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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
   FORM 10-Q   (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2005ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to
 Commission File Number No. 0-23930   TARGETED GENETICS CORPORATION (Exact name of Registrant as specified in its charter)
   Washington
    
    91-1549568(State of Incorporation)
    
    (IRS Employer Identification No.)
 1100 Olive Way, Suite 100
Seattle, WA 98101(Address of principal executive offices, including zip code) (206) 623-7612(Registrants telephone number, including area code)   Indicate by check mark whether the registrant: (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No o Indicate the number of shares outstanding of each of the issuers classes of common
stock, as of the latest practicable date. Common Stock, $0.01 par value
    
    85,628,244(Class)
    
    (Outstanding at April 18, 2005)




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TARGETED GENETICS CORPORATION
Quarterly Report on Form 10-Q
For the quarter ended March 31, 2005 TABLE OF CONTENTS Page No.PART I
    
    FINANCIAL INFORMATIONItem 1.
    
    Financial Statementsa)
    
    Condensed Consolidated Balance Sheets at March 31, 2005 and December 31, 2004
    
    
    1b)
    
    Condensed Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004
    
    
    2c)
    
    Condensed Consolidated Statements of Cash Flows for the three months ended March 31,2005 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
    
    
    20Item 4.
    
    Controls and Procedures
    
    
    20PART II
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    21Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    21Item 3.
    
    Defaults Upon Senior Securities
    
    
    21Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    21Item 5.
    
    Other Information
    
    
    21Item 6.
    
    Exhibits
    
    
    21SIGNATURES
    
    
    21EXHIBIT INDEX
    
    
    22EXHIBIT 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) March 31,
    
    
    December 31,2005
    
    
    2004ASSETSCurrent assets:Cash and cash equivalents
    
    $
    30,423,000
    
    
    $
    34,096,000Accounts receivable
    
    
    104,000
    
    
    
    404,000Prepaid expenses and other
    
    
    275,000
    
    
    
    653,000Total current assets
    
    
    30,802,000
    
    
    
    35,153,000Property and equipment, net
    
    
    2,351,000
    
    
    
    2,495,000Goodwill, net
    
    
    31,649,000
    
    
    
    31,649,000Other assets
    
    
    608,000
    
    
    
    668,000Total assets
    
    $
    65,410,000
    
    
    $
    69,965,000LIABILITIES AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable and accrued expenses
    
    $
    2,217,000
    
    
    $
    1,436,000Accrued employee expenses
    
    
    500,000
    
    
    
    1,030,000Accrued restructure charges
    
    
    342,000
    
    
    
    407,000Current portion of long-term obligations
    
    
    982,000
    
    
    
    1,122,000Total current liabilities
    
    
    4,041,000
    
    
    
    3,995,000Accrued restructure charges and deferred rent
    
    
    6,146,000
    
    
    
    6,026,000Long-term obligations
    
    
    10,127,000
    
    
    
    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, 120,000,000 shares authorized,
85,628,244 shares issued and outstanding at March 31, 2005 and
85,626,326 shares issued and outstanding at December 31, 2004
    
    
    856,000
    
    
    
    856,000Additional paid-in capital
    
    
    279,751,000
    
    
    
    279,745,000Accumulated deficit
    
    
    (235,511,000
    )
    
    
    (230,839,000
    )Total shareholders equity
    
    
    45,096,000
    
    
    
    49,762,000Total liabilities and shareholders equity
    
    $
    65,410,000
    
    
    $
    69,965,000
 See accompanying notes to condensed consolidated financial statements 1




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TARGETED GENETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited) Three months endedMarch 31,2005
    
    
    2004Revenue under collaborative agreements
    
    $
    2,000,000
    
    
    $
    1,320,000Operating expenses:Research and development
    
    
    4,539,000
    
    
    
    4,237,000General and administrative
    
    
    1,885,000
    
    
    
    1,750,000Restructure charges
    
    
    219,000
    
    
    
    195,000Total operating expenses
    
    
    6,643,000
    
    
    
    6,182,000Loss from operations
    
    
    (4,643,000
    )
    
    
    (4,862,000
    )Investment income
    
    
    100,000
    
    
    
    124,000Interest expense
    
    
    (129,000
    )
    
    
    (120,000
    )Net loss
    
    $
    (4,672,000
    )
    
    $
    (4,858,000
    )Net loss per common share (basic and diluted)
    
    $
    (0.05
    )
    
    $
    (0.07
    )Shares used in computation of basic and diluted
net loss per common share
    
    
    85,628,000
    
    
    
    72,874,000
 See accompanying notes to condensed consolidated financial statements 2




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TARGETED GENETICS CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited) Three months endedMarch 31,2005
    
    
    2004Operating activities:Net loss
    
    $
    (4,672,000
    )
    
    $
    (4,858,000
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation and amortization
    
    
    324,000
    
    
    
    333,000Non-cash interest expense
    
    
    115,000
    
    
    
    70,000Changes in assets and liabilities:Decrease in accounts receivable
    
    
    300,000
    
    
    
    158,000Decrease in prepaid expenses and other
    
    
    378,000
    
    
    
    54,000Decrease in other assets
    
    
    60,000
    
    
    
    142,000Increase (decrease) in current liabilities
    
    
    146,000
    
    
    
    (749,000
    )Increase in deferred revenue
    
    
    
    
    
    
    1,604,000Increase (decrease) in accrued restructure
expenses and deferred rent
    
    
    55,000
    
    
    
    (164,000
    )Net cash used in operating activities
    
    
    (3,294,000
    )
    
    
    (3,410,000
    )Investing activities:Purchases of property and equipment
    
    
    (180,000
    )
    
    
    (84,000
    )Net cash used in investing activities
    
    
    (180,000
    )
    
    
    (84,000
    )Financing activities:Net proceeds from sales of common stock
    
    
    6,000
    
    
    
    23,813,000Payments under leasehold improvements and
equipment financing arrangements
    
    
    (205,000
    )
    
    
    (257,000
    )Net cash provided by (used in) financing activities.
    
    
    (199,000
    )
    
    
    23,556,000Net increase (decrease) in cash and cash equivalents
    
    
    (3,673,000
    )
    
    
    20,062,000Cash and cash equivalents, beginning of period
    
    
    34,096,000
    
    
    
    21,057,000Cash and cash equivalents, end of period
    
    $
    30,423,000
    
    
    $
    41,119,000
 See accompanying notes to condensed consolidated financial statements 3




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TARGETED GENETICS CORPORATION 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)  1.
    Basis of Presentation The unaudited condensed consolidated financial statements included in this quarterly
report have been prepared by Targeted Genetics Corporation, or Targeted Genetics, according to the
rules and regulations of the Securities and Exchange Commission, or SEC, and according to
accounting principles generally accepted in the United States of America, or GAAP, for interim
financial statements. The accompanying balance sheet information as of December 31, 2004 is
derived from our audited financial statements. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with GAAP have been omitted in
accordance with the SECs rules and regulations. Our condensed consolidated financial statements
include the accounts of Targeted Genetics and our inactive, wholly owned subsidiaries, Genovo, Inc.
and TGCF Manufacturing Corporation.Our results of operations for the three months ended March 31,
2004 also include the results of CellExSys, Inc., or CellExSys, our majority-owned subsidiary, that
was merged into Chromos, Inc. in July 2004. All significant intercompany transactions have been
eliminated in consolidation. The financial statements reflect, in the opinion of management, all
adjustments which consist solely of normal recurring adjustments necessary to present fairly our
financial position and results of operations as of and for the periods indicated. Certain
reclassifications have been made to conform prior period results to the current period
presentation. We do not believe that our results of operations for the three months ended March 31,
2005 are necessarily indicative of the results to be expected for the full year. The unaudited condensed consolidated financial statements included in this quarterly report
should be read in conjunction with our audited consolidated financial statements and related
footnotes included in our annual report on Form 10-K for the year ended December 31, 2004.  2.
    Long-Term Obligations Long-term obligations consisted of the following: March 31,
    
    
    December 31,2005
    
    
    2004Loan payable to Biogen, due August 2006
    
    $
    10,000,000
    
    
    $
    10,000,000Loan payable to Biogen, due September 2005
    
    
    634,000
    
    
    
    624,000Equipment financing obligations
    
    
    475,000
    
    
    
    680,000Total obligations
    
    
    11,109,000
    
    
    
    11,304,000Less current portion
    
    
    (982,000
    )
    
