UNITED
      STATES


SECURITIES
      AND EXCHANGE COMMISSION


WASHINGTON,
      D.C. 20549


**FORM
      10-Q**




(Mark
                One)x
            QUARTERLY
                REPORT UNDER SECTION 13 OR 15(d) OFTHE
                SECURITIES EXCHANGE ACT OF 1934 FOR THEQUARTERLY
                PERIOD ENDED MARCH 31, 2006o
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d)OF
                THE SECURITIES EXCHANGE ACT OF 1934 FOR THETRANSITION
                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 ý    Non-accelerated
      filer  ̈





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, 2006:
      98,519,355








**TARGETED
      GENETICS CORPORATION**


Quarterly
      Report on Form 10-Q


For
      the
      quarter ended March 31, 2006




TABLE
      OF
      CONTENTS




Page No**.**PART I
            
            FINANCIAL
                INFORMATIONItem 1.
            
            Financial
                Statementsa)
            
            Condensed
              Consolidated
              Balance Sheets at March 31, 2006 and December 31, 2005
            
            1b)
            
            Condensed
                Consolidated Statements of Operations for the three months ended
                March 31,
                2006 and 2005
            
            2c)
            
            Condensed
                Consolidated Statements of Cash Flows for the three months ended
                March 31,
                2006 and 2005
            
            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
                  4.
            
            Controls
                  and Procedures
            
            15PART
                II
            
            OTHER
                INFORMATIONItem
                  1.
            
            Legal
                  Proceedings
            
            15Item
                1A.
            
            Risk
                Factors
            
            15Item
                2.
            
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            
            17Item
                3.
            
            Defaults
              Upon Senior Securities
            
            17Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders
            
            17Item
                5.
            
            Other
                Information
            
            17Item
                6.
            
            Exhibits
            
            17SIGNATURES
            
            18EXHIBIT
                INDEX
            
            19






i




**PART
      I    FINANCIAL INFORMATION**




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




**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(Unaudited)**




**March
                31,**
            
            **December
                31,****2006**
            
            **2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            15,998,000
            
            $
            14,122,000Accounts
                receivable
            
            
            991,000
            
            
            380,000Prepaid
                expenses and other
            
            
            619,000
            
            
            683,000Total
                current assets
            
            
            17,608,000
            
            
            15,185,000Property
                and equipment, net
            
            
            1,611,000
            
            
            1,747,000Goodwill
            
            
            31,649,000
            
            
            31,649,000Other
                assets
            
            
            215,000
            
            
            217,000Total
                assets
            
            $
            51,083,000
            
            $
            48,798,000**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable and accrued expenses
            
            $
            1,840,000
            
            $
            1,770,000Accrued
                employee expenses
            
            
            566,000
            
            
            587,000Accrued
                restructure charges
            
            
            645,000
            
            
            1,838,000Deferred
                revenue
            
            
            750,000
            
            
            278,000Current
                portion of long-term obligations
            
            
            116,000
            
            
            155,000Total
                current liabilities
            
            
            3,917,000
            
            
            4,628,000Accrued
                restructure charges and deferred rent
            
            
            7,097,000
            
            
            5,422,000Long-term
                obligations
            
            
            8,161,000
            
            
            8,177,000Commitments
                and ContingenciesShareholders’
              equity:Preferred
                stock, $0.01 par value, 6,000,000 shares authorized:Series
                A preferred stock, 800,000 shares designated, none issued and
                outstanding
            
            
            —
            
            
            —Common
                stock, $0.01 par value, 180,000,000 shares authorized, 98,501,855
                shares
                issued and outstanding at March 31, 2006 and 85,694,244 shares issued
                and
                outstanding at December 31, 2005
            
            
            985,000
            
            
            857,000Additional
                paid-in capital
            
            
            284,668,000
            
            
            279,772,000Accumulated
                deficit
            
            
            (253,769,000
            )
            
            (250,037,000
            )Accumulated
                other comprehensive income (loss)
            
            
            24,000
            
            
            (21,000
            )Total
                shareholders’ equity
            
            
            31,908,000
            
            
            30,571,000Total
                liabilities and shareholders’ equity
            
            $
            51,083,000
            
            $
            48,798,000




See
      accompanying notes to condensed consolidated
      financial statements




