initial Phase II clinical trial for our cystic fibrosis candidate and we are preparing a publication of the data from that trial. We plan to initiate a confirmatory Phase II clinical trial for our product candidate for cystic fibrosis in mid-2003. Our product candidates for cancer have been evaluated in Phase I and Phase II clinical trials. We have pre-clinical development programs for the treatment of hemophilia, arthritis and an AIDS vaccine. In connection with the operational changes that we implemented in 2002 and the termination of our collaboration with Wyeth in February 2003, we suspended further clinical development of our cancer and hemophilia product development programs. Accordingly, we will not generate any product revenue for at least several years and only then if we can successfully develop and commercialize our product candidates. Commercializing our potential products depends upon successful completion of additional research and development and testing, in both preclinical and clinical trials. Completion of clinical trials may take several years or more. 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 will 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.

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.

To our knowledge, no gene therapy products have received regulatory approval for marketing from the U.S. Food and Drug Administration, or FDA, or similar regulatory agencies in other countries. Because our product candidates involve new and unproven technologies, we believe that regulatory approval may proceed more slowly than 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 and efficacy 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 from the 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.

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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 frequently change. 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 we may encounter unacceptable side effects 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.

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 upon many factors, including:

As of March 31, 2003, we had approximately $12.2 million in cash and cash equivalents. In addition, we expect to receive additional collaborative funding of up to $5.6 million under our collaborations with Biogen, which ends in September 2003, and IAVI which ends in December 2003. We believe that our cash and cash equivalents and the funding anticipated under our collaborations, will be sufficient to fund our operations at least through the end of 2003. We are pursuing opportunities to obtain additional capital to fund our operations beyond that time. Additional sources of financing could involve one or more of the following:

Additional funding may not be available to us on reasonable terms, if at all. The funding that we expect to receive from our collaborative partners depends on continued scientific progress under the collaboration and our collaborative partners’ ability and willingness to continue or extend the collaborations. In December 2002, we initiated significant cost reduction measures, including further reductions in staffing and expenses. As part of these cost reduction measures, we:

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If we are unable to successfully access additional capital, we may need to take further significant cost reduction measures. These adjustments may include scaling back, delaying or terminating one or more of our cystic fibrosis, arthritis or AIDS vaccine 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.

If we lose our strategic partners or if our collaborative relationships are unsuccessful, we may be unable to develop our potential products.

A significant portion of our operating expenses is funded through our collaborative agreements with third parties. We have collaborative development agreements with Biogen and IAVI under which, we expect to receive approximately $5.6 million in additional funding for research activities to be conducted in 2003. This funding is to reimburse research and development expenses we incur in connection with the applicable development collaboration.

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 covered by the collaboration, we may be unable to continue our research and development program for that product candidate. In addition, the loss of significant amounts of collaborative funding could cause not only the delay, reduction or termination of the related research and development programs, but also 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. IAVI has the right to terminate this collaboration or its obligation to provide research funding at any time for scientific or business reasons with 90 days notice. Termination of our IAVI collaboration would significantly affect our operating activities. For example, Wyeth has terminated our hemophilia collaboration, effective February 2003. As a result, we have suspended further development of our hemophilia product candidate until we can find another development partner or secure other sources of funding for the program and reduced the scope of our other company-funded research and development activities and reduced the size of our workforce by approximately 30%.

If our strategic partners terminate or decline to extend our collaborations, we may be unable to develop our potential products.

Our strategic partners, along with outside scientific consultants and contractors, also 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 and development collaborations, research under sponsored research agreements and contract manufacturing services. In addition, collaborations with established pharmaceutical and biotechnology companies and academic, research and public health organizations, particularly those that are leaders in the field, often provide a measure of validation of our product development efforts in the eyes of securities 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 strategic partners, consultants and contractors. If they do not dedicate sufficient time or 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 strategic 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 strategic partners may decline to extend the collaboration, or may extend the collaboration with a significantly reduced scope, for a number of scientific or business reasons. Competition for scientific consultants and strategic 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.

A significant portion of our operating expenses is funded through collaborations with third parties. We have the following active strategic partnerships:

One or both of these strategic partners may choose not to continue the collaboration, or may choose to terminate the collaboration at any time. The loss of any of our collaborations may result in the loss of access to intellectual property, know-how and development support. As a result, the development of the affected product candidate could be delayed or terminated.

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The reduction in workforce associated with our recent operational changes may impair our ability to develop our potential products.