    
    (1,122,000
    )Total long-term obligations
    
    $
    10,127,000
    
    
    $
    10,182,000
 Future aggregate principal payments related to long-term obligations are $927,000 for the
remainder of 2005, $10,156,000 in 2006, $25,000 in 2007, $1,000 in 2008 and zero in 2009.  3.
    Accrued Restructure Charges We apply the provisions of Statement of Financial Accounting Standards, or SFAS No. 146,
Accounting for Costs Associated with Exit or Disposal Activities,as it relates to our facility
in Bothell, Washington and record restructure charges on the operating lease for the facility in
response to our decision to discontinue use of the facility. Accrued restructure charges represent
our best estimate of the fair value of the liability as determined under SFAS No. 146 and are
computed as the fair value of the difference between the remaining lease payments, net of assumed
sub-lease income and expense. We also record accretion expense based upon changes in the accrued
liability that results from the passage of time at an assumed discount rate of 10%. Accretion
expense is recorded on an ongoing basis as a restructure charge in our consolidated statements of
operations. 4




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The table below presents a reconciliation of the accrued restructure liability for the three
month period ended March 31, 2005: ContractTerminationCostsDecember 31, 2004 accrued liability
    
    $
    6,348,000Charges incurred
    
    
    100,000Adjustments to the liability
    
    
    119,000Amount paid
    
    
    (175,000
    )March 31, 2005 accrued liability
    
    $
    6,392,000
 During the three months ended March 31, 2005, we recorded accretion expense of $119,000 and a
charge of $100,000 for a change in estimate related to additional time that we believe it may
require to identify a sublease tenant for the portion of our Bothell facility that we intend to
sublease. Through March 31, 2005, we have recorded contract termination costs relating to our
Bothell facility and our former facility in Sharon Hill, Pennsylvania, which we discontinued using
in February 2002, totaling $7.9 million. We expect to incur an additional $2.5 million in
accretion expense through the September 2015 expiration of the Bothell lease. Further development or commercialization of any of our product candidates may require the use
of a portion of our Bothell facility to fulfill our manufacturing requirements. While the
application of SFAS No. 146 includes an assumption for sublease income from the facility, we do not
currently intend to sublease a portion of the Bothell facility. We ratably expense this assumed
net sublease income over the remaining term of the lease and classify this expense as research and
development expense. If we decide to utilize this facility, any remaining accrued restructure
charges related to the portion of the facility placed into service will be reversed, net of any
applicable deferred credits, and recorded as a one-time credit to restructure charges and reflected
in the period in which use is resumed. We would base any decision to use this facility on a number
of factors, including the progress of our product candidates in clinical development, the estimated
duration of facility design and construction, the estimated timing of product manufacturing
requirements, the ability of our current manufacturing capabilities to meet demand, and the
availability of resources. However, unless we resume use of the facility, we will continue to
account for the lease in accordance with SFAS No. 146 and will periodically evaluate the
assumptions and record additional restructure charges as necessary. Because restructure charges
are estimates based upon assumptions regarding the timing and amounts of future events, significant
adjustments to the accrual may be necessary in the future based on the actual outcome of events and
as we become aware of new facts and circumstances.  4.
    Stock Compensation As permitted by the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, we
currently follow Accounting Principles Board Opinion, or APB, No. 25, Accounting for Stock Issued
to Employees,and related interpretations in accounting for employee stock option grants. We do
not recognize compensation expense for options granted to employees and members of our board of
directors because we grant all options at fair market value on the date of grant. The value of
options and warrants to purchase common stock granted to non-employees are recorded as an expense
over their service period based on their fair value. No options or warrants have been issued to
non-employees during any of the periods presented. As allowed by SFAS No. 123, we do not recognize
compensation expense on stock options granted to employees and directors. However, if we had
elected to recognize compensation expense based on the fair market value at the grant dates for the
stock options granted, the pro forma net loss and net loss per common share would have been as
follows: Three months endedMarch 31,2005
    
    
    2004Net loss:As reported
    
    $
    (4,672,000
    )
    
    $
    (4,858,000
    )Pro forma stock-based compensation expense
    
    
    (464,000
    )
    
    
    (235,000
    )Pro forma
    
    $
    (5,136,000
    )
    
    $
    (5,093,000
    )Basic and diluted net loss per share:As reported
    
    $
    (0.05
    )
    
    $
    (0.07
    )Pro forma
    
    
    (0.06
    )
    
    
    (0.07
    )
 In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, Share Based
Payment. SFAS No. 123R requires all share-based payments to employees, including grants of
employee stock options, to be recognized in the statement of operations based upon their fair
values. Pro forma disclosure will no longer be an alternative under SFAS No. 5




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123R. We are currently required to adopt SFAS No. 123R as of January 1, 2006. We do not
expect the adoption of SFAS No. 123R to have a significant effect on our financial condition or
cash flows, however its adoption will result in ongoing non-cash stock compensation charges that
will increase our reported net loss and our net loss per share. We plan to apply the modified prospective method of adopting SFAS No. 123R which will result
in prospective charges to expense beginning as of the effective date of SFAS No. 123R for options
as they vest. Alternatively, we have the option of applying the modified retrospective method
which, in addition to the prospective charges applicable under the modified prospective approach,
would include a one-time cumulative effect of accounting change for options that are vested as of
the effective date. At this time we cannot predict the ultimate impact of adopting SFAS No. 123R
because the impact will depend on levels of share-based payments granted in the future. However,
had we adopted SFAS No. 123R in prior periods, the impact would have approximated the amounts
presented above in the disclosure of pro forma net loss and net loss per share.  5.
    Investment in Securities of Chromos Molecular Systems, Inc. In July 2004, our majority-owned subsidiary, CellExSys Inc., was merged into Chromos Inc., a
wholly owned subsidiary of Chromos Molecular Systems Inc., or Chromos. In connection with the
merger, Chromos issued 1.5 million shares of its common stock and a secured convertible debenture
totaling approximately $3.4 million Canadian. The debenture is repayable at Chromos option in
either cash or by the issuance of shares of Chromos common stock, assuming certain conditions are
met by Chromos, including compliance with all material provisions of the merger agreement,
debenture and other related agreements. Our ownership in CellExSys at the time of the merger was
approximately 79%. As a result, we received approximately 1.2 million shares of Chromos common
stock and a 79% share of any payments made by Chromos under the debenture. We record the common
stock and debenture at fair value in our financial statements, which as of December 31, 2004
totaled $453,000. We review the carrying value of the debenture for signs of impairment on a
regular basis and record the shares of Chromos common stock at market value. On April 1, 2005, Chromos announced its financial results for the year ended December 31, 2004
and restructuring efforts intended to significantly reduce its operating costs. Chromos also
reported that its available cash reserves would not fund its operations beyond May 2005 and
terminated substantially all of the former employees of CellExSys. As a result of this
announcement, the workforce reduction and the diminished financial condition of Chromos, we have
reduced the carrying value of the debenture to zero in our financial statements as of March 31,
2005. Investment income in the accompanying statement of operations for the quarter ended March
31, 2005 includes a $63,000 non-cash charge to reduce the carrying value of the debenture as we
deemed the impairment in value to be other than temporary. The approximately 1.2 million shares of
Chromos common stock that we hold are recorded in the accompanying balance sheet at $390,000 based
on the closing market price on March 31, 2005, which decreased substantially on April 1, 2005 as a
result of the Chromos restructuring announcement. We will recognize any changes in the market
value of this investment in the period of such change. One of the members of our Board of
Directors is also a member of Chromos Board of Directors. 6




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Item 2.
    Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Statements This quarterly report on Form 10-Q contains forward-looking statements that involve risks
and uncertainties. Forward-looking statements include statements about our product development and
commercialization goals and expectations, potential market opportunities, our plans for and
anticipated results of our clinical development activities and the potential advantage of our
product candidates, and other statements that are not historical facts. Words such as may,
will, believes, estimates, expects, anticipates, plans and intends, or statements
concerning potential or opportunity and other words of similar meaning or the negative thereof,
may identify forward-looking statements, but the absence of these words does not mean that the
statement is not forward-looking. In making these statements, we rely on a number of assumptions
and make predictions about the future. Our actual results could differ materially from those stated
in, or implied by, forward-looking statements for a number of reasons, including the risks
described in the section entitled Factors Affecting Our Operating Results, Our Business and Our
Stock Price in Part I, Item 2 of this quarterly report. You should not unduly rely on these forward-looking statements, which speak only as of the
date of this quarterly report. We undertake no obligation to publicly revise any forward-looking
statement after the date of this quarterly report to reflect circumstances or events occurring
after the date of this quarterly report or to conform the statement to actual results or changes in
our expectations. You should, however, review the factors, risks and other information we provide
in the reports we file from time to time with the SEC. Business Overview Targeted Genetics Corporation develops gene therapy products and technologies for
treating both acquired and inherited diseases. Our gene therapy product candidates are designed to
treat disease by appropriately modifying cellular function at a genetic level. This involves
introducing genetic material into target cells and expressing it in a manner that provides the
desired effect. We have assembled a broad base of proprietary intellectual property that we believe
gives us the potential to address the significant diseases that are the primary focus of our
business. Our proprietary intellectual property includes gene therapy uses of certain genes,
methods of transferring genetic material into cells, processes to manufacture our AAV-based product
candidates and other proprietary technologies and processes. In addition, we have established
expertise and development capabilities focused in the areas of preclinical research and
development, manufacturing and manufacturing process scale-up, quality control, quality assurance,
regulatory affairs and clinical trial design and implementation. We believe that our focus and
expertise will enable us to develop products based on our proprietary intellectual property. Gene therapy products involve the use of delivery vehicles, called vectors, to place genetic
material into target cells. Our proprietary vector technologies include both viral and synthetic
vectors. Our viral vector development activities, which use modified viruses to deliver genetic
material into cells are focused on adeno-associated virus, or AAV, a virus that has not been
associated with any human disease or illness. We believe that AAV provides a number of safety and
gene delivery advantages over other viruses for several potential gene therapy products, including
each of our product candidates currently under development. Our synthetic vectors deliver genetic
material into cells using lipids, which are fatty, water-insoluble organic substances that can
promote gene uptake through cell membranes. We believe that synthetic vectors may provide a number
of gene delivery advantages for repeated, efficient delivery of therapeutic genetic material into
rapidly dividing cells, such as certain types of tumor cells. Although all of our current product
development candidates utilize AAV as the delivery vector, we believe that possessing capabilities
in both viral and synthetic approaches provides advantages in our corporate partnering efforts and
increases the range of our potential products that may reach the market. In March 2005, we announced the results for our second Phase II clinical trial of tgAAVCF, our
AAV-based product candidate for the treatment patients with mild to moderate cystic fibrosis. In
this study, tgAAVCF failed to meet its primary endpoint of statistically significant improvement in
lung function, 30 days following initial administration of tgAAVCF compared to placebo. Based on
these results, we have decided not to pursue further development of tgAAVCF and have focused our
efforts on other clinical and preclinical stage programs. We have two product candidates in Phase I clinical trials. The first is an AAV-based
prophylactic vaccine candidate for high-risk populations in developing nations to protect against
the progression of Human Immunodeficiency Virus, or HIV, infection to Acquired Immune Deficiency
Syndrome, or AIDS. This program is being developed in collaboration with the International AIDS
Vaccine Initiative, or IAVI, a non-profit organization, and the Columbus Childrens Research
Institute at Childrens Hospital in Columbus, Ohio, or CCRI. In December 2003, IAVI initiated a
Phase I initial dose escalation safety trial in humans for our AIDS vaccine product candidate in
Europe. This dose-escalation safety trial is designed to enroll up to 50 volunteers who are
uninfected with HIV and in good health. Each participant in this trial received a single injection
of the vaccine candidate or 7




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placebo and was monitored for safety and immune response. Preliminary results from this study
were announced in February 2005 and suggest that tgAAC09 was safe and well-tolerated in this trial.
Results also showed that at the doses evaluated in this initial trial, a single administration of
tgAAC09, did not elicit a significant immune response. These results support further development of
tgAAC09 and clinical evaluation at higher dose levels. We will continue to monitor these volunteers
in accordance with our clinical trial protocol. The current Phase I clinical trial of tgAAC09 is
the initial step in a comprehensive development strategy of this vaccine program. IAVI expanded the
single-dose Phase I trial to include sites in India. The purpose of this study is to further
evaluate the safety of the vaccine in the population that would participate in subsequent efficacy
trials, assuming continued development of the vaccine candidates. Additionally, in a non-human
primate study, it was demonstrated that antibody and T cell responses increased after a second
dose, or boost, of tgAAC09 vaccine. Based on this preclinical data and upon receiving the necessary
regulatory approvals, we plan to expand the European Phase I trial to evaluate the safety and
immunogenicity of this vaccine after a second dose. After volunteers who receive a second dose of
tgAAC09 have been monitored according to protocol, we will report the data from the entire study.
While these clinical trials are underway, we continue to pursue the development of additional
vaccine candidates, including vaccines based on different serotypes, or strains, of AAV believed to
be more efficient delivery systems for gene-based vaccines to muscle. Preclinical studies of these
vaccine approaches have demonstrated an ability to elicit an immune response at lower dose levels. Our second product candidate in a clinical trial is an AAV-based product candidate for the
treatment of inflammatory arthritis. In March 2004, we initiated a Phase I clinical trial for this
product candidate. This dose-escalation safety trial is designed to enroll up to 24 patients with
rheumatoid arthritis, psoriatic arthritis or ankylosing spondylitis. This study is primarily
designed to evaluate the safety of tgAAC94 of escalating doses. We also expect to collect data on
signs and symptoms of disease, molecular markers of disease and gene expression in both a
drug-treated and placebo-treated groups of patients. We expect to be able to present data from the
trial in mid-2005. We have established broad capabilities in applying our gene delivery technologies and have
developed an infrastructure that allows us to leverage these capabilities into multiple product
opportunities. We have also developed processes to manufacture our potential products at a scale
amenable to clinical development and expandable to large-scale production for advancing our
potential products to commercialization. These methods are similar to the methods used to
manufacture other biologics. This has enabled us to establish collaborations with others. In
December 2004, we initiated a collaboration with Celladon Corporation to pursue the development of
AAV-based treatments for congestive heart failure. In January 2005, we initiated a collaboration
with Sirna Therapeutics, Inc. to pursue the development of an AAV-based treatment for Huntingtons
disease. We believe that our development and manufacturing capabilities may enable us to establish
additional strategic partnerships or collaborations. We believe that a wide range of diseases may potentially be treated or prevented with
gene-based products, including cancer, genetic diseases and infectious diseases. We believe that
there is also a significant opportunity to treat diseases that are currently treated using
proteins, monoclonal antibodies or small molecule drugs. These diseases may be more effectively
treated by gene-based therapies that may provide a long-term or a localized method of treatment.
Additionally, we believe that there are potential therapeutic applications where a gene-based
approach to delivering a therapeutic protein may be preferred due to inherent difficulties in
delivering the therapeutic protein itself. Our business strategy is to leverage our proprietary
intellectual property and AAV development capabilities into multiple product development programs
and collaborations to maximize our product opportunities. Using AAV gene delivery systems, we are
developing product candidates across multiple diseases with the belief that gene-based therapies
may provide a means to treat diseases not fully treatable with current biologic and pharmaceutical
drugs. We believe that, if successful, we can establish significant market potential for our
product candidates. Currently there are no commercially available gene therapy products in the
United States. We intend to pursue product development programs to enable us to demonstrate proof
of concept and eventually commercialize gene-based therapeutics to address currently unmet medical
needs in treating disease. The development of pharmaceutical products, including our potential AIDS, inflammatory
arthritis, congestive heart failure, and Huntingtons disease product candidates discussed above,
involves extensive preclinical development followed by human clinical trials that take several
years or more to complete. The length of time required to completely develop any product candidate
varies substantially according to the type, complexity and novelty of the product candidate, the
degree of involvement by a development partner and the intended use of the product candidate. Our
commencement and rate of completion of clinical trials may vary or be delayed for many reasons,
including those discussed in the section entitled Factors Affecting Our Operating Results, Our
Business and Our Stock Price presented below. 8




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Results of Operations Revenue Revenue increased to $2.0 million for the three months ended March 31, 2005 from $1.3 million
for the same period in 2004. Revenue in 2005 and 2004 primarily reflect amounts earned under our
AIDS vaccine collaboration with IAVI. We expect that our revenue for the remainder of 2005 will
consist primarily of research and development revenue earned under our collaboration with IAVI and
smaller amounts of revenue earned from our collaborations with Celladon and Sirna expected later in
2005. Our revenue for the next several years will depend on the continuation of the current
collaborations with IAVI, Celladon and Sirna and our success with entering into and performing
under potential new collaborations. Operating Expenses Research and Development Expenses. Research and development expenses increased to $4.5
million for the three months ended March 31, 2005 from $4.2 million for the same period in 2004.
This increase generally reflects higher costs in our AIDS vaccine and inflammatory arthritis
programs. Research and preclinical development program expenses in 2004 include costs associated
with CellExSys, which were eliminated in July 2004 following the merger of CellExSys into Chromos.
We expect that our research and development expenses for the remainder of 2005 will vary depending
on the timing of outside services necessary to support our clinical programs and our newly
initiated collaborations with Celladon and Sirna. The following is an allocation of our total research and development costs between our
programs in clinical development and those that are in research or preclinical stages of
development: Three months endedMarch 31,2005
    
    
    2004Programs in clinical development:AIDS vaccine
    
    $
    1,124,000
    
    
    $
    529,000Inflammatory arthritis
    
    
    586,000
    
    
    
    81,000Cystic fibrosis
    
    
    189,000
    
    
    
    136,000Indirect costs
    
    
    1,511,000
    
    
    
    884,000Total clinical development program expense
    
    
    3,410,000
    
    
    
    1,630,000Research and preclinical development
program expense
    
    
    1,129,000
    
    
    
    2,607,000Total research and development expense
    
    $
    4,539,000
    
    
    $
    4,237,000
 Research and development costs attributable to programs in clinical development include the
costs of salaries and benefits, clinical trial costs, outside services, materials and supplies
incurred to support the clinical programs. Indirect costs allocated to clinical programs include
facility and occupancy costs, research and development administrative costs, and license and
royalty payments. These costs are further allocated between clinical and preclinical programs
based on relative levels of program activity. IAVI separately manages and funds the clinical trial
costs of our AIDS vaccine program and the Cystic Fibrosis Foundation separately funded the external
costs of the Phase II clinical trial of tgAAVCF. As a result, we do not include those costs in our
research and development expenses. We discontinued development of our cystic fibrosis product
candidate in March 2005. Costs attributed to research and preclinical programs represent our earlier-stage development
activities, including costs incurred for the Huntingtons disease and congestive heart failure
programs as well as other programs prior to their transition into clinical trials. Research and
preclinical program expense also includes costs that are not allocable to a clinical development
program, such as unallocated manufacturing infrastructure costs. Because we conduct multiple
research projects and utilize resources across several programs, our research and preclinical
development costs are not directly assigned to individual programs. For purposes of reimbursement from our collaboration partners, we capture the level of effort
expended on a program through our project management system, which is based primarily on human
resource time allocated to each program, supplemented by an allocation of indirect costs and other
specifically identifiable costs, if any. As a result, the costs allocated to a program do not
necessarily reflect the actual costs of the program. 9




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General and Administrative Expenses. General and administrative expenses increased to
$1.9 million for the three months ended March 31, 2005, from $1.8 million for the same period in
2004. This increase primarily reflects higher professional service costs related to patent
issuances in the current year, offset by lower personnel costs due to the merger of CellExSys into
Chromos in July 2004. Restructure Charges.Restructure charges increased to $219,000 for the three months ended
March 31, 2005, from $195,000 for the same period in 2004. Restructuring charges in 2005 consist
of accretion expense totaling $119,000 and a charge related to updated sublease rental assumptions
that may be achieved from our Bothell facility totaling $100,000. We record accretion expense
based upon changes in the accrued restructure liability that results from the passage of time at an
assumed discount rate of 10%. Accretion expense is recorded on an ongoing basis and is reflected
as a charge in the accompanying statements of operations as a restructuring charge. Other Income and Expense Investment Income. Investment income decreased to $100,000 for the three months ended March
31, 2005, from $124,000 for the same period in 2004. The decrease reflects a $63,000 non-cash
charge to reduce the carrying value of our share of the Chromos debenture received as part of the
CellExSys merger. This non-cash charge, which reduced the debenture carrying value to zero, was
partially offset by higher investment income. Interest Expense. Interest expense relates to interest on outstanding loans from our
collaborative partners, notes and obligations under equipment financing arrangements that we use to
finance purchases of laboratory and computer equipment, furniture and leasehold improvements.
Interest expense increased to $129,000 for the three months ended March 31, 2005, from $120,000 for
the same period in 2004, reflecting an increase of the London Interbank Offered Rate, or LIBOR,
used to calculate interest on a $10 million loan owed to Biogen offset by lower interest charges on
decreased principal amounts outstanding under our equipment financing arrangements. Liquidity and Capital Resources Our combined cash and cash equivalents decreased to $30.4 million at March 31, 2005,
compared to $34.1 million at December 31, 2004 and our net working capital decreased to $26.8
million at March 31, 2005, compared to $31.2 million at December 31, 2004. Our principal use of
cash was $3.3 million to fund our operations during the period. Our shareholders equity decreased
to $45.1 million at March 31, 2005, compared to $49.8 million at December 31, 2004 due to our net
loss of $4.7 million for the quarter ended March 31, 2005. We have financed our product development activities and general corporate functions primarily
through proceeds from public and private sales of our equity securities, through cash payments
received from our collaborative partners and proceeds from the issuance of debt. To a lesser
degree, we have also financed our operations through interest earned on cash and cash equivalents,
loan funding under equipment leasing agreements and research grants. These financing sources have
historically allowed us to maintain adequate levels of cash and investments. Our AIDS vaccine candidate and our inflammatory arthritis product candidate are both in Phase
I clinical trials. We expect to continue incurring significant expense in advancing our product
candidates toward commercialization. As a result, we do not expect to generate sustained positive
cash flow from our operations for at least the next several years and only then if we can
successfully develop and commercialize our product candidates. We will require substantial
additional financial resources to fund the development and commercialization of our product
candidates and expand research and development of our product candidates for treating additional
diseases. We have an ongoing collaboration with IAVI and CCRI to develop an AIDS vaccine for use in
non-industrialized countries. We are developing our product candidate for Huntingtons disease
under a collaboration with Sirna where we share the development costs, and any potential revenues
with Sirna. Under our collaboration with Celladon to develop products to treat congestive heart
failure, we have agreed to contribute up to $2 million to support development activities under the
collaboration. This contribution will consist primarily of internal development and manufacturing
efforts at rates agreed to by the parties. We are entitled to receive payments from Celladon for
our research and development efforts above $2 million. We had previously expected that our cash requirements for 2005 would range from $22 million to $24
million. As a result of discontinuing our cystic fibrosis program, we have eliminated certain
operating activities previously planned to occur during 2005. We have also recently completed the
preparation of development plans under our new collaborations with Celladon and Sirna, under which
we expect to receive additional sources of funding during 2005. As a result, we now expect that
our cash requirements for 2005 will range from $20 million to $22 million and that our cash and
cash equivalents at March 31, 2005, plus the funding from our partners will be sufficient to fund
our operations until approximately mid-2006. This estimate is based on 10




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our ability to perform planned research and development activities and the receipt of planned
funding from our collaborators. Although our development collaboration with IAVI has been extended
through the end of 2006, the development plan and budget under the collaboration is established on
an annual basis. While we expect this program to continue through at least the duration of the
current collaboration term, we have not established the work plan and budget for 2006 with IAVI and
have therefore not yet made an assumption as to the level of funding that we may receive from IAVI
in 2006. We have a $650,000 loan from Biogen that is due in September 2005. We have a $10 million
note payable to Biogen that is due in August 2006, which will require that we raise additional
capital, or seek an alternative arrangement to repay the note. Our near-term financing strategy has included leveraging our development capabilities and
intellectual assets into additional capital raising opportunities, advancing our clinical
development programs and accessing the public and private capital markets at appropriate times.
During 2004, we raised approximately $30 million in new equity capital and have recently entered
into new strategic collaborations with Celladon and Sirna that leverage our development
capabilities. In March 2005, we announced the initial results of a Phase II clinical trial of
tgAAVCF and our decision to discontinue the development of the product candidate based on those
results. The results of this trial and the discontinuance of the program have impacted our ability
to raise additional capital and have caused us to focus our financing strategy around advancement
of our two other programs in clinical development and our new development collaborations and
leveraging value out of our other intellectual assets and capabilities. We expect the level of our
future operating expenses to be driven by the needs of our product development programs, offset by
the availability of funds through partner-funded collaborations, equity offerings or other
financing activities. The size, scope and pace of our development activities depend on the
availability of these resources. Our future cash requirements will depend on many factors,
including:  
    the rate and extent of scientific progress in our research and development programs;
    the timing, costs and scope of, and our success in, clinical trials, obtaining regulatory
approvals and filing, prosecuting and enforcing patents;
    competing technological and market developments;
    the timing and costs of, and our success in, any product commercialization activities and
facility expansions, if and as required; and
    the expense and outcome of any litigation or administrative proceedings involving our
intellectual property, or access to third-party intellectual property through licensing
agreements. IAVI has the right to terminate our collaboration and its obligation to provide research
funding at any time for any reason with 90 days notice. If we were to lose the collaborative
funding expected from IAVI and were unable to obtain alternative sources of funding for the AIDS
vaccine product candidate, we may be unable to continue our research and development program for
that product candidate. Our other development collaborations contain similar termination
provisions which if terminated would result in the loss of funding and may cause us to terminate
development efforts on the program. Additional sources of financing could involve one or more of the following:  
    entering into additional product development and funding collaborations or other strategic
transactions, or extending or expanding our current collaborations;
    selling or licensing our technology or product candidates;
    borrowing under loan or equipment leasing arrangements;
    issuing equity in the public or private markets; or
    issuing debt. Additional funding may not be available to us on reasonable terms, if at all. Depending on our
ability to successfully access additional funding, we may be forced to implement significant cost
reduction measures. These adjustments may include scaling back, delaying or terminating one or more
research and development programs, curtailing capital expenditures or reducing other operating
activities. We may also be required to relinquish some rights to our technology or product
candidates or grant licenses on unfavorable terms, either of which would reduce the ultimate value
to us of the technology or product candidates. 11




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Factors Affecting Our Operating Results, Our Business and Our Stock Price In addition to the other information contained in this quarterly report, you should carefully
read and consider the following risk factors. If any of these risks actually occur, our business,
operating results or financial condition could be harmed. This could cause the trading price of our
stock to decline, and you could lose all or part of your investment. Risks Related to Our Business We expect to continue to operate at a loss and may never become profitable. Substantially all of our revenue has been derived under collaborative research and development
agreements relating to the development of our potential product candidates. We have incurred, and
will continue to incur for the foreseeable future, significant expense to develop our research and
development programs, conduct preclinical studies and clinical trials, seek regulatory approval for
our product candidates and provide general and administrative support for these activities. As a
result, we have incurred significant net losses since inception, and we expect to continue to incur
substantial additional losses in the future. As of March 31, 2005, we had an accumulated deficit of
approximately $235.5 million. We may never generate profits and, if we do become profitable, we may
be unable to sustain or increase profitability. All of our product candidates are in early-stage clinical trials or preclinical development, and if
we are unable to successfully develop and commercialize our product candidates we will be unable to
generate sufficient capital to maintain our business. In December 2003, IAVI initiated a Phase I trial for our AIDS vaccine product candidate in
Europe. In March 2004, we initiated a Phase I trial for our inflammatory arthritis product
candidate in the United States and Canada. We will not generate any product revenue for at least
several years and then only if we can successfully develop and commercialize our product
candidates. Commercializing our potential products depends on successful completion of additional
research and development and testing, in both preclinical development and clinical trials. Clinical
trials may take several years or more to complete. The commencement, cost and rate of completion of
our clinical trials may vary or be delayed for many reasons, including the risks discussed
elsewhere in this section. If we are unable to successfully complete preclinical and clinical
development of some or all of our product candidates in a timely manner, we may be unable to
generate sufficient product revenue to maintain our business. Even if our potential products succeed in clinical trials and are approved for marketing,
these products may never achieve market acceptance. If we are unsuccessful in commercializing our
product candidates for any reason, including greater effectiveness or economic feasibility of
competing products or treatments, the failure of the medical community or the public to accept or
use any products based on gene delivery, inadequate marketing and distribution capabilities or
other reasons discussed elsewhere in this section, we will be unable to generate sufficient product
revenue to maintain our business. If we are unable to raise additional capital when needed, we will be unable to conduct our
operations and develop our potential products. Because internally generated cash flow will not fund development and commercialization of our
product candidates, we will require substantial additional financial resources. Our future capital
requirements will depend on many factors, including:  
    the rate and extent of scientific progress in our research and development programs;
    the timing, costs and scope of, and our success in, conducting clinical trials,
obtaining regulatory approvals and pursuing patent prosecutions;
    competing technological and market developments;
    the timing and costs of, and our success in, any commercialization activities and
facility expansions, if and as required; and
    the existence and/or outcome of any litigation or administrative proceedings involving
intellectual property. We expect that our cash and cash equivalents at March 31, 2005, plus the funding from IAVI for
2005 work under our AIDS vaccine collaboration and funding from our other partners will be
sufficient to fund our operations until approximately 12




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mid-2006. This estimation is based on our ability to perform planned research and development
activities and the receipt of planned funding from our collaborators. In August 2006, our $10
million note payable to Biogen is due, which will require that we raise additional capital to repay
the note or seek an alternative arrangement to repay the note. We also have a $650,000 loan from
Biogen that is due in September 2005. Although our development collaboration with IAVI has been
extended through the end of 2006, the development plan and budget under the collaboration is
established on an annual basis. While we expect this program to continue through at least the
duration of the current collaboration term, we have not established the work plan and budget for
2006 with IAVI and have therefore not yet made an assumption as to the level of funding that we may
receive from IAVI in those years. Additional sources of financing could involve one or more of the
following:  
    extending or expanding our current collaborations;
    entering into additional product development collaborations;
    selling or licensing our technology or product candidates;
    borrowing under loan or equipment leasing arrangements;
    issuing equity in the public or private markets; or
    issuing debt. Additional funding may not be available to us on reasonable terms, if at all. The funding that we expect to receive from IAVI depends on continued scientific progress under
the collaboration and IAVIs ability and willingness to continue or extend the collaboration. If we
are unable to successfully access additional capital, we may need to scale back, delay or terminate
one or more of our development programs, curtail capital expenditures or reduce other operating
activities. We may also be required to relinquish some rights to our technology or product
candidates or grant or take licenses on unfavorable terms, either of which would reduce the
ultimate value to us of our technology or product candidates. The regulatory approval process for our product candidates is costly, time-consuming and subject to
unpredictable changes and delays, and our product candidates may never receive regulatory approval. No gene therapy products have received regulatory approval for marketing from the U.S. Food
and Drug Administration, or FDA. Because our product candidates involve new and unproven
technologies, we believe that the regulatory approval process may proceed more slowly compared to
clinical trials involving traditional drugs. The FDA and applicable state and foreign regulators
must conclude at each stage of clinical testing that our clinical data suggest acceptable levels of
safety in order for us to proceed to the next stage of clinical trials. In addition, gene therapy
clinical trials conducted at institutions that receive funding for recombinant DNA research from
the U.S. National Institutes of Health, or NIH, are subject to review by the NIHs Office of
Biotechnology Activities Recombinant DNA Advisory Committee, or RAC. Although NIH guidelines do not
have regulatory status, the RAC review process can impede the initiation of the trial, even if the
FDA has reviewed the trial and approved its initiation. Moreover, before a clinical trial can begin
at an NIH-funded institution, that institutions Institutional Biosafety Committee must review the
proposed clinical trial to assess the safety of the trial. The regulatory process for our product candidates is costly, time-consuming and subject to
unpredictable delays. The clinical trial requirements of the FDA, NIH and other agencies and the
criteria these regulators use to determine the safety and efficacy of a product candidate vary
substantially according to the type, complexity, novelty and intended use of the potential
products. In addition, regulatory requirements governing gene and cell therapy products have
changed frequently and may change in the future. Accordingly, we cannot predict how long it will
take or how much it will cost to obtain regulatory approvals for clinical trials or for
manufacturing or marketing our potential products. Some or all of our product candidates may never
receive regulatory approval. A product candidate that appears promising at an early stage of
research or development may not result in a commercially successful product. Our clinical trials
may fail to demonstrate the safety and efficacy of a product candidate or a product candidate may
generate unacceptable side affects or other problems during or after clinical trials. Should this
occur, we may have to delay or discontinue development of the product candidate, and the corporate
partner that supports development of that product candidate may terminate its support. Delay or
failure to obtain, or unexpected costs in obtaining, the regulatory approval necessary to bring a
potential product to market could decrease our ability to generate sufficient product revenue to
maintain our business. 13