1





**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(Unaudited)**




**Three
                months ended**
              **March
                31,****2006**
            
            **2005**Revenue
                under collaborative agreements
            
            $
            2,430,000
            
            $
            2,000,000Operating
                expenses:Research
                and development
            
            
            3,677,000
            
            
            4,539,000General
                and administrative
            
            
            1,481,000
            
            
            1,885,000Restructure
                charges
            
            
            1,042,000
            
            
            219,000Total
                operating expenses
            
            
            6,200,000
            
            
            6,643,000Loss
                from operations
            
            
            (3,770,000
            )
            
            (4,643,000
            )Investment
                income
            
            
            151,000
            
            
            100,000Interest
                expense
            
            
            (113,000
            )
            
            (129,000
            )Net
                loss
            
            $
            (3,732,000
            )
            $
            (4,672,000
            )Net
                loss per common share (basic and diluted)
            
            $
            (0.04
            )
            $
            (0.05
            )Shares
                used in computation of basic and diluted net loss per common
                share
            
            
            88,692,000
            
            
            85,628,000




See
        accompanying notes to condensed consolidated financial
        statements





2




**TARGETED
      GENETICS CORPORATION**




**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(Unaudited)**








**Three
                months ended****March
                31,****2006**
            
            **2005**Operating
                activities:Net
                loss
            
            $
            (3,732,000
            )
            $
            (4,672,000
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            168,000
            
            
            324,000Stock-based
                compensation
            
            
            221,000
            
            
            —Loss
                (gain) on investments
            
            
            (5,000
            )
            
            63,000Non-cash
                interest expense
            
            
            —
            
            
            115,000Changes
                in assets and liabilities:Decrease
                (increase) in accounts receivable
            
            
            (611,000
            )
            
            300,000Decrease
                in prepaid expenses and other
            
            
            78,000
            
            
            315,000Decrease
                in other assets
            
            
            2,000
            
            
            60,000Increase
                in current liabilities
            
            
            49,000
            
            
            146,000Increase
                in deferred revenue
            
            
            472,000
            
            
            —Increase
                in accrued restructure expenses and deferred rent
            
            
            482,000
            
            
            55,000Net
                cash used in operating activities
            
            
            (2,876,000
            )
            
            (3,294,000
            )Investing
                activities:Purchases
                of property and equipment
            
            
            (32,000
            )
            
            (180,000
            )Proceeds
                from sale of investments
            
            
            36,000
            
            
            —Net
                cash provided by (used in) investing activities
            
            
            4,000
            
            
            (180,000
            )Financing
                activities:Net
                proceeds from sales of common stock
            
            
            4,803,000
            
            
            6,000Payments
                under leasehold improvements and equipment financing
                arrangements
            
            
            (55,000
            )
            
            (205,000
            )Net
                cash provided by (used in) financing activities
            
            
            4,748,000
            
            
            (199,000
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            1,876,000
            
            
            (3,673,000
            )Cash
                and cash equivalents, beginning of period
            
            
            14,122,000
            
            
            34,096,000Cash
                and cash equivalents, end of period
            
            $
            15,998,000
            
            $
            30,423,000




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, 2005 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,
      2006
      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, 2005.





Our
      combined cash and cash equivalents total $16.0 million at March 31, 2006. We
      expect that these funds plus the funding we expect from our partners will be
      sufficient to fund our operations into the first 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 capital raising opportunities,
      advancing our clinical development programs and accessing the public and private
      capital markets at appropriate times. Additional funding may not be available
      to
      us on reasonable terms, if at all. Depending on our ability to successfully
      access additional funding, we may be forced to take cost reduction measures
      that
      may include scaling back, delaying or terminating one or more research and
      development programs, curtailing capital expenditures or reducing other
      operating activities. We have prepared the accompanying financial statements
      assuming that we will continue as a going concern and our financial statements
      do not reflect adjustments that may impact the amount and classifications of
      assets or liabilities that may result from these liquidity
      uncertainties.





***Stock-Based
      Compensation***





Effective
      the beginning of 2006, we adopted Statement of Financial Accounting Standard,
      or
      SFAS, No. 123(R), “*Share-Based
      Payment,”*and
      elected to adopt the modified prospective application method. Accordingly,
      stock-based compensationcost
      is
      measured at the grant date, based on the fair value of the award and is
      recognized as an expense over the requisite service period. For stock awards
      granted in 2006, stock-based compensation expenses are recognized over the
      option vesting period under the straight-line attribution method. For stock
      awards granted prior to 2006, stock-based compensation expenses are recognized
      under the multiple option method prescribed by Financial Accounting Standards
      Board, or FASB, Interpretation No. 28. Previously reported amounts have not
      been
      restated.





