##### Table of Contents



UNITED
STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER
30, 2005
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM
              TO
 COMMISSION FILE NUMBER: 0-23930
 TARGETED GENETICS CORPORATION
 
  Washington
    
    91-1549568(State of Incorporation)
    
    (I.R.S. Employer Identification No.)
  
   
  
  þ o
 þ o
 o þ




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TARGETED GENETICS CORPORATION
  Page No.PART I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statementsa) Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004
    
    
    1b) Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004
    
    
    2c)  Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
    
    
    3d)  Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    7Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    22Item 4.
    
    Controls and Procedures
    
    
    22PART II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    23Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    23Item 3.
    
    Defaults Upon Senior Securities
    
    
    23Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    23Item 5.
    
    Other Information
    
    
    23Item 6.
    
    Exhibits
    
    
    23SIGNATURES
    
    
    24EXHIBIT INDEX
    
    
    25EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
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PART I      FINANCIAL INFORMATION
 
 Item 1. Financial Statements
 TARGETED GENETICS CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 September 30,
    
    
    December 31,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    17,151,000
    
    
    $
    34,096,000Accounts receivable
    
    
    611,000
    
    
    
    404,000Prepaid expenses and other
    
    
    699,000
    
    
    
    653,000Total current assets
    
    
    18,461,000
    
    
    
    35,153,000Property and equipment, net
    
    
    2,104,000
    
    
    
    2,495,000Goodwill, net
    
    
    31,649,000
    
    
    
    31,649,000Other assets
    
    
    209,000
    
    
    
    668,000Total assets
    
    $
    52,423,000
    
    
    $
    69,965,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable and accrued expenses
    
    $
    1,880,000
    
    
    $
    1,436,000Accrued employee expenses
    
    
    564,000
    
    
    
    1,030,000Accrued restructure charges
    
    
    1,053,000
    
    
    
    407,000Current portion of long-term obligations
    
    
    188,000
    
    
    
    1,122,000Total current liabilities
    
    
    3,685,000
    
    
    
    3,995,000Accrued restructure charges and deferred rent
    
    
    6,366,000
    
    
    
    6,026,000Long-term obligations
    
    
    8,197,000
    
    
    
    10,182,000CommitmentsShareholders equity:Preferred
stock, $0.01 par value, 6,000,000 shares authorized: Series A preferred stock, 800,000 shares designated, none
issued and outstanding
    
    
    
    
    
    
    Common stock, $0.01 par value, 180,000,000 shares authorized,
85,631,244 shares issued and outstanding at September 30, 2005
and 85,626,326 shares issued and outstanding at December 31,
2004
    
    
    856,000
    
    
    
    856,000Additional paid-in capital
    
    
    279,752,000
    
    
    
    279,745,000Accumulated deficit
    
    
    (246,488,000
    )
    
    
    (230,839,000
    )Accumulated other comprehensive income
    
    
    55,000
    
    
    
    Total shareholders equity
    
    
    34,175,000
    
    
    
    49,762,000Total liabilities and shareholders equity
    
    $
    52,423,000
    
    
    $
    69,965,000
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TARGETED GENETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Revenue under collaborative agreements
    
    $
    1,468,000
    
    
    $
    2,388,000
    
    
    $
    4,930,000
    
    
    $
    6,469,000Operating expenses:Research and development
    
    
    4,653,000
    
    
    
    4,268,000
    
    
    
    14,000,000
    
    
    
    13,333,000General and administrative
    
    
    1,490,000
    
    
    
    1,476,000
    
    
    
    5,035,000
    
    
    
    5,292,000Restructure charges
    
    
    1,188,000
    
    
    
    381,000
    
    
    
    1,526,000
    
    
    
    797,000Total operating expenses
    
    
    7,331,000
    
    
    
    6,125,000
    
    
    
    20,561,000
    
    
    
    19,422,000Loss from operations
    
    
    (5,863,000
    )
    
    
    (3,737,000
    )
    
    
    (15,631,000
    )
    
    
    (12,953,000
    )Gain on sale of majority-owned subsidiary
    
    
    
    
    
    
    1,006,000
    
    
    
    
    
    
    
    1,006,000Investment income
    
    
    315,000
    
    
    
    123,000
    
    
    
    382,000
    
    
    
    268,000Interest expense
    
    
    (135,000
    )
    
    
    (116,000
    )
    
    
    (400,000
    )
    
    
    (353,000
    )Net loss
    
    $
    (5,683,000
    )
    
    $
    (2,724,000
    )
    