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If we are unable to obtain or maintain licenses for necessary third-party technology on acceptable
terms or to develop alternative technology, we may be unable to develop and commercialize our
product candidates. We have entered into exclusive and nonexclusive license agreements that give us and our
partners rights to use technologies owned or licensed by commercial and academic organizations in
the research, development and commercialization of our potential products. For example, we have a
gene transfer technology license agreement with Amgen Inc., or Amgen, as the successor to Immunex
Corporation, or Immunex, under which we have license rights to certain Immunex proprietary
technology specifically applicable to gene therapy applications. In a February 2004 letter, Amgen
took the position that we are not licensed, either exclusively or non-exclusively, to use Immunex
intellectual property covering TNFR:Fc or therapeutic uses for TNFR:Fc. We have responded with a
letter confirming our confidence that the gene transfer technology license agreement provides us
with an exclusive worldwide license to use the gene construct coding for TNFR:Fc for gene therapy
applications. We have had and continue to have further communications with Amgen regarding our
differences. Notwithstanding our confidence, it is possible that a resolution of those differences,
through litigation or otherwise, could cause delay or discontinuation of our development of tgAAC94
or our inability to commercialize any resulting product. We believe that we will need to obtain additional licenses to use patents and unpatented
technology owned or licensed by others for use, compositions, methods, processes to manufacture
compositions, processes to manufacture and purify gene delivery product candidates and other
technologies and processes for our present and potential product candidates. If we are unable to
maintain our current licenses for third-party technology or obtain additional licenses on
acceptable terms, we may be required to expend significant time and resources to develop or license
replacement technology. If we are unable to do so, we may be unable to develop or commercialize the
affected product candidates. In addition, the license agreements for technology for which we hold
exclusive licenses typically contain provisions that require us to meet minimum development
milestones in order to maintain the license on an exclusive basis for some or all fields of the
license. We also have license agreements for some of our technologies, which may require us to
sublicense certain of our rights. If we do not meet these requirements, our licensor may convert
all or a portion of the license to a nonexclusive license or, in some cases, terminate the license. In many cases, patent prosecution of our licensed technology is controlled solely by the
licensor. If our licensors fail to obtain and maintain patent or other protection for the
proprietary intellectual property we license from them, we could lose our rights to the
intellectual property or our exclusivity with respect to those rights, and our competitors could
market competing products using the intellectual property. Licensing of intellectual property is of
critical importance to our business and involves complex legal, business and scientific issues and
is complicated by the rapid pace of scientific discovery in our industry. Disputes may arise
regarding intellectual property subject to a licensing agreement, including:  
    the scope of rights granted under the license agreement and other interpretation-related
issues;
    the extent to which our technology and processes infringe on intellectual property of
the licensor that is not subject to the licensing agreement;
    the sublicensing of patent and other rights under our collaborative development
relationships;
    the ownership of inventions and know-how resulting from the joint creation or use of
intellectual property by our licensors and us and our partners; and
    the priority of invention of patented technology. If disputes over intellectual property that we have licensed prevent or impair our ability to
maintain our current licensing arrangements on acceptable terms, we may be unable to successfully
develop and commercialize the affected product candidates. Failure to recruit patients could delay or prevent clinical trials of our potential products, which
could delay or prevent the development of potential products. Identifying and qualifying patients to participate in clinical trials of our potential
products is critically important to our success. The timing of our clinical trials depends on the
speed at which we can recruit patients to participate in testing our product candidates. We have
experienced delays in some of our clinical trials, and we may experience similar delays in the
future. If patients are unwilling to participate in our gene therapy trials because of negative
publicity from adverse events in the biotechnology or gene therapy industries or for other reasons,
including competitive clinical trials for similar patient populations, the timeline for recruiting
patients, conducting trials and obtaining regulatory approval of potential products will be
delayed. These delays could result in increased costs, delays in advancing our product development,
delays in testing the effectiveness of our technology or termination of the clinical trials
altogether. 14




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Litigation involving intellectual property, product liability or other claims and product recalls
could strain our resources, subject us to significant liability, damage our reputation or result in
the invalidation of our proprietary rights. As our product development efforts progress, especially in potentially significant markets
such as AIDS or inflammatory arthritis therapies, the risk increases that others may claim that our
processes and potential products infringe on their intellectual property rights. In addition,
administrative proceedings, litigation or both may be necessary to enforce our intellectual
property rights or determine the rights of others. Defending or pursuing these claims, regardless
of their merit, would be costly and would likely divert managements attention and resources away
from our operations. If there were to be an adverse outcome in litigation or an interference
proceeding, we could face potential liability for significant damages or be required to obtain a
license to the patented process or technology at issue, or both. If we are unable to obtain a
license on acceptable terms, or to develop or obtain alternative technology or processes, we may be
unable to manufacture or market any product or potential product that uses the affected process or
technology. Clinical trials and the marketing of any potential products may expose us to liability claims
resulting from the testing or use of our products. Gene therapy treatments are new and unproven,
and potential known and unknown side effects of gene therapy may be serious and potentially
life-threatening. Product liability claims may be made by clinical trial participants, consumers,
healthcare providers or other sellers or users of our products. Although we currently maintain
liability insurance, the costs of product liability and other claims against us may exceed our
insurance coverage. In addition, we may require increased liability coverage as additional product
candidates are used in clinical trials and commercialized. Liability insurance is expensive and may
not continue to be available on acceptable terms. A product liability or other claim or product
recall not covered by or exceeding our insurance coverage could significantly harm our financial
condition. In addition, adverse publicity resulting from a product recall or a liability claim
against us, one of our partners or another gene therapy company could significantly harm our
reputation and make it more difficult to obtain the funding and collaborative partnerships
necessary to maintain our business. If we lose IAVI as a partner, we may be unable to develop our AIDS vaccine product candidate. We have a collaborative development agreement with IAVI, which expires in December 2006, that
we expect to provide us with funding to reimburse research and development and manufacturing
expenses we incur in connection with the collaboration. As a result, a significant portion of our
operating expenses are funded through our collaborative agreements with IAVI. Additionally, IAVI
directly funds the Phase I clinical trial for our AIDS vaccine product candidate. IAVI has the right to terminate the collaboration or its obligation to provide funding at any
time for any reason with 90 days notice, which would significantly affect our operating activities.
The loss of significant amounts of collaborative or clinical trial funding could cause the delay,
reduction or termination of the related research and development programs, and a reduction in
capital expenditures and other operating activities necessary to support general operations. Such a
reduction could further impede our ability to develop our product candidates. If we do not attract and retain qualified personnel, we may be unable to develop and commercialize
some of our potential products. Our future success depends in large part on our ability to attract and retain key technical
and management personnel. All of our employees, including our executive officers, can terminate
their employment with us at any time. We have programs in place designed to retain personnel,
including competitive compensation packages and programs to create a positive work environment.
Other companies, research and academic institutions and other organizations in our field compete
intensely for employees, however, and we may be unable to retain our existing personnel or attract
additional qualified employees and consultants. If we experience significant turnover or difficulty
in recruiting new personnel, our research and development of product candidates could be delayed
and we could experience difficulty in generating sufficient revenue to maintain our business. If our partners or scientific consultants terminate, reduce or delay our relationships with them,
we may be unable to develop our potential products. Our partners provide funding, manage regulatory filings, aid and augment our internal research
and development efforts and provide access to important intellectual property and know-how. Their
activities include, for example, support in processing the regulatory filings of our product
candidates and funding clinical trials. Our outside scientific consultants and contractors perform
research, develop technology and processes to advance and augment our internal efforts and provide
access to important intellectual property and know-how. Their activities include, for example,
clinical evaluation of our product candidates, product development activities performed under our
research collaborations, research under sponsored research agreements and contract manufacturing
services. Collaborations with established pharmaceutical and biotechnology companies and academic,
research and public health organizations often provide a measure of validation of our product
development efforts in the eyes of securities 15