***Recently
      Issued Accounting Standards***




In
      May
      2005, the FASB issued SFAS No. 154 “ *Accounting
      Changes and Error Corrections.”* SFAS
      No.
      154 changes the requirements for accounting and reporting a change in accounting
      principle. We are required to adopt SFAS No. 154 for accounting changes and
      error corrections that occur after January 1, 2006. Under SFAS No. 154, our
      results of operations and financial condition will be impacted only if we
      implement changes in accounting principles that are addressed by the standards
      or if we correct accounting errors in future periods.


4





**2.   Long-Term
      Obligations**




Long-term
      obligations consisted of the following:




**March
                31,******
            
            **December
                31,********2006**
            
            **2005**Loans
                payable to Biogen Idec
            
            $
            8,150,000
            
            $
            8,150,000Equipment
                financing obligations
            
            
            127,000
            
            
            182,000Total
                obligations
            
            
            8,277,000
            
            
            8,332,000Less
                current portion
            
            
            (116,000
            )
            
            (155,000
            )Total
                long-term obligations
            
            $
            8,161,000
            
            $
            8,177,000





We
      have
      two loans payable to Biogen Idec, a beneficial owner of approximately 11.9%
      of
      our outstanding common shares. As of March 31, 2006 we have $7.5 million of
      principle remaining on a $10.0 million note payable. 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. The loan
      contains financial covenants establishing limits on our ability to declare
      or
      pay cash dividends and scheduled payments of $2.5 million of principal amount
      plus accrued interest are due on each of August 1, 2007, 2008 and 2009. In
      addition, we have agreed to 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. The second loan is a
      promissory note payable to Biogen Idec which we assumed in 2000 as part of
      our
      acquisition of Genovo. This promissory note has an outstanding principal amount
      of $650,000, bears no interest and matures in August 2007.





Future
      aggregate principal payments related to long-term obligations are $100,000
      for
      the remainder of 2006, $3,176,000 in 2007, $2,501,000 in 2008, $2,500,000 in
      2009 and zero in 2010.





**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, 2006:





**Contract
                Termination****Costs**
            
            **Employee
                Termination****Benefits**
            
            **Total**December
                31, 2005 accrued liability
            
            $
            7,149,000
            
            $
            —
            
            $
            7,149,000Charges
                incurred
            
            
            639,000
            
            
            219,000
            
            
            858,000Adjustments
                to the liability (accretion)
            
            
            184,000
            
            
            —
            
            
            184,000Amount
                paid
            
            
            (346,000
            )
            
            (219,000
            )
            
            (565,000
            )March
                31, 2006 accrued liability
            
            $
            7,626,000
            
            $
            —
            
            $
            7,626,000


.





For
      the
      three months ended March 31, 2006, we have recorded additional restructure
      charges of $639,000 as a result of updating our estimates of costs and sublease
      income associated with exiting the Bothell facility. Market conditions for
      subleasing the facility continued to be poor, therefore, we extended our
      estimate for additional time that may be required to find a sublease tenant.
      In
      addition, we reviewed and adjusted downward our assumptions surrounding
      escalation in sublease rental income. Adjustments to the accrued restructure
      liability for the three months ended March 31, 2006 reflect $184,000 of
      accretion expense for the period. The total of these charges and adjustments
      to
      the liability are reflected as restructure charges in the accompanying Condensed
      Consolidated Statement of Operations.


5





Restructuring
      charges also includes $219,000 of restructuring expenses related to the
      restructuring announced in January 2006 in order to reduce expenses and realign
      resources to advance our inflammatory arthritis product through clinical trials.
      We reduced our workforce by 26 employees, primarily in early-stage research
      and
      development groups and in operational and general and administrative functions.
      We do not anticipate any additional charges related to this
      restructuring.





Through
      March 31, 2006, we have recorded contract termination costs totaling $9.2
      million for our Bothell facility. We expect to incur an additional $3.4 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
      March
      10, 2006, we sold 12,791,611 shares of our common stock in a public offering
      at
      a price of $0.39 per share and received net proceeds of approximately $4.8
      million.





***Stock
      Compensation***





We
      have
      various stock option plans (Option Plans) that provