UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C. 20549


**FORM
      10-Q**




(Mark
                One)x
            QUARTERLY
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934
                FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934 FOR THE TRANSITION PERIOD FROM _______________ TO
                _______________





COMMISSION
      FILE NUMBER: 0-23930





**TARGETED
      GENETICS CORPORATION**


(EXACT
      NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)




Washington
            91-1549568(State
                of Incorporation)
            (I.R.S.
                Employer Identification No.)




1100
      Olive Way, Suite 100 Seattle, WA 98101


(Address
      of principal executive offices)(Zip Code)





(206)
      623-7612


(Registrant’s
      telephone number, including area code)






(Former
      name, former address and former fiscal year, if changed since last
      report)





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 the filing requirements
      for
      at least the past 90 days. Yes x No o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.
      (check one):





Large
      accelerated filer  ̈    Accelerated
      filer  ̈    Non-accelerated
      filer ý





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). o Yes x No





Shares
      of
      Common Stock, par value $0.01 per share, outstanding as of May 1, 2007:
      13,114,368













**TARGETED
      GENETICS CORPORATION**


Quarterly
      Report on Form 10-Q


For
      the
      quarter ended March 31, 2007




TABLE
      OF
      CONTENTS


Page No**.**PART I
              
              FINANCIAL
                  INFORMATIONItem 1.
              
              Financial
                  Statementsa)
              
              Condensed
                  Consolidated Balance Sheets at March 31, 2007 and December 31,
                  2006
              
              1b)
              
              Condensed
                  Consolidated Statements of Operations for the three months ended
                  March 31,
                  2007 and 2006
              
              2c)
              
              Condensed
                  Consolidated Statements of Cash Flows for the three months ended
                  March 31,
                  2007 and 2006
              
              3d)
              
              Notes
                  to Condensed Consolidated Financial Statements
              
              4Item
                  2.
              
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              9Item
                  3.
              
              Quantitative
                  and Qualitative Disclosures About Market Risk
              
              14Item
                  4T.
              
              Controls
                  and Procedures
              
              14PART
                  II
              
              OTHER
                  INFORMATIONItem
                  1.
              
              Legal
                  Proceedings
              
              15Item
                  1A.
              
              Risk
                  Factors
              
              15Item
                  2.
              
              Unregistered
                  Sales of Equity Securities and Use of Proceeds
              
              16Item
                  3.
              
              Defaults
                  Upon Senior Securities
              
              17Item
                  4.
              
              Submission
                  of Matters to a Vote of Security Holders
              
              17Item
                  5.
              
              Other
                  Information
              
              17Item
                  6.
              
              Exhibits
              
              17SIGNATURES
              
              18INDEX
                  TO EXHIBITS
              
              19




i




**PART
      I    FINANCIAL INFORMATION**




**Item
      1.** ***Financial
      Statements*** ****




**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(Unaudited)**




**March
                31,**
            
            **December
                31,****2007**
            
            **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            11,254,000
            
            $
            6,206,000Accounts
                receivable
            
            
            944,000
            
            
            1,498,000Prepaid
                expenses and other
            
            
            340,000
            
            
            531,000Total
                current assets
            
            
            12,538,000
            
            
            8,235,000Property
                and equipment, net
            
            
            951,000
            
            
            1,100,000Goodwill
            
            
            7,926,000
            
            
            7,926,000Other
                assets
            
            
            203,000
            
            
            206,000Total
                assets
            
            $
            21,618,000
            
            $
            17,467,000**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable and accrued expenses
            
            $
            2,213,000
            
            $
            1,901,000Accrued
                employee expenses
            
            
            561,000
            
            
            861,000Accrued
                restructure charges
            
            
            1,831,000
            
            
            1,046,000Deferred
                revenue
            
            
            93,000
            
            
            251,000Current
                portion of long-term obligations
            
            
            1,114,000
            
            
            1,129,000Total
                current liabilities
            
            
            5,812,000
            
            
            5,188,000Accrued
                restructure charges and deferred rent
            
            
            5,396,000
            
            
            6,342,000Long-term
                obligations
            
            
            569,000
            
            
            570,000Commitments
                and ContingenciesShareholders’
                equity:
              Preferred
                stock, $0.01 par value, 600,000 shares authorized:Series
                A preferred stock, 180,000 shares designated, none issued and
                outstanding
            
            
            —
            
            
            —Common
                stock, $0.01 par value, 18,000,000 shares authorized, 13,109,902
                shares
                issued and outstanding at March 31, 2007 and 10,921,736 shares issued
                and
                outstanding at December 31, 2006
            
            
            131,000
            
            
            109,000Additional
                paid-in capital
            
            
            297,572,000
            
            
            289,324,000Accumulated
                deficit
            
            
            (287,862,000
            )
            
            (284,027,000
            )Accumulated
                other comprehensive loss
            
            
            —
            
            
            (39,000
            )Total
                shareholders’ equity
            
            
            9,841,000
            
            
            5,367,000Total
                liabilities and shareholders’ equity
            
            $
            21,618,000
            
            $
            17,467,000




See
      accompanying notes to condensed consolidated financial statements





1


**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(Unaudited)**





**Three
                months ended**
              **March
                31,****2007**
            
            **2006**Revenue
                under collaborative agreements
            
            $
            1,661,000
            
            $
            2,430,000Operating
                expenses:Research
                and development
            
            
            3,696,000
            
            
            3,677,000General
                and administrative
            
            
            1,552,000
            
            
            1,481,000Restructure
                charges
            
            
            184,000
            
            
            1,042,000Total
                operating expenses
            
            
            5,432,000
            
            
            6,200,000Loss
                from operations
            
            
            (3,771,000
            )
            
            (3,770,000
            )Investment
                income (loss)
            
            
            (65,000
            )
            
            151,000Interest
                expense
            
            
            —
            
            
            (113,000
            )Net
                loss
            
            $
            (3,836,000
            )
            $
            (3,732,000
            )Net
                loss per common share (basic and diluted)
            
            $
            (0.30
            )
            $
            (0.42
            )Shares
                used in computation of basic and diluted net loss per common
                share
            
            
            12,865,000
            
            
            8,869,000





See
      accompanying notes to condensed consolidated financial statements




2


**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**





**Three
                months ended****March
                31,****2007**
            
            **2006**Operating
                activities:Net
                loss
            
            $
            (3,836,000
            )
            $
            (3,732,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
            