    $
    (15,649,000
    )
    
    $
    (12,032,000
    )Net loss per common share (basic and
diluted)
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.18
    )
    
    $
    (0.15
    )Shares used in computation of basic and
diluted net loss per common share
    
    
    85,630,000
    
    
    
    81,629,000
    
    
    
    85,629,000
    
    
    
    78,713,000
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TARGETED GENETICS CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 Nine months endedSeptember 30,2005
    
    
    2004Operating activities:Net loss
    
    $
    (15,649,000
    )
    
    $
    (12,032,000
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation and amortization
    
    
    1,009,000
    
    
    
    998,000Loss on investments
    
    
    136,000
    
    
    
    Gain on sale of majority-owned subsidiary
    
    
    
    
    
    
    (1,006,000
    )Changes in assets and liabilities:Decrease (increase) in accounts receivable
    
    
    (207,000
    )
    
    
    165,000Increase in prepaid expenses and other
    
    
    (173,000
    )
    
    
    (23,000
    )Decrease in other assets
    
    
    459,000
    
    
    
    146,000Increase in current liabilities
    
    
    4,000
    
    
    
    176,000Decrease in deferred revenue
    
    
    
    
    
    
    (676,000
    )Increase (decrease) in accrued restructure
expenses and deferred rent
    
    
    986,000
    
    
    
    (59,000
    )Net cash used in operating activities
    
    
    (13,435,000
    )
    
    
    (12,311,000
    )Investing activities:Purchases of property and equipment
    
    
    (618,000
    )
    
    
    (346,000
    )Proceeds from sale of investments
    
    
    46,000
    
    
    
    Net cash used in investing activities
    
    
    (572,000
    )
    
    
    (346,000
    )Financing activities:Net proceeds from sales of common stock
    
    
    7,000
    
    
    
    23,805,000Repayment of debt
    
    
    (2,500,000
    )
    
    
    Payments under leasehold improvements and
equipment financing arrangements
    
    
    (445,000
    )
    
    
    (918,000
    )Proceeds under leasehold improvements and
equipment financing arrangements
    
    
    
    
    
    
    46,000Net cash provided by (used in) financing activities.
    
    
    (2,938,000
    )
    
    
    22,933,000Net increase (decrease) in cash and cash equivalents
    
    
    (16,945,000
    )
    
    
    10,276,000Cash and cash equivalents, beginning of period
    
    
    34,096,000
    
    
    
    21,057,000Cash and cash equivalents, end of period
    
    $
    17,151,000
    
    
    $
    31,333,000
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TARGETED GENETICS CORPORATION
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
 1. Basis of Presentation
 .
    2. Long-Term Obligations
  September 30,
    
    
    December 31,2005
    
    
    2004Loans payable to Biogen Idec
    
    $
    8,150,000
    
    
    $
    10,624,000Equipment financing obligations
    
    
    235,000
    
    
    
    680,000Total obligations
    
    
    8,385,000
    
    
    
    11,304,000Less current portion
    
    
    (188,000
    )
    
    
    (1,122,000
    )Total long-term obligations
    
    $
    8,197,000
    
    
    $
    10,182,000
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3. Accrued Restructure Charges
 Accounting for Costs Associated with Exit or Disposal Activities,
  ContractTerminationCostsDecember 31, 2004 accrued liability
    
    $
    6,348,000Charges incurred
    
    
    1,132,000Adjustments to the liability (accretion)
    
    
    394,000Amount paid
    
    
    (561,000
    )September 30, 2005 accrued liability
    
    $
    7,313,000
  
    
    an increase in the square footage available for sublease and related increase in sublease income;
    
    an increase in the amount of time to find a sublease tenant;
    
    an increase in broker commissions; and
    
    a decrease in estimated costs of tenant improvements.
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4. Stock Compensation
 Accounting for Stock-Based Compensation Accounting for Stock Issued
to Employees,
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss:As reported
    
    $
    (5,683,000
    )
    
    $
    (2,724,000
    )
    
    $
    (15,649,000
    )
    
    $
    (12,032,000
    )Proforma stock-based
compensation expense
    
    
    (374,000
    )
    
    
    (520,000
    )
    
    
    (1,242,000
    )
    
    
    (1,094,000
    )Pro forma
    
    $
    (6,057,000
    )
    
    $
    (3,244,000
    )
    
    $
    (16,891,000
    )
    
    $
    (13,126,000
    )Basic net loss per share:As reported
    
    $
    (0.07
    )
    
    $
    (0.03
    )
    
    $
    (0.18
    )
    
    $
    (0.15
    )Pro forma
    
    
    (0.07
    )
    
    
    (0.04
    )
    
    
    (0.20
    )
    
    
    (0.17
    )
 Share Based
Payment
  5. Investment in Securities of Chromos Molecular Systems, Inc.
  6




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6. Other Comprehensive Loss
  Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net loss as reported
    
    $
    (5,683,000
    )
    
    $
    (2,724,000
    )
    
    $
    (15,649,000
    )
    
    $
    (12,032,000
    )Other comprehensive loss:Unrealized gain on
available-for-sale
securities
    
    
    48,000
    
    
    
    
    
    
    
    48,000
    
    
    
    Foreign currency
translation adjustment
    
    
    7,000
    
    
    
    
    
    
    
    7,000
    
    
    
    Other comprehensive loss
    
    $
    (5,628,000
    )
    
    $
    (2,724,000
    )
    
    $
    (15,594,000
    )
    
    $
    (12,032,000
    )
 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 Forward-Looking Statements
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Business Overview
     
    
    Intra-articular injections of tgAAC94 were safe and well-tolerated at doses up to
1x1011
DRP per ml of joint volume among patients currently taking conventional
disease modifying anti-rheumatic drugs.
    
    No drug-related serious adverse events have been reported to date in the eleven drug-treated subjects.
    
    Although the study is not powered to show efficacy, in those treated with a single dose of
tgAAC94, continued measurable improvements in swelling and tenderness were observed. Six of
the eleven drug-treated subjects received a higher dose and the reduction in mean scores
appears to be greater than in the five of the eleven drug-treated subjects that
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
    
    In the non-injected joints of the tgAAC94 treated groups there also appears to be a trend
in the decrease in mean tenderness and swelling scores over time, which was not observed in
the subjects receiving placebo.
  
    
    safety,
    
    signs and symptoms of disease as measured by standardized arthritis index scores for tenderness and swelling,
    
    molecular markers of disease, and
    
    gene expression in injected joints.
    9




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Results of Operations
 Revenue
  Operating Expenses
 Research and Development Expenses
 10




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Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Programs in clinical development:Inflammatory arthritis
    
    $
    615,000
    
    
    $
    540,000
    
    
    $
    1,782,000
    
    
    $
    1,446,000AIDS vaccine
    
    
    337,000
    
    
    
    1,094,000
    
    
    
    2,325,000
    
    
    
    2,664,000Cystic fibrosis
    
    
    191,000
    
    
    
    206,000
    
    
    
    465,000
    
    
    
    658,000Indirect costs
    
    
    889,000
    
    
    
    1,528,000
    
    
    
    3,499,000
    
    
    
    4,096,000Total clinical development program expense
    
    
    2,032,000
    
    
    
    3,368,000
    
    
    
    8,071,000
    
    
    
    8,864,000Research and preclinical development
program expense
    
    
    2,621,000
    
    
    
    900,000
    
    
    
    5,929,000
    
    
    
    4,469,000Total research and development expense
    
    $
    4,653,000
    
    
    $
    4,268,000
    
    
    $
    14,000,000
    
    
    $
    13,333,000
    General and Administrative Expenses
 Restructure Charges.
 Other Income and Expense
 Investment Income
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Interest Expense
 Liquidity and Capital Resources
     $
  12




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
    
    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 product commercialization activities and
facility expansions, if and as required; and
    
    the existence and outcome of any litigation or administrative proceedings involving
intellectual property.
   
    
    issuing equity in the public or private markets;
    
    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 financing arrangements; or
    
    issuing debt.
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Factors Affecting Our Operating Results, Our Business and Our Stock Price
  Risks Related to 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.
  
    
    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.
  
    
    issuing equity in the public or private markets;
    
    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 financing arrangements; and/or
    
    issuing debt.
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We expect to continue to operate at a loss and may never become profitable.
  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.
   Failure to recruit subjects could delay or prevent clinical trials of our potential products, which
could delay or prevent the development of potential products.
  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.
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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.
    
    
    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
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
    
    the priority of invention of patented technology.
  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.
   If we lose our collaborative partners, we may be unable to develop our potential products.
  If we do not attract and retain qualified personnel, we may be unable to develop and commercialize
some of our potential products.
  If our partners or scientific consultants terminate, reduce or delay our relationships with them,
we may be unable to develop our potential products.
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The success of our clinical trials and preclinical studies may not be indicative of results in a
large number of subjects of either safety or efficacy.
  We may be unable to adequately protect our proprietary rights domestically or overseas, which may
limit our ability to successfully market any product candidates.
   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.
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Post-approval manufacturing or product problems or failure to satisfy applicable regulatory
requirements could prevent or limit our ability to market our products.
  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.
   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.
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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.
  
    
    research and development;
    
    clinical trials;
    
    obtaining FDA and other regulatory approvals;
    
    manufacturing; and
    
    marketing and distribution.
   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.
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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 Capital Market
and we may be delisted from the NASDAQ Capital Market, the liquidity and market price of our common
stock would decline.
   Concentration of ownership of our common stock may give certain shareholders significant influence
over our business.
  
    
    election of directors;
    
    amendment of our charter documents; or
    
    approval of significant corporate transactions, such as a change of control of Targeted Genetics.
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Market fluctuations or volatility could cause the market price of our common stock to decline and
limit our ability to raise capital.
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
 Notes payable:
 Expected Maturity Date2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    TotalMaturities of long-term obligations:Variable rate note
    
    $
    
    
    
    $
    
    
    
    $
    2,500,000
    
    
    $
    2,500,000
    
    
    $
    2,500,000
    
    
    $
    7,500,000Fixed rate notes
    
    
    
    
    
    
    
    
    
    
    650,000
    
    
    
    
    
    
    
    
    
    
    
    650,000Fixed rate equipment financing
    
    
    53,000
    
    
    
    155,000
    
    
    
    26,000
    
    
    
    1,000
    
    
    
    
    
    
    
    235,000Total
    
    $
    53,000
    
    
    $
    155,000
    
    
    $
    3,176,000
    
    
    $
    2,501,000
    
    
    $
    2,500,000
    
    
    $
    8,385,000
 
 Item 4. Controls and Procedures
 Evaluation of disclosure controls and procedures.
 Changes in internal control over financial reporting.
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PART II    OTHER INFORMATION
 
 Item 1. Legal Proceedings
  
 Item 2. Unregistered Sales of Securities and Use of Proceeds
  
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other Information
  
 Item 6. Exhibits
  23




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SIGNATURES
  Date: November 3, 2005
    
    TARGETED GENETICS CORPORATIONBy:
    
    /s/ H. STEWART PARKERH. Stewart Parker,President, Chief Executive Officer and Director(Principal Executive Officer)Date: November 3, 2005
    
    By:
    
    /s/ DAVID J. POSTONDavid J. Poston,Acting Chief Financial Officer(Principal Financial and Accounting Officer)
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TARGETED GENETICS CORPORATION
 
 INDEX TO EXHIBITS
 Incorporated by Reference
 Exhibit No.
    
    Exhibit Description
    
    
    
    Form
    
    Date
    
    Number
    
    Filed Herewith3.1
    
    Amended and Restated Articles of Incorporation
    
    
    
    8-K
    
    05/26/05
    
    
    3.13.2
    
    Amended and Restated Bylaws
    
    
    
    10-K
    
    12/31/96
    
    
    3.210.1
    
    Amendment No. 2 to Funding Agreement, dated
September 1, 2005, between Targeted Genetics and
Biogen Idec
    
    
    
    8-K
    
    9/1/05
    
    
    10.110.2
    
    Amended and Restated Promissory Note of Targeted
Genetics dated September 1, 2005 (issued to Biogen
Idec in principal amount of $10,000,000)
    
    
    
    8-K
    
    9/1/05
    
    
    10.210.3
    
    Amended and Restated Promissory Note of Targeted
Genetics dated September 1, 2005 (issued to Biogen
Idec in principal amount of $650,000)
    
    
    
    8-K
    
    9/1/05
    
    
    10.310.4
    
    Form of Senior Management Employment Agreement
    
    
    
    S-1
    
    3/30/94
    
    
    10.610.5
    
    Form of Indemnity Agreement
    
    
    
    10-K
    
    12/31/96
    
    
    10.231.1
    
    Certification of Chief Executive Officer pursuant
to Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended
    
    
    
    
    
    
    
    
    
    
    
    X31.2
    
    Certification of Chief Financial Officer pursuant
to Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended
    
    
    
    
    
    
    
    
    
    
    
    X32.1
    
    Certification of Chief Executive Officer
pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
    
    
    
    
    
    
    
    
    
    
    
    X32.2
    
    Certification of Chief Financial Officer
pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002
    
    
    
    
    
    
    
    
    
    
    
    X
 25