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analysts, investors and the medical community. The development of certain of our potential
products, and therefore the success of our business, depends on the performance of our partners,
consultants and contractors. If they do not dedicate sufficient time, regulatory or other technical
resources to the research and development programs for our product candidates or if they do not
perform their obligations as expected, we may experience delays in, and may be unable to continue,
the preclinical or clinical development of those product candidates. Each of our collaborations and
scientific consulting relationships concludes at the end of the term specified in the applicable
agreement unless we and our partners agree to extend the relationship. Any of our partners may
decline to extend the collaboration, or may be willing to extend the collaboration only with a
significantly reduced scope, for a number of scientific or business reasons. Competition for
scientific consultants and partners in gene therapy is intense. We may be unable to successfully
maintain our existing relationships or establish additional relationships necessary for the
development of our product candidates on acceptable terms, if at all. If we are unable to do so,
our research and development programs may be delayed or we may lose access to important
intellectual property or know-how. The success of our clinical trials and preclinical studies may not be indicative of results in a
large number of patients of either safety or efficacy. The successful results of our technology in preclinical studies using animal models may not be
predictive of the results that we will see in our clinical trials. In addition, results in
early-stage clinical trials are based on limited numbers of patients and generally test for drug
safety rather than efficacy. Our reported progress and results from our early phases of clinical
testing of our product candidates may not be indicative of progress or results that will be
achieved from larger populations, which could be less favorable. Moreover, we do not know if the
favorable results we have achieved in clinical trials will have a lasting effect. If a larger group
of patients does not experience positive results, or if any favorable results do not demonstrate a
beneficial effect, our product candidates that we advance to clinical trials, may not receive
approval from the FDA for further clinical trials or commercialization. For example, in March
2005, we discontinued the development of tgAAVCF following the analysis of Phase II clinical trial
data in which tgAAVCF failed to achieve the efficacy endpoints of the trial. We may be unable to adequately protect our proprietary rights domestically or overseas, which may
limit our ability to successfully market any product candidates. Our success depends substantially on our ability to protect our proprietary rights and operate
without infringing on the proprietary rights of others. We own or license patents and patent
applications, and will need to license additional patents, for genes, processes, practices and
techniques critical to our present and potential product candidates. If we fail to obtain and
maintain patent or other intellectual property protection for this technology, our competitors
could market competing products using those genes, processes, practices and techniques. The patent
process takes several years and involves considerable expense. In addition, patent applications and
patent positions in the field of biotechnology are highly uncertain and involve complex legal,
scientific and factual questions. Our patent applications may not result in issued patents and the
scope of any patent may be reduced both before and after the patent is issued. Even if we secure a
patent, the patent may not provide significant protection and may be circumvented or invalidated. We also rely on unpatented proprietary technology and technology that we have licensed on a
nonexclusive basis. While we take precautions to protect our proprietary unpatented technology, we
may be unable to meaningfully protect this technology from unauthorized use or misappropriation by
a third party. Our competitors could also obtain rights to our nonexclusively licensed proprietary
technology. In any event, other companies may independently develop equivalent proprietary
information and techniques. If our competitors develop and market competing products using our
unpatented or nonexclusively licensed proprietary technology or substantially similar technology,
our products, if successfully developed, could suffer a reduction in sales or be forced out of the
market. If we do not develop adequate development, manufacturing, sales, marketing and distribution
capabilities, either alone or with our business partners, we will be unable to generate sufficient
product revenue to maintain our business. Our potential products require significant development of new processes and design for the
advancement of the product candidate through manufacture, preclinical and clinical testing. We may
be unable to continue development or meet critical milestones with our partners due to technical or
scientific issues related to manufacturing or development. We currently do not have the physical
capacity to manufacture large-scale quantities of our potential products. This could limit our
ability to conduct large clinical trials of a product candidate and to commercially launch a
successful product candidate. In order to manufacture product at such scale, we will need to expand
or improve our current facilities and staff or supplement them through the use of contract
providers. If we are unable to obtain and maintain the necessary manufacturing capabilities, either
alone or through third parties, we will be unable to manufacture our potential products in
quantities sufficient to sustain our business. Moreover, we are unlikely to become profitable if
we, or our contract providers, are unable to manufacture our potential products in a cost-effective
manner. 16




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In addition, we have no experience in sales, marketing and distribution. To successfully
commercialize any products that may result from our development programs, we will need to develop
these capabilities, either on our own or with others. We intend to enter into collaborations with
other entities to utilize their mature marketing and distribution capabilities, but we may be
unable to enter into marketing and distribution agreements on favorable terms, if at all. If our
current or future collaborative partners do not commit sufficient resources to timely marketing and
distributing our future products, if any, and we are unable to develop the necessary marketing and distribution capabilities on our own, we will be
unable to generate sufficient product revenue to sustain our business. Post-approval manufacturing or product problems or failure to satisfy applicable regulatory
requirements could prevent or limit our ability to market our products. Commercialization of any products will require continued compliance with FDA and other
federal, state and local regulations. For example, our current manufacturing facility, which is
designed for manufacturing our AAV vectors for clinical and development purposes, is subject to the
Good Manufacturing Practices requirements and other regulations of the FDA, as well as to other
federal, state and local regulations such as the Occupational Health and Safety Act, the Toxic
Substances Control Act, the Resource Conservation and Recovery Act and the Environmental Protection
Act. Any future manufacturing facilities that we may construct for large-scale commercial
production will also be subject to regulation. We may be unable to obtain regulatory approval for
or maintain in operation this or any other manufacturing facility. In addition, we may be unable to
attain or maintain compliance with current or future regulations relating to manufacture, safety,
handling, storage, record keeping or marketing of potential products. If we fail to comply with
applicable regulatory requirements or discover previously unknown manufacturing, contamination,
product side effects or other problems after we receive regulatory approval for a potential
product, we may suffer restrictions on our ability to market the product or be required to withdraw
the product from the market. Risks Related to Our Industry Adverse events in the field of gene therapy could damage public perception of our potential
products and negatively affect governmental approval and regulation. Public perception of our product candidates could be harmed by negative events in the field of
gene therapy. For example, in 2003, fourteen patients in a French academic clinical trial being
treated for x-linked severe combined immunodeficiency in a gene therapy trial using a retroviral
vector showed correction of the disease, although three of the patients subsequently developed
leukemia. Serious adverse events, including patient deaths have occurred in clinical trials.
Adverse events and the resulting publicity, as well as any other adverse events in the field of
gene therapy that may occur in the future, could result in a decrease in demand for any products
that we may develop. The commercial success of our product candidates will depend in part on public
acceptance of the use of gene therapy for preventing or treating human diseases. If public
perception is influenced by claims that gene therapy is unsafe, our product candidates may not be
accepted by the general public or the medical community. The public and the medical community may
conclude that our technology is unsafe. Future adverse events in gene therapy or the biotechnology industry could also result in
greater governmental regulation, unfavorable public perception, stricter labeling requirements and
potential regulatory delays in the testing or approval of our potential products. Any increased
scrutiny could delay or increase the costs of our product development efforts or clinical trials. Our use of hazardous materials exposes us to liability risks and regulatory limitations on their
use, either of which could reduce our ability to generate product revenue. Our research and development activities involve the controlled use of hazardous materials,
including chemicals, biological materials and radioactive compounds. Our safety procedures for
handling, storing and disposing of these materials must comply with federal, state and local laws
and regulations, including, among others, those relating to solid and hazardous waste management,
biohazard material handling, radiation and air pollution control. We may be required to incur
significant costs in the future to comply with environmental or other applicable laws and
regulations. In addition, we cannot eliminate the risk of accidental contamination or injury from
hazardous materials. If a hazardous material accident were to occur, we could be held liable for
any resulting damages, and this liability could exceed our financial resources. Accidents unrelated
to our operations could cause federal, state or local regulatory agencies to restrict our access to
hazardous materials needed in our research and development efforts, which could result in delays in
our research and development programs. Paying damages or experiencing delays caused by restricted
access could reduce our ability to generate revenue and make it more difficult to fund our
operations. 17




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The intense competition and rapid technological change in our market may result in pricing
pressures and failure of our potential products to achieve market acceptance. We face increasingly intense competition from a number of commercial entities and institutions
that are developing gene therapy technologies. Our competitors include early-stage and more
established gene delivery companies, other biotechnology companies, pharmaceutical companies,
universities, research institutions and government agencies developing gene therapy products or
other biotechnology-based therapies designed to treat the diseases on which we focus. We also face
competition from companies using more traditional approaches to treating human diseases, such as
surgery, medical devices and pharmaceutical products. As our product candidates become commercial
gene therapy products that may affect commercial markets of the analogous protein or traditional
pharmaceutical therapy, disputes including lawsuits, demands, threats or patent challenges may
arise in an effort to slow our development. In addition, we compete with other companies to acquire
products or technology from research institutions or universities. Many of our competitors have
substantially more financial and infrastructure resources and larger research and development
staffs than we do. Many of our competitors also have greater experience and capabilities than we do
in:  
    research and development;
    clinical trials;
    obtaining FDA and other regulatory approvals;
    manufacturing; and
    marketing and distribution. In addition, the competitive positions of other companies, institutions and organizations,
including smaller competitors, may be strengthened through collaborative relationships.
Consequently, our competitors may be able to develop, obtain patent protection for, obtain
regulatory approval for, or commercialize new products more rapidly than we do, or manufacture and
market competitive products more successfully than we do. This could limit the prices we could
charge for the products that we are able to market or result in our products failing to achieve
market acceptance. Gene therapy is a rapidly evolving field and is expected to continue to undergo significant
and rapid technological change and competition. Rapid technological development by our competitors,
including development of technologies, products or processes that are more effective or more
economically feasible than those we have developed, could result in our actual and proposed
technologies, products or processes losing market share or becoming obsolete. Healthcare reform measures and the unwillingness of third-party payors to provide adequate
reimbursement for the cost of our products could impair our ability to successfully commercialize
our potential products and become profitable. Sales of medical products and treatments depends substantially, both domestically and abroad,
on the availability of reimbursement to the consumer from third-party payors. Our potential
products may not be considered cost-effective by third-party payors, who may not provide coverage
at the price set for our products, if at all. If purchasers or users of our products are unable to
obtain adequate reimbursement, they may forego or reduce their use of our products. Even if
coverage is provided, the approved reimbursement amount may not be high enough to allow us to
establish or maintain pricing sufficient to realize a sufficient return on our investment. Increasing efforts by governmental and third-party payors, such as Medicare, private insurance
plans and managed care organizations, to cap or reduce healthcare costs will affect our ability to
commercialize our product candidates and become profitable. We believe that third-party payors will
attempt to reduce healthcare costs by limiting both coverage and level of reimbursement for new
products approved by the FDA. There have been and will continue to be a number of federal and state
proposals to implement government controls on pricing, the adoption of which could affect our
ability to successfully commercialize our product candidates. Even if the government does not adopt
any such proposals or reforms, their announcement could impair our ability to raise capital. 18




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Risks Related to Our Common Stock If we are unable to comply with the minimum requirements for quotation on the NASDAQ SmallCap
Market and we lose our quotation on NASDAQ, the liquidity and market price of our common stock
would decline. Our stock is listed on the NASDAQ SmallCap Market. In order to continue to be listed on the
NASDAQ SmallCap Market, we must meet specific quantitative standards, including maintaining a
minimum bid price of $1.00 for our common stock. The closing bid price of our common stock has
been below the $1.00 requirement for extended periods of time on multiple occasions in March and
April 2005. If at any time we can not maintain this minimum standard for 30 consecutive trading
days, the delisting process may be initiated. Ultimately, if we are unable to comply with the
minimum bid price requirement and the other current or future listing requirements, we would lose
our quotation on the NASDAQ SmallCap Market. Delisting of our common stock from the NASDAQ
SmallCap Market would likely result in a substantial loss in liquidity of our common stock and in a
decline in its market price, and you could lose all or part of your investment. In addition, our
ability to raise capital through the issuance of debt or equity securities may be impaired if our
common stock is delisted. Concentration of ownership of our common stock may give certain shareholders significant influence
over our business. A small number of investors own a significant number of shares of our common stock. As of
March 31, 2005, Biogen held approximately 12.1 million and Elan (together with its affiliates) held
approximately 11.6 million shares of our common stock. Together these holdings represent
approximately 27.7% of our common shares outstanding as of March 31, 2005. This concentration of
stock ownership may allow these shareholders to exercise significant control over our strategic
decisions and block, delay or substantially influence all matters requiring shareholder approval,
such as:  
    election of directors;
    amendment of our charter documents; or
    approval of significant corporate transactions, such as a change of control of Targeted Genetics. The interests of these shareholders may conflict with the interests of other holders of our
common stock with regard to such matters. Furthermore, this concentration of ownership of our
common stock could allow these shareholders to delay, deter or prevent a third party from acquiring
control of Targeted Genetics at a premium over the then-current market price of our common stock,
which could result in a decrease in our stock price. Market fluctuations or volatility could cause the market price of our common stock to decline and
limit our ability to raise capital. The stock market in general and the market for biotechnology-related companies in particular
have experienced extreme price and volume fluctuations, often unrelated to the operating
performance of the affected companies. The market price of the securities of biotechnology
companies, particularly companies such as ours without earnings and product revenue, has been
highly volatile and is likely to remain so in the future. Any report of clinical trial results that
are below the expectations of financial analysts or investors could result in a decline in our
stock price. We believe that in the past, similar levels of volatility have contributed to the
decline in the market price of our common stock, and may do so again in the future. Trading volumes
of our common stock can increase dramatically, resulting in a volatile market price for our common
stock. In addition, the trading price of our common stock could decline significantly as a result
of sales of a substantial number of shares of our common stock, or the perception that significant
sales could occur. For example, at March 31, 2005, Elan held approximately 11.6 million shares of our common
stock. Between December 31, 2004 and January 5, 2005, Elan reported the sale of 395,000 shares of
our common stock. In accordance with the termination agreement that we entered into in Elan with in
March 2004, Elan is permitted to sell quantities of stock our equal to 175% of the volume
limitation set forth in Rule 144(e)(1) promulgated under the Securities Act of 1933, as amended.
The sale of significant quantities of stock by Elan, or other holders of significant shares of our
stock, could adversely impact the price of our common stock. 19




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Item 3.
    Quantitative and Qualitative Disclosures About Market Risk Notes payable:Our results of operations are affected by changes in short-term
interest rates as a result of a loan from Biogen that contains a variable interest rate. Interest
payments on this loan are determined by the LIBOR plus a margin of 1%. The carrying amount of the
note payable approximates fair value because the interest rate on this instrument changes with, or
approximates, market rates. The following table provides information as of March 31, 2005, about
our obligations that are sensitive to changes in interest rate fluctuations: Expected Maturity Date2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009
    
    
    TotalMaturities of long-term obligations:Variable rate note
    
    $
    
    
    
    $
    10,000,000
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    10,000,000Fixed rate notes
    
    
    634,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    634,000Fixed rate equipment financing
    
    
    293,000
    
    
    
    156,000
    
    
    
    25,000
    
    
    
    1,000
    
    
    
    
    
    
    
    475,000Total
    
    $
    927,000
    
    
    $
    10,156,000
    
    
    $
    25,000
    
    
    $
    1,000
    
    
    $
    
    
    
    $
    11,109,000
 
  Item 4.
    Controls and Procedures Evaluation of disclosure controls and procedures.Based on our managements evaluation,
with the participation of our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of our disclosure controls and procedures as of the end of the period covered by this
quarterly report, our Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures are effective in ensuring that information we are required to
disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended,
is recorded, processed, summarized and reported within the time periods specified in the Securities
and Exchange Commission rules and forms. Changes in internal control over financial reporting.There was no change in our internal
control over financial reporting, that occurred during the period covered by this quarterly report
that materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting. 20




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PART II OTHER INFORMATION 
  Item 1.
    Legal Proceedings None. 
  Item 2.
    Unregistered Sales of Securities and Use of Proceeds Certain of our loan agreements contain financial covenants establishing limits on our
ability to declare or pay cash dividends. 
  Item 3.
    Defaults Upon Senior Securities None. 
  Item 4.
    Submission of Matters to a Vote of Security Holders None. 
  Item 5.
    Other Information None. 
  Item 6.
    Exhibits See the Index to Exhibits included in this quarterly report. 
 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the
registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized. Targeted Genetics CorporationDate:     April 27, 2005
    
    By:
    
    /s/ H. Stewart ParkerH. Stewart Parker,
President, Chief Executive Officer and Director
(Principal Executive Officer)Date:     April 27, 2005
    
    By:
    
    /s/ Todd E. SimpsonTodd E. Simpson, Vice President,
Finance and Administration,
Chief Financial Officer,
Secretary and Treasurer
(Principal Financial and Accounting Officer)
 21




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##### Table of Contents



TARGETED GENETICS CORPORATION 
 INDEX TO EXHIBITS Exhibit No.
    
    Description
    
    Note3.1
    
    Restated Articles of Incorporation (Exhibit 3.1)
    
    (A)3.2
    
    Amended and Restated Bylaws (Exhibit 3.2)
    
    (B)31.1
    
    Certification of Chief Executive Officer pursuant to
Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended31.2
    
    Certification of Chief Financial Officer pursuant to
Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended32.1
    
    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
200232.2
    
    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
   (A)
    
    Incorporated by reference to the designated exhibit included with
Targeted Genetics Quarterly Report on Form 10-Q (No. 0-23930) for the quarter ended June 30,
2002.(B)
    
    Incorporated by reference to the designated exhibit included with Targeted Genetics
Annual Report on Form 10-K (No. 0-23930) for the year ended December 31, 1996. 22