            
            144,000
            
            
            168,000Stock-based
                compensation
            
            
            184,000
            
            
            221,000Loss
                (gain) on investments
            
            
            207,000
            
            
            (5,000
            )Changes
                in assets and liabilities:Decrease
                (increase) in accounts receivable
            
            
            554,000
            
            
            (611,000
            )Decrease
                in prepaid expenses and other
            
            
            12,000
            
            
            78,000Decrease
                in other assets
            
            
            3,000
            
            
            2,000Increase
                in current liabilities
            
            
            13,000
            
            
            49,000Increase
                (decrease) in deferred revenue
            
            
            (158,000
            )
            
            472,000Increase
                (decrease) in accrued restructure expenses and deferred
                rent
            
            
            (161,000
            )
            
            482,000Net
                cash used in operating activities
            
            
            (3,038,000
            )
            
            (2,876,000
            )Investing
                activities:Purchases
                of property and equipment
            
            
            —
            
            
            (32,000
            )Proceeds
                from sale of investments
            
            
            16,000
            
            
            36,000Net
                cash provided by investing activities
            
            
            16,000
            
            
            4,000Financing
                activities:Net
                proceeds from sales of capital stock (and warrants)
            
            
            8,058,000
            
            
            4,797,000Proceeds
                from the exercise of stock options
            
            
            28,000
            
            
            6,000Payments
                under leasehold improvements and equipment financing
                arrangements
            
            
            (16,000
            )
            
            (55,000
            )Net
                cash provided by financing activities
            
            
            8,070,000
            
            
            4,748,000Net
                increase (decrease) in cash and cash equivalents
            
            
            5,048,000
            
            
            1,876,000Cash
                and cash equivalents, beginning of period
            
            
            6,206,000
            
            
            14,122,000Cash
                and cash equivalents, end of period
            
            $
            11,254,000
            
            $
            15,998,000




See
      accompanying notes to condensed consolidated financial statements




3


**TARGETED
      GENETICS CORPORATION**





**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**




**(Unaudited)**




**1.   Summary
      of Significant Accounting Policies**





***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, 2006 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 *.* 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,
      2007
      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, 2006.





In
      May
      2006, our Board of Directors approved a 1-for-10 reverse stock split, which
      became effective on May 11, 2006. All references to common stock, common shares
      outstanding, average number of common shares outstanding, per share amounts
      and
      options in these financial statements and notes to financial statements have
      been restated to reflect the 1-for-10 common stock reverse split on a
      retroactive basis.





Our
      combined cash and cash equivalents totaled $11.3 million at March 31, 2007. We
      believe that our current resources, including the capital raised in January
      2007
      and the cash anticipated to be received from our collaborative partners, are
      sufficient to fund our planned operations, including our clinical trials, into
      the fourth quarter of 2007.  This
      estimate is based on our ability to perform planned research and development
      activities and the receipt of planned funding from our collaborators. Our
      near-term financing strategy includes leveraging our development capabilities
      and intellectual property assets into additional commercial opportunities,
      advancing our clinical development programs, and accessing the public and
      private capital markets at appropriate times. Depending on our ability to successfully access additional funding, we may
      be
      forced to preserve our cash position through a combination of cost reduction
      measures, sales of assets likely at values significantly below their potential
      worth, or the pursuit of alternative financing transactions that would likely
      be
      on terms disadvantageous to us and dilutive to our shareholders.  We
      have
      prepared the accompanying financial statements on a going concern basis, which
      assumes that we will realize our assets and satisfy our liabilities in the
      normal course of business.  The
      accompanying financial statements do not include any adjustments to reflect
      the
      possible future effects on the recoverability and classification of assets
      or
      the amounts and classifications of liabilities that may result from the outcome
      of the uncertainty related to our ability to continue as a going
      concern .





***Accounting
      for Uncertainties in Income Taxes***





Effective
      the beginning of 2007, we adopted Financial Accounting Standards Board, or
      FASB,
      Interpretation No. 48, “*Accounting
      for Uncertainty in Income Taxes,”*or
      FIN
      48. FIN 48 provides guidance to address uncertainty in tax positions and
      clarifies the accounting for income taxes by specifying a minimum recognition
      threshold which income tax positions must achieve before being recognized in
      the
      financial statements. The adoption of FIN 48 had no impact on our net loss,
      earnings per share or financial position for the quarter ended March 31,
      2007.





4





***Recently
      Issued Accounting Standards***




In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No. 157, *“Fair
      Value Measurements,”* or SFAS
      No. 157. SFAS No. 157 provides guidance for using fair value to
      measure assets and liabilities and requires expanded information about the
      extent to which companies measure assets and liabilities at fair value, the
      information used to measure fair value, and the effect of fair value
      measurements on earnings. The standard applies whenever other standards require
      or permit assets or liabilities to be measured at fair value. The standard
      does
      not expand the use of fair value in any new circumstances. SFAS No. 157 is
      effective for fiscal years beginning after November 15, 2007. We are in the
      process of evaluating the adoption of SFAS No. 157 and have not yet
      determined its impact, if any.




**2.   Long-Term
      Obligations**




Long-term
      obligations consist of the following:




**March
                31,******
            
            **December
                31,********2007**
            
            **2006**Loans
                payable to Biogen Idec
            
            $
            1,672,000
            
            $
            1,672,000Equipment
                financing obligations
            
            
            11,000
            
            
            27,000Total
                obligations
            
            
            1,683,000
            
            
            1,699,000Less
                current portion
            
            
            (1,114,000
            )
            
            (1,129,000
            )Total
                long-term obligations
            
            $
            569,000
            
            $
            570,000





As
      of
      March 31, 2007, we owed $1.7 million to Biogen Idec, a beneficial owner of
      approximately 16.6% of our outstanding common shares, which is the remaining
      debt owed to Biogen Idec. As part of a 2006 restructuring, we agreed to terms
      that resulted in the remaining $1.7 million, which consists of $1.5 million
      principal and $167,000 of estimated future interest payments, to be paid to
      Biogen Idec in two installments: $1.0 million plus accrued interest on August
      1,
      2007 and the remaining balance on August 1, 2008. In 2006, we also agreed to
      accelerate repayment of the 2007 installment and repay that portion within
      thirty days of a change in control of the company. We must apply one-third
      of
      certain up-front payments received from potential future corporate
      collaborations to the outstanding balance on this loan payable, first to
      repayment of any accrued and unpaid interest on the principal being repaid,
      and
      second to the repayment of outstanding principal in reverse order of maturity.
      Outstanding borrowings under this unsecured loan agreement bear interest at
      the
      one-year London Interbank Offered Rate, or LIBOR, plus 1%, which is reset
      quarterly. Since the estimated future interest payments are included in the
      balance of the obligation, we will not incur further interest charges
      attributable to this debt. The loan contains financial covenants that limit
      our
      ability to declare or pay cash dividends.





Future
      aggregate principal payments related to the Biogen Idec debt are $1.0 million
      in
      2007, $525,000 in 2008 and zero in 2009, 2010 and 2011.





**3.   Accrued
      Restructure Charges**





We
      apply
      the provisions of 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 as a result of our 2003 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 sublease 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 through the end of the lease term in September
      2015
      and is reflected as a restructuring charge in the accompanying consolidated
      statements of operations.





The
      table
      below presents a reconciliation of the accrued restructure liability for the
      three month period ended March 31, 2007:





**Contract
                Termination****Costs**December
                31, 2006 accrued liability
            
            $
            7,377,000Adjustments
                to the liability (accretion)
            
            
            184,000Amount
                paid
            
            
            (345,000
            )March
                31, 2007 accrued liability
            
            $
            7,216,000




5




Adjustments
      to the accrued restructure liability for the three months ended March 31, 2007
      reflect $184,000 of accretion expense for the period. This adjustment to the
      liability is reflected as restructure charges in the accompanying condensed
      consolidated statement of operations.





Through
      March 31, 2007, we have recorded contract termination costs totaling $10.2
      million for our Bothell facility. We expect to incur an additional $2.8 million
      in accretion expense through the expiration of the Bothell lease in September
      2015.





We
      periodically evaluate our restructuring estimates and 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.
      Equity**





***Financing***





On
      January 11, 2007, we sold 2.2 million shares of our common stock in a private
      placement at a price of $4.00 per share and received net proceeds of
      approximately $8.1 million. In addition, in connection with the financing,
      we
      issued warrants to purchase up to 763,000 shares of our common stock. These
      warrants expire in January 2012 and are exercisable at $5.41 per share beginning
      July 19, 2007. We also issued a warrant to purchase approximately 16,000 shares
      of our common stock as compensation to the placement agent in this transaction.





***Stock
      Compensation***





We
      have
      various stock option plans, or Option Plans, that provide for the issuance
      of
      nonqualified and incentive stock options to acquire up to 1,297,944 shares
      of
      our common stock. These stock options may be granted by our Board of Directors
      to our employees, directors and officers and to consultants, agents, advisors
      and independent contractors who provide services to us. The exercise price
      for
      incentive stock options must not be less than the fair market value of the
      shares on the date of grant. Options granted under our Option Plans expire
      no
      later than ten years from the date of grant and generally vest and become
      exercisable over a four-year period following the date of grant. In 2003, as
      part of an employee retention plan, we granted options to purchase 65,500 shares
      of our common stock with accelerated vesting periods which ranged from twelve
      to
      eighteen months. In 2006, also as part of an employee retention plan, we granted
      options to purchase an aggregate of 306,500 shares of our common stock with
      a
      twelve month vesting period. Every non-employee member of our Board of Directors
      receives an annual nonqualified stock option grant and these options vest over
      a
      twelve-month period provided the grantee continues service to us. Upon the
      exercise of stock options, we issue new shares from shares reserved for issuance
      under our Option Plans.





Effective
      January 2006, we adopted SFAS No. 123R, *“Share-Based
      Payment.”* SFAS No.
      123R requires us to expense the fair value of stock options granted over the
      vesting period. We have recognized compensation expense of $184,000 for the
      three months ended March 31, 2007 and $221,000 for the three months ended March
      31, 2006. This compensation expense includes: (a) compensation cost for all
      share-based stock options granted prior to, but not yet vested as of January
      1,
      2006, based on the grant-date fair value used for prior pro forma disclosures
      and (b) compensation cost for all share-based payments granted subsequent to
      January 1, 2006, based on the grant-date fair value estimate in accordance
      with
      the provisions of SFAS No. 123R. We value awards granted subsequent to January
      1, 2006 at fair value in accordance with provisions of SFAS No. 123R and
      recognize stock-based compensation expense on a straight line basis over the
      service period of each award. For the first quarter ended March 31, 2007, we
      classified $95,000 as research and development expense and $89,000 as general
      and administrative expense. As of March 31, 2007, total unrecognized
      compensation cost related to unvested options was approximately $463,000, net
      of
      estimated forfeitures, which we expect to recognize over a weighted average
      period of approximately 7 months.




6





Following
      is a summary of stock option activity and related prices for the quarter ended
      March 31, 2007:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Remaining**
              **Average**
              **Contractual****Term
                (Years)**
            
            **Intrinsic****Value**Outstanding,
                December 31, 2006
            
            
            835,085
            
            $
            15.39Granted
            
            
            8,400
            
            
            3.88Exercised
            
            
            (8,166
            )
            
            3.44Expired
            
            
            (9,726
            )
            
            47.50Forfeited
            
            
            (27,586
            )
            
            9.16Outstanding,
                March 31, 2007
            
            
            798,007
            
            $
            15.21
            
            
            7.00
            
            $
            403,000Exercisable,
                March 31, 2007
            
            
            597,286
            
            $
            17.98
            
            
            6.49
            
            $
            264,000




The
      aggregate intrinsic value is determined using the closing price of our common
      stock of $3.71 on March 31, 2007. The intrinsic value of stock options exercised
      was $13,000 during the three months ended March 31, 2007 and was $1,000 during
      the three months ended March 31, 2006. We received $28,000 from the exercise
      of
      stock options for the three months ended March 31, 2007.





Stock
      options outstanding and exercisable as of March 31, 2007 are summarized
      below:





**Outstanding**
            
            **Exercisable****Range
                of Exercise Prices**
            
            **Number
                of**
              **Option****Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**
            
            **Weighted
                Average**
              **Remaining**
              **Contractual
                Life**
              **(Years)**
            
            **Number
                of**
              **Option
                Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**$   
                1.80 - $   3.24
            
            
            108,699
            
            $
            2.46
            
            
            8.90
            
            
            71,330
            
            $
            2.553.80 -      3.80
            
            
            187,000
            
            
            3.80
            
            
            9.19
            
            
            129,750
            
            
            3.803.99 -      9.10
            
            
            162,285
            
            
            7.43
            
            
            7.50
            
            
            101,767
            
            
            7.1810.80
                -    14.90
            
            
            160,084
            
            
            13.10
            
            
            6.79
            
            
            116,904
            
            
            13.1015.30 -  148.80
            
            
            179,939
            
            
            43.68
            
            
            3.31
            
            
            177,535
            
            
            43.96Balance,
                March 31, 2007
            
            
            798,007
            
            $
            15.21
            
            
            7.00
            
            
            597,286
            
            $
            17.98





The
      fair
      value of each stock option award is estimated on the date of the grant using
      the
      Black-Scholes-Merton option pricing model. The
      weighted average fair value of options granted was $3.05 per share for the
      first
      quarter 2007 and $3.67 for the first quarter 2006. The
      following are the weighted average assumptions for the periods
      noted:





**Three
                Months ended March 31,****2007**
            
            **2006**Expected
                dividend rate
            
            
            Nil
            
            
            NilExpected
                stock price volatility
            
            
            1.047
                - 1.095
            
            
            1.086Risk-free
                interest rate range
            
            
            4.56
                - 4.58
            %
            
            4.25
            %Expected
                life of options
            
            
            4
                - 5 years
            
            
            5
                years





*Expected
      Dividend:* We
      do not
      anticipate any dividends based on our current dividend restrictions related
      to
      our Biogen Idec note.





*Expected
      Life:* Our
      expected life represents the period that our stock-based awards are expected
      to
      be outstanding. We determine expected life based on historical experience and
      vesting schedules of similar awards.





*Expected
      Volatility:* Our
      expected volatility represents the weighted average historical volatility of
      the
      shares of our common stock for the most recent four-year and five-year periods.





*Risk-Free
      Interest Rate:* We
      base the risk-free interest rate used on the implied yield currently available
      on U.S. Treasury zero-coupon issues with an equivalent remaining term.
      Where the expected term of our stock-based awards do not correspond with the
      terms for which interest rates are quoted, we perform a straight-line
      interpolation to determine the rate from the available term
      maturities.




7





*Forfeiture
      Rate:* We
      apply
      an estimated forfeiture rate that we derived from historical employee
      termination behavior. If the actual number of forfeitures differs from our
      estimates, we may record additional adjustments to compensation expense in
      future periods.





**5.  
      Other Comprehensive Loss**




Comprehensive
      loss is the total of net loss and all other non-owner changes in equity.
      Comprehensive loss includes net unrealized gains from investments and foreign
      currency translations on our common stock investment in Chromos Molecular
      Systems Inc., or Chromos, as presented in the following table:





**Three
                months ended**
              **March
                31,****2007**
            
            **2006**Net
                loss as reported
            
            $
            (3,836,000
            )
            $
            (3,732,000
            )Other
                comprehensive income:Unrealized
                gain on available-for-sale securities
            
            
            —
            
            
            8,000Foreign
                currency translation adjustment
            
            
            —
            
            
            16,000Other
                comprehensive loss
            
            $
            (3,836,000
            )
            $
            (3,708,000
            )





**6.  
      Investments**





As
      of
      March 31, 2007, w e
      held
      approximately 2.4 million shares of Chromos, a
      publicly traded company whose common stock is listed on the Toronto Stock
      Exchange. Periodically, we sell these shares on a specific identification method
      based on when we received the shares. During the three months ended March 31,
      2007, we sold 100,000 shares resulting in a realized gain of
      $1,000.





We
      record
      our common stock investment in Chromos at fair market value and record changes
      in the fair market value of this stock in accumulated other comprehensive loss.
      We periodically evaluate our Chromos stock for signs of impairment that may
      be
      other-than-temporary, which would necessitate a reduction in the carrying value
      of the investment and charge to expense. During the first quarter of 2007,
      due
      to the declining market value of the Chromos securities and a decline in Chromos’
financial position, we determined that our investment is other-than-temporarily
      impaired. Accordingly, we wrote the asset down to the fair market value of
      the
      Chromos stock on March 31, 2007 and recognized a realized loss of
      $208,000.





**Fair
                Value**
            
            **Unrealized
                Loss**
            
            **Proceeds
                from the sale of securities**
            
            **Realized
                Loss**Marketable
                equity securities
            
            $
            133,000
            
            $
            —
            
            $
            16,000
            
            $
            (207,000
            )





**7.  
      Income Taxes**





We
      adopted the provisions of FASB Interpretation No. 48, *“Accounting
      for Uncertainty in Income Taxes”* ,
      or FIN
      48, on January 1, 2007. We have been in a net operating loss position since
      inception and have not recognized any tax benefits for any of our income tax
      positions as a result of a full valuation allowance. There were no changes
      to
      the amount of recognized tax benefits as a result of adopting FIN 48, and there
      were no changes to the recognized tax benefits during the quarter ended March
      31, 2007.





Historically,
      we have not incurred any interest or penalties associated with tax matters
      and
      no interest or penalties were recognized during the three months ended March
      31,
      2007. We have adopted a policy whereby amounts related to interest and penalties
      associated with tax matters are classified as additional income tax expense
      when
      incurred.





Tax
      years
      that remain open for examination include 2003, 2004, 2005, and 2006. In
      addition, tax years from 1992 to 2002 may be subject to examination in the
      event
      that we utilize the NOLs from those years in our current or future year tax
      returns.





8


**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,
      our future cash requirements and the sufficiency of our cash and cash
      equivalents to meet these requirements, our ability to raise capital when needed
      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 a 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 “Risk
      Factors” in Part I, Item IA of our annual report on Form 10-K for the year ended
      December 31, 2006, as supplemented by the section entitled “Risk Factors” in
      Part II, Item 1A 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 risk factors and other information
      we provide in the reports we file from time to time with the SEC.




**BUSINESS
      OVERVIEW**





We
      are a
      clinical-stage therapeutic biotechnology company. We are at the forefront of
      developing, with the goal of commercializing, a new class of therapeutic
      products called gene therapeutics. We believe that a wide range of diseases
      may
      potentially be treated or prevented with gene therapeutics. In addition to
      treating diseases that have not had treatments in the past, we believe that
      there is also a significant opportunity to use gene therapeutics to more
      effectively treat diseases that are currently treated using other therapeutic
      classes of drugs such as protein-based drugs, monoclonal antibodies or small
      molecule drugs.





Gene
      therapeutics consist of a delivery vehicle, called a vector, and genetic
      material. The role of the vector is to carry the genetic material into a target
      cell. Once delivered into the cell, the gene can express or direct production
      of
      the specific proteins encoded by the gene. Gene therapeutics may be used to
      treat disease facilitating the normal protein production or gene regulation
      capabilities of cells. In addition, gene therapeutics may be used to enable
      cells to produce more of a certain protein or different proteins than they
      normally produce thereby treating a disease state. A new class of gene
      therapeutics currently receiving attention is RNA interference or RNAi. RNAi
      comprises small RNA molecules that once delivered into the cell may shut down
      or
      interfere with cellular functions. The vectors developed by us for delivery
      of
      genes may be particularly useful for the delivery of this new class of genetic
      therapeutics.





We
      are
      primarily focused on the following product development programs:





**Description**
            
            **Indication**
            
            **Funding
                Partner**
            
            **Development
                Status**AAV
                delivery of TNF-alpha antagonist (tgAAC94)
            
            Inflammatory
                Arthritis
            
            Self
                funded
            
            Phase
                I/IIAAV
                delivery of HIV antigens (tgAAC09)
            
            HIV/AIDS
            
            IAVI
            
            Phase
                IIAAV
                delivery of HIV antigens (HVDDT)
            
            HIV/AIDS
            
            NIAID
            
            PreclinicalAAV
                delivery of SERCA2a
            
            Congestive
                Heart Failure
            
            Celladon
            
            PreclinicalAAV
                expression of htt shRNA (RNAi)
            
            Huntington’s
                disease
            
            Sirna
                Therapeutics
            
            Preclinical





Most
      of
      our expenses are related to the development of our research and development
      programs, the conduct of preclinical studies and clinical trials and general
      and
      administrative support for these activities. We have financed the company
      primarily through proceeds from public and private sales of our equity
      securities, through cash payments received from our collaborative partners
      for
      product development and manufacturing activities, and through proceeds from
      the
      issuance of debt and loan funding under equipment financing arrangements. On
      January 11, 2007, we sold 2.2 million shares of our common stock in a private
      placement at a price of $4.00 per share and received net proceeds of
      approximately $8.1 million. In addition, in connection with the financing we
      issued warrants to purchase up to 763,000 shares of our common stock. We also
      issued a warrant to purchase approximately 16,000 shares of our common stock
      as
      compensation to the placement agent in this transaction.




9





As
      of
      March 31, 2007, our accumulated deficit totaled $287.9 million. We expect to
      generate substantial additional losses for the foreseeable future, primarily
      due
      to the costs associated with funding our inflammatory arthritis clinical
      development program, developing and maintaining our manufacturing capabilities
      and developing our intellectual property assets.





We
      will
      require access to significantly higher amounts of capital than we currently
      have
      in order to successfully develop our lead inflammatory arthritis product
      candidate or our partnered product candidates. We may be unable to obtain
      required funding when needed or on acceptable terms, obtain or maintain
      corporate partnerships, or complete acquisition transactions necessary or
      desirable to complete the development of our product candidates.





**CRITICAL
      ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS**





Other
      than with respect to those items described below, there have been no material
      changes from the critical accounting policies, estimates and assumptions as
      disclosed in Item 7 “Management’s Discussion and Analysis of Financial Condition
      and Results of Operations” of the Company’s annual report on Form 10-K for the
      year ended December 31, 2006. The critical accounting policies, estimates and
      assumptions below have been updated to provide more recent financial and factual
      information as of March 31, 2007.





***Accounting for Uncertainties in Income Taxes***





Effective
      the beginning of 2007, we adopted FASB Interpretation No. 48, “ *Accounting
      for Uncertainty in Income Taxes,”* or
      FIN
      48. FIN 48 provides guidance to address uncertainty in tax positions and
      clarifies the accounting for income taxes by specifying a minimum recognition
      threshold which income tax positions must achieve before being recognized in
      the
      financial statements. The adoption of FIN 48 had no impact on our net loss,
      earnings per share or financial position for the quarter ended March 31, 2007.




The
      application of income tax law is inherently complex. Laws and regulations in
      this area are voluminous and are often ambiguous. As such, we are required
      to
      make many subjective assumptions and judgments regarding our income tax
      exposures. Interpretations of and guidance surrounding income tax laws and
      regulations change over time. Changes in our subjective assumptions and
      judgments can materially affect amounts recognized in the consolidated balance
      sheets and statements of income.





**RESULTS
      OF OPERATIONS**





***Revenue***





Revenue
      decreased to $1.7 million for the three months ended March 31, 2007 as compared
      to $2.4 million for the same period in 2006. The decrease in revenue reflects
      lower research and development activities under our collaboration with the
      International AIDS Vaccine Initiative, or IAVI, and
      Celladon Corporation, or Celladon, partially offset by an increase in research
      and development activities under the National Institute of Allergy and
      Infectious Diseases, or NIAID, funded HIV/AIDS vaccine project in collaboration
      with the Children’s Hospital of Philadelphia, or CHOP, and the Columbus
      Children’s Research Institute, or CCRI. We expect that our revenue for the
      remainder of 2007 will consist primarily of research and development revenue
      earned from the NIAID-funded HIV/AIDS project and work under our collaboration
      with Celladon. For the next several years, our revenue will depend on the
      continuation of the current collaborations and our success in entering into
      and
      performing under new collaborations.





***Operating
      Expenses***





*Research
      and Development Expenses* .    Research
      and development expenses remained consistent at $3.7 million for the three
      months ended March 31, 2007 and 2006.  Costs related to our inflammatory
      arthritis program increased due to higher clinical trial activity and a higher
      number of enrolled subjects. This cost increase was partially offset by lower
      costs related to our HIV/AIDS vaccine collaboration with IAVI as a result of
      less development activity as the project has progressed into clinical testing.
      Research and preclinical development program expenses decreased due to modestly
      less research and development activity related to our congestive heart failure
      collaboration with Celladon. We expect that our research and development
      expenses for the remainder of 2007 will vary depending on the timing of outside
      services necessary to support our clinical programs, our collaboration with
      Celladon and our subcontract with CCRI and CHOP in support of the NIAID HIV/AIDS
      vaccine project.




10





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 ended**
              **March
                31,****2007**
            
            **2006**Programs
                in clinical development:Inflammatory
                arthritis
            
            $
            762,000
            
            $
            558,000IAVI
                HIV/AIDS vaccine
            
            
            109,000
            
            
            317,000Indirect
                costs and other
            
            
            522,000
            
            
            347,000Total
                clinical development program expense
            
            
            1,393,000
            
            
            1,222,000Research
                and preclinical development program expense
            
            
            2,303,000
            
            
            2,455,000Total
                research and development expense
            
            $
            3,696,000
            
            $
            3,677,000





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 HIV/AIDS vaccine program for the developing world.
      As a result, we do not include those costs in our research and development
      expenses.





Costs
      attributed to research and preclinical programs represent our earlier-stage
      development activities and include costs incurred for development activities
      for
      the NIAID-funded HIV/AIDS vaccine under a subcontract with CHOP and CCRI and
      the
      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 programs identified in the table above
      do not necessarily reflect the actual costs of the program.





*General
      and Administrative Expenses* .    General
      and administrative expenses increased to $1.6 million for the three months
      ended
      March 31, 2007 from $1.5 million for the same period in 2006. This increase
      reflects higher patent charges and compensation expense partially offset by
      lower audit fees.





*Restructure
      Charges.* Restructure
      charges decreased to $184,000 for the three months ended March 31, 2007 compared
      to $1.0 million for the same period in 2006. Restructuring charges in 2006
      include charges of $639,000 related to changes in our expectations regarding
      market conditions for the Bothell facility subleasing market and $219,000
      related to employee termination benefits of our restructuring efforts to realign
      our cost structure. Restructuring charges also include accretion expense of
      $184,000 in both the three months ended March 31, 2007 and 2006.





***Other
      Income and Expense***





*Investment
      Income (Loss)* .    
      Investment income reflects interest income earned on our short term investments
      and realized gains or losses on our investment in Chromos Molecular Systems
      Inc,
      or Chromos. Investment income decreased to a loss of $65,000 for the three
      months ended March 31, 2007 compared to income of $151,000 for the same period
      in 2006. For the three month period ended March 31, 2007, also investment income
      reflects a $208,000 realized loss related to an other-than-temporary impairment
      loss on our investment in Chromos due to the declining market value of the
      Chromos securities combined with decline in Chromos’ financial
      position.





*Interest
      Expense* .    
      Interest expense decreased to zero for the three months ended March 31, 2007,
      compared to $113,000 for the same period in 2006. In November 2006, we
      restructured a $8.15 million outstanding loan from Biogen Idec by exchanging
      $5.65 million of the balance for common shares of our stock, making a $500,000
      payment and establishing a new repayment schedule for the remaining balance.
      As
      a result of restructuring the Biogen Idec debt, the $1.7 million carrying value
      of the remaining debt includes the related estimated future interest payments
      and accordingly, we did not record interest expense on the Biogen Idec expense
      in the three months ended March 31, 2007. We do not expect to record future
      interest expense on this restructured debt.




11





**Liquidity
      and Capital Resources**




We
      had
      cash and cash equivalents balances of $11.3 million at March 31, 2007 compared
      to $6.2 million at December 31, 2006. Our cash and cash equivalents
      increased in the three months ended March 31, 2007 primarily reflecting the
      net
      proceeds of $8.1 million from our January 2007 sale of our common stock and
      warrants partially offset by our net loss and the resulting cash used in
      operations of $3.0 million.





On
      January 11, 2007, we sold 2.2 million shares of our common stock in a private
      placement at a price of $4.00 per share and received net proceeds of
      approximately $8.1 million. In addition, in connection with the financing we
      issued warrants to purchase up to 763,000 shares of our common
      stock. **** We
      also
      issued a warrant to purchase approximately 16,000 shares of our common stock
      as
      compensation to the placement agent in this transaction. We
      intend
      to continue to seek appropriate opportunities to access the public and private
      capital markets, however, our ability to issue equity securities at the current
      market price will likely be adversely affected by the fact that we are presently
      ineligible under SEC rules to utilize Form S-3 for primary offerings of our
      securities because the aggregate market value of our outstanding common stock
      held by non-affiliates is less than $75 million.





Our
      primary expenses are related to the development of our research and development
      programs, the conduct of preclinical studies and clinical trials and general
      and
      administrative support for these activities. Our HIV/AIDS vaccine candidate
      for
      the developing world and our inflammatory arthritis product candidate are both
      in 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 lead
      product candidate in inflammatory arthritis.





We
      are
      currently focusing our development funding on our inflammatory arthritis product
      candidate, which is in Phase I/II clinical trials. We currently fund all costs
      of this program from our working capital and expect to do so for the foreseeable
      future, although our strategy is to ultimately seek a partner to fund
      later-stage development of this program.





In
      addition to the funding necessary to advance our product development and fund
      our ongoing operating costs, we also have significant lease commitments,
      long-term obligations and outstanding debt that draw on our cash resources.
      Our
      most significant obligations are approximately $12.9 million of remaining
      Bothell facility lease payments, which we are obligated to pay at $1.4 million
      to $1.6 million per year until the year 2015 and $1.5 million of aggregate
      principal payments to Biogen Idec under an outstanding loan payable. Under
      our
      2006 modified loan agreement with Biogen Idec, t he
      $1.5
      million principal balance bears interest at the rate of LIBOR plus 1% and we
      agreed to repay $1.0 million on August 1, 2007 and the remaining balance on
      August 1, 2008. In addition, the agreement provides for early repayment of
      the
      2007 installment within thirty days of a change in control of the company.
      The
      Biogen Idec loan agreement includes a provision that requires us to apply
      one-third of certain up-front payments received from potential future corporate
      collaborations to the outstanding balance on this loan payable.





We
      will
      need to raise additional capital to make the scheduled payments and to repay
      these notes.





We
      expect
      the level of our future operating expenses to be driven by the needs of our
      product development programs, our debt obligations and our lease obligations
      offset by the availability of funds through equity offerings, partner-funded
      collaborations or other financing or business development activities. The size,
      scope and pace of our product 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, conducting clinical
                trials, obtaining regulatory approvals and pursuing patent
                prosecutions;





·
            competing
                technological and market developments;





·
            the
                timing and costs of, and our success in, any product commercialization
                activities and facility expansions, if and as required;
                and





·
            the
                existence and outcome of any litigation or administrative proceedings
                involving intellectual property.





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 financing agreements and research grants. These
      financing sources have historically allowed us to maintain adequate levels
      of
      cash and cash equivalents.




12





Our
      development collaborations have typically provided us with funding in several
      forms, including purchases of our equity securities, loans, payments for
      reimbursement of research and development costs and milestone fees and payments.
      We and our partners typically agree on a target disease and create a development
      plan for the product candidate, which generally extends for multiple one-year
      terms and is subject to termination or extension. For example, when the IAVI
      collaboration was initiated in 2000, it originally had a three-year term yet
      the
      work plan was established and funded on an annual basis. In 2004, we and IAVI
      agreed to extend the underlying program through the end of 2006 and in 2006
      we
      agreed to further extend the program until the expiration of the term of the
      last patent within the patent rights controlled by us and utilized in the IAVI
      vaccine. In 2005, we extended the scope of our HIV/AIDS vaccine program
      activities to the developed world, via our collaboration with CHOP and CCRI
      through a subcontract with the NIAID. To date we have received $1.6 million
      under this subcontract and our portion of the remaining project funding could
      be
      up to an additional $16.6 million over the remaining four years of the contract.
      The funding is awarded to us in annual installments based on an approved work
      plan and achievement of milestones.





The
      funding from each of our collaborative partners fully offsets our incremental
      program costs caused by each collaboration and generally also partially funds
      development of our company-funded inflammatory arthritis product candidate
      and
      our overhead and fixed costs. Our revenue from collaborative agreements and
      licenses totaled $9.9 million in 2006 and, assuming that we complete all of
      the
      planned development activities for each of these funded projects, we expect
      revenue from our collaborative partners of up to $10 million in
      2007.





Each
      of
      our collaborations has provisions that allow our partners the right to terminate
      both the underlying collaboration and the obligation to provide research funding
      at any time with as little as 90 days notice. If we were to lose the
      collaborative funding expected from the NIAID, Celladon or IAVI collaborations
      and were unable to obtain alternative sources of funding, we would be unable
      to
      continue our research and development program for that product candidate and
      our
      cash horizon would be shortened.





Our
      near-term financing strategy includes leveraging our development capabilities
      and intellectual property assets into additional capital raising opportunities,
      advancing our clinical development programs and accessing the public and private
      capital markets at appropriate times. Our financing strategy is focused
      around the advancement of our two programs in clinical development, advancement
      of our newer development collaborations and generating value from our
      intellectual assets and capabilities. In the biotechnology industry, there
      is a
      low level of success in clinical trials and our ability to raise capital depends
      in part on clinical trial success.





We
      are
      currently evaluating additional sources of financing that could involve one
      or
      more of the following:





·
            entering
                into additional product development
                collaborations;





·
            mergers
                and acquisitions;





·
            issuing
                equity in the public or private markets;





·
            extending
                or expanding our current
                collaborations;





·
            selling
                or licensing our technology or product candidates;





·
            borrowing
                under loan or equipment financing arrangements;
                and/or





·
            issuing
                debt.





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





We
      expect
      that our total cash requirements for 2007 will range from **$** 13
      million to $16 million and that our cash and cash equivalents at March 31,
      2007,
      plus the anticipated funding from our product development collaborations and
      contracts will be sufficient to fund our operations into the fourth quarter
      of
      2007. This estimate is based on our ability to perform planned research and
      development activities and the receipt of planned funding from our
      collaborators.





Depending
      on our ability to successfully access additional funding, we may be forced
      to
      implement additional cost reduction measures. Further adjustments may include
      scaling back or delaying our inflammatory arthritis development program, staff
      reductions, scaling back our intellectual property prosecution, subleasing
      portions of our lab facilities, 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.




13





**Item
      3.** ***Quantitative
      and Qualitative Disclosures About Market Risk*** ****





*Items
      with interest rate risk:*





·  *Short
      term investments* :
      Because
      of the short-term nature of our investments, we believe that our exposure to
      market rate fluctuations on our investments is minimal. Currently, we do not
      use
      any derivative or other financial instruments or derivative commodity
      instruments to hedge any market risks and do not plan to employ these
      instruments in the future. At March 31, 2007, we held $11.3 million in cash,
      which is primarily invested in money market funds and denominated in U.S.
      dollars. An analysis of the impact on these securities of a hypothetical 10%
      change in short-term interest rates from those in effect at March 31, 2007,
      indicates that such a change in interest rates would not have a significant
      impact on our financial position or on our expected results of operations in
      2007.





·  *Notes
      payable* :  Our
      results of operations are affected by changes in short-term interest rates
      as a
      result of a loan from Biogen Idec that contains a variable interest rate.
      Interest payments on this loan are established quarterly based upon LIBOR plus
      1%. In 2006, in connection with the restructuring of this debt we accrued
      estimated remaining future interest payments of $167,000 on the promissory
      note
      at a rate of 6.33%. Changes in market interest rates and the timing of these
      remaining interest payments may ultimately result in adjustments to the gain
      on
      debt restructuring we recognized in 2006. 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, 2007, about our obligations that are sensitive
      to
      changes in interest rate fluctuations:





Expected
                Maturity Date2007
            
            2008
            
            2009
            
            2010
            
            2011
            
            TotalVariable
                rate note
            
            $
            1,000,000
            
            $
            525,000
            
            $
            —
            
            $
            —
            
            $
            —
            
            $
            1,525,000





*Items
      with market and foreign currency exchange risk:*





·  *Investment
      in Chromos Molecular Systems, Inc.:* At March
      31, 2007, we held 2.4 million shares of Chromos common shares with a market
      value of $0.065 per common share as quoted by the Toronto Stock Exchange and
      denominated in Canadian dollars. As of March 31, 2007 the Canadian dollar to
      US
      dollar exchange rate was US $0.8655 per CA $1.00. As of March 31, 2007, this
      investment is recorded at $133,000 and is classified within prepaid expenses
      and
      other. We recorded a realized loss of $208,000 in the quarter ended March 31,
      2007 due to an other-than-temporary impairment resulting from a decline in
      market value of the Chromos securities combined with decline in Chromos’
financial position. We hold these shares of common stock as available-for-sale
      securities as we periodically sell them on the Toronto Stock Exchange. As a
      result of selling 100,000 shares of Chromos stock in the three months ended
      March 31, 2007, we recorded $1,000 of net realized gains and received $16,000
      in
      cash. The amount of potential realizable value in this investment will be
      determined by the market, the exchange rate between the Canadian and US dollar
      and our ability to sell the shares in the open market.