In December 2002, we implemented a plan to restructure our operations to reduce expenses and focus our resources on our cystic fibrosis, arthritis and AIDS vaccine product development programs. In connection with the December restructuring, we reduced our staff by approximately 30% on February 14, 2003. This restructuring may continue to have undesirable consequences, such as increased employee attrition. In addition, many of the terminated employees possess specific knowledge or expertise that may later prove to be important to our operations. As a result of these factors, our ability to respond to challenges in the future may be impaired and we may be unable to take advantage of new opportunities.

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 excessive turnover or difficulties in recruiting new personnel, our research and development of product candidates could be delayed and we could experience difficulties in generating sufficient revenue to maintain our business.

If we are unable to obtain and 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 license agreements, both exclusive and nonexclusive, 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 licensed several issued and pending patents for the gene used in our cancer product development programs, the vector and gene delivered in our product candidate for cystic fibrosis and the processes that we use to manufacture our AAV-based product candidates. If we are unable to maintain our current licenses for third-party technology or, if necessary, 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, such as the license for the process that we use to manufacture our AAV-based product candidates, typically contain provisions requiring us to meet minimum development milestones in order to maintain the license on an exclusive basis. If we do not meet these requirements, our licensor may convert the license to a nonexclusive license or 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 critical to our business 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:

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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. For example, in July 1997 the licensor of our licensed CFTR gene and related vector was notified that the United States Patent and Trademark Office, or USPTO, had declared an interference proceeding to determine whether our licensor or an opposing party has the priority of invention to the patent application on the CFTR gene and related vector. Our tgAAVCF product candidate for treating cystic fibrosis uses our proprietary AAV delivery technology to deliver a normal copy of the CFTR gene. In April 2003, we were notified that the U.S. Federal Circuit Court of Appeals affirmed the priority of invention of our licensor surrounding our licensor’s intellectual property rights to the CF gene and protein. Our license agreement with the licensor provides us with the licensed patient rights we believe we need to develop our product candidate. If our licensor does not retain, assert or defend its rights to the CFTR vector, and we cannot maintain access at a reasonable cost or develop or obtain a license to a replacement vector at a reasonable cost, we may be unable to commercialize our potential tgAAVCF product.

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

Results in early-stage clinical trials are based on limited numbers of patients. Our reported progress and results from our early phases of clinical testing of our cystic fibrosis and cancer 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 lasting effect, our product candidate for cystic fibrosis, or any other potential products that we advance to clinical trials, may not receive approval from the FDA for further clinical trials or commercialization. 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.

In addition, 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. If successful results for a potential product in animal models are not replicated in clinical trials, we may have to expend greater resources to pass the clinical trial stage and obtain regulatory approval of the product candidate or abandon its development.

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 critical 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 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 industry or for other reasons, 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 proving the effectiveness of our technology or termination of the clinical trials altogether.

We may be unable to adequately protect our proprietary rights, which may limit our ability to successfully market any products.

Our success substantially depends 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 may 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 substantially 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.

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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 the biotechnology industry expands, the risk increases that others may claim that our processes and potential products infringe on their patents. 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 a litigation or 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, health care 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 do not develop adequate 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.

We currently do not have the capacity to manufacture large-scale commercial quantities of our potential products. To do so, 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.

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 strategic partners 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.

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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 November 1999, a patient being treated for a rare metabolic disorder died in a gene therapy trial using an adenoviral vector to deliver a therapeutic gene. Genovo, Inc., a company we later acquired, was alleged to have provided partial funding for this investigator-sponsored trial conducted at the University of Pennsylvania. Other patient deaths, though unrelated to gene therapy, have occurred in other clinical trials. These deaths 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. For example, there has been concern in the past regarding the potential safety and efficacy of gene therapy products derived from pathogenic viruses like adenoviruses. Our product candidates use AAV vectors, which are derived from a nonpathogenic virus, or non-viral vectors. However, the public and the medical community nonetheless may conclude that our technology is unsafe. Moreover, to the extent that unfavorable publicity or negative public perception arising from other biotechnology-related fields such as human cloning and stem-cell research are linked in the public mind to gene therapy, our industry will be harmed.

Future adverse events in, or negative public perception regarding, gene therapy or the biotechnology industry could also result in greater governmental regulation, 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.

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 and cell 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. 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:

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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 substantially depend, 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.

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.

On January 8, 2003, our stock was transferred from the NASDAQ National Market to the NASDAQ SmallCap Market. In order to continue to be listed on the NASDAQ SmallCap Market, we must meet specific quantitative standards, including maintaining $2.5 million in shareholders’ equity and a minimum bid price of $1.00 for our common stock. Our shareholders’ equity as of March 31, 2003 totaled $5.1 million; however, the closing bid price of our common stock is below $1.00. We are not in compliance with the minimum $1.00 bid price per share requirement; however, we meet the NASDAQ SmallCap Market’s initial listing requirement of $5 million of shareholders’ equity. Accordingly, we have been provided an additional 180 calendar days, or until September 15, 2003, to regain compliance with the minimum $1.00 bid price per share requirement. If we continue to meet the other core initial listing requirements of the NASDAQ SmallCap Market at the end of this 180-day grace period, we will be granted an additional 90-day grace period to regain compliance with the $1.00 minimum bid price per share requirement. Ultimately, if we are unable to satisfy the minimum bid price requirement or if we are unable to comply with the minimum shareholders’ equity requirement and all of the other current or future listing requirements, we could lose our quotation on the NASDAQ SmallCap Market. Delisting of our common stock from the NASDAQ SmallCap Market would likely result in a 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 and the ability to disproportionately affect our stock price.

A significant number of shares of our common stock are held by a small number of investors, including holdings by Biogen, Celltech and Elan. Elan also has the right to convert principal and interest outstanding under a loan facility into our common stock and to exchange its shares of our Series B preferred stock into shares of our common stock. As of March 31, 2003, if Elan had converted the outstanding balance on the loan facility and exchanged its preferred shares into common stock, Elan would own approximately 10.5 million shares of our common stock. 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:

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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. We believe that this volatility has contributed to the decline in the market price of our common stock, and may do so in the future. 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. In the past, securities class action litigation has been brought against companies that experience volatility in the market price of their securities. Market fluctuations in the price of our common stock could also adversely affect our collaborative opportunities and our future ability to sell equity securities at a price we deem appropriate. As a result, you could lose all or part of your investment.

Our future capital-raising activities could involve the issuance of equity securities, which would dilute your investment and could result in a decline in the trading price of our common stock.

To meet all or a portion our long-term funding requirements, we may sell securities in the public or private equity markets if and when conditions are favorable, even if we do not have an immediate need for additional capital at that time. Raising funds through the issuance of equity securities will dilute the ownership of our existing shareholders. Furthermore, we may enter into financing transactions at prices that represent a substantial discount to market price. A negative reaction by investors and securities analysts to any discounted sale of our equity securities could result in a decline in the trading price of our common stock.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Short-term investments. Because of the short-term nature of our investments, we believe that our exposure to market rate fluctuations on those investments is minimal. Currently, we do not use any derivative or other financial instruments or derivative commodity instruments to hedge any market risks and do not plan to employ these instruments in the future. At March 31, 2003, we held $12.2 million in cash and cash equivalents, which are primarily invested in a short-term bond fund that invests in securities that, on the average, mature in less than 12 months. An analysis of the impact on these securities of a hypothetical 10% change in short-term interest rates from those in effect at March 31, 2003, indicates that such a change in interest rates would not have a significant impact on our financial position or on our expected results of operations in 2003.

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 amounts of the notes payable and equipment financing arrangements approximate fair value because the interest rates on these instruments change with, or approximate, market rates. The following table provides information as of March 31, 2003, about our obligations that are sensitive to changes in interest rate fluctuations (in millions):

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Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures. H. Stewart Parker, our Chief Executive Officer, and Todd E. Simpson, our Chief Financial Officer, have evaluated the effectiveness of our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-14(c) and 15d-14(c)) within 90 days prior to filing this report. Based on their evaluation, Ms. Parker and Mr. Simpson have concluded that our disclosure controls and procedures are effective in design and operation to allow us to properly record, process, summarize and report financial data in periodic reports we submit to the SEC.

Changes in internal controls. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of Ms. Parker’s and Mr. Simpson’s evaluation.

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PART II OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 2. Changes in 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 and Reports on Form 8-K

(a) See the Index to Exhibits included in this quarterly report.

(b) On January 8, 2003, we filed a current report on Form 8-K to announce the transfer of our common stock listing from the NASDAQ National Market to the NASDAQ SmallCap Market.

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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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Certification

I, H. Stewart Parker, certify that:

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Certification

I, Todd E. Simpson, certify that:

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TARGETED GENETICS CORPORATION

INDEX TO EXHIBITS

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