**Item
      4T.*****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 SEC 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.




14




**PART
      II    OTHER INFORMATION**




**Item
      1.    Legal Proceedings**




None.




**Item
      1A.    Risk Factors**





Other
      than with respect to the risk factors below, there have been no material changes
      from the risk factors disclosed in “Section 1A. Risk Factors” of our annual
      report on Form 10-K for the year ended December 31, 2006. The risk factors
      below were disclosed on the Form 10-K and have been updated to provide more
      recent financial and factual information as of March 31, 2007.





**Risks
      Related to Our Business**





***The
      audit report prepared by our independent registered public accounting firm
      relating to our financial statements for the year ended December 31, 2006
      includes an explanatory paragraph expressing substantial doubt about our ability
      to continue as a going concern.***





We
      estimate that our cash and cash equivalents on hand, plus expected funding
      from
      our partners, will be sufficient to fund our operations into the fourth quarter
      of 2007. This estimate is based on our ability to perform planned research
      and
      development activities and the receipt of expected funding from our partners.
      Prior to that time, we will need to raise additional capital to continue to
      fund
      operations at their current level. In addition, as of March 31, 2007, we owed
      to
      Biogen Idec approximately $1.5 million in aggregate principal amount pursuant
      to
      an outstanding promissory note.





If
      we do
      not raise additional funds, we would be forced to preserve our cash position
      through a combination of additional cost reduction measures, sales of assets
      likely at values significantly below their potential worth, or the pursuit
      of
      alternative financing transactions that would likely be on terms disadvantageous
      to us and significantly dilutive to our shareholders. We may need to augment
      our
      cash through additional and possibly repetitive dilutive financings. If we
      are
      unable to raise additional funds, we could be forced to discontinue our
      operations.





***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 product commercialization
                activities and facility expansions, if and as required;
                and  ·
            the existence and outcome of any litigation or
              administrative proceedings involving intellectual
              property.




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


·
              entering
                  into additional product development
                  collaborations;
 
 ·
              mergers and
                acquisitions;
 
 ·
              issuing equity in the public or private markets;
 
 ·
              extending or expanding our current
                collaborations;
  15
  ·
              selling or licensing our technology or product
                candidates;
 
 ·
              borrowing under loan or equipment financing arrangements;
                and/or
 
 ·
              issuing debt.


Additional
      funding may not be available to us on reasonable terms, if at all. Our ability
      to issue equity, and our ability to issue it at the current market price, may
      be
      adversely affected by the fact that we are presently ineligible under SEC rules
      to utilize Form S-3 for primary offerings of our securities because the
      aggregate market value of our outstanding common stock held by non-affiliates
      is
      less than $75.0 million.





The
      perceived risk associated with the possible sale of a large number of shares
      of
      our common stock could cause some of our shareholders to sell their stock,
      thus
      causing the price of our stock to decline. In addition, actual or anticipated
      downward pressure on our stock price due to actual or anticipated sales of
      stock
      could cause some institutions or individuals to engage in short sales of our
      common stock, which may itself cause the price of our stock to decline.





If
      our
      stock price declines, we may be unable to raise additional capital. A sustained
      inability to raise capital could force us to go out of business. Significant
      declines in the price of our common stock could also impair our ability to
      attract and retain qualified employees, reduce the liquidity of our common
      stock
      and result in the delisting of our common stock from the NASDAQ Capital
      Market.





The
      funding that we expect to receive from our collaborations depends on continued
      scientific progress under the collaborations and our collaborators’ 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.





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





Substantially all of our revenue to date 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, 2007, we had an accumulated
      deficit of $287.9 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
      March 2006, we initiated a Phase I/II 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. 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.





**Item
      2.    Unregistered Sales of Securities and Use of
      Proceeds**




Our
      loan
      agreement with Biogen Idec contains financial covenants establishing limits
      on
      our ability to declare or pay cash dividends.




16




**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.




17





**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.


TARGETEDGENETICSCORPORATIONDate:
                May 9, 2007
            By:
            /s/H.STEWARTPARKER**H.
                Stewart Parker,**
              **President,
                Chief Executive Officer and Director**
              **(Principal
                Executive Officer)**


Date:
                May 9, 2007
            By:
            /s/    DAVIDJ.
                POSTON**David
                J. Poston,**
              **Chief
                Financial Officer**
              **(Principal
                Financial and Accounting
                Officer)**




18





**INDEX
      TO EXHIBITS**




**Incorporated
                by Reference****Exhibit
                Number**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date
                of First Filing**
            
            **Exhibit
                Number**
            
            **Filed
                Herewith**3.1
            
            Amended
                and Restated Articles of Incorporation
            
            8-K
            
            5/12/06
            
            3.13.2
            
            Amended
                and Restated Bylaws
            
            10-K
            
            3/17/97
            
            3.24.1
            
            Registration
                Rights Agreement among Targeted Genetics Corporation and certain
                investors
                dated as of January 8, 2007
            
            8-K
            
            1/8/07
            
            10.210.1
            
            Amendment
                No. 3 to Exclusive Sublicense Agreement, dated as of March 9, 2007,
                between Targeted Genetics and Alkermes, Inc. *
            
            10-K
            
            3/29/07
            
            10.5(c)10.2
            
            Securities
                Purchase Agreement among Targeted Genetics Corporation and certain
                investors dated January 8, 2007
            
            8-K
            
            1/8/07
            
            10.110.3
            
            Form
                of Warrant to Purchase Shares of Common Stock of Targeted Genetics
                Corporation dated January 11, 2007
            
            8-K
            
            1/8/07
            
            10.331.1
            
            Certification
                of Chief Executive Officer pursuant to Rules 13a-15(e) and 15d-15(e)
                under
                the Securities Exchange Act of 1934, as amended
            
            
            
            
            
            
            
            X31.2
            
            Certification
                of Chief Financial Officer pursuant to Rules 13a-15(e) and 15d-15(e)
                under
                the Securities Exchange Act of 1934, as amended
            
            
            
            
            
            
            
            X32.1
            
            Certification
                of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            
            X32.2
            
            Certification
                of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
                adopted
                pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
            
            
            
            
            
            
            
            X





*
            Portions
                of this exhibit have been omitted based on a grant of confidential
                treatment from the SEC. The omitted portions of this exhibit have
                been
                filed separately with the SEC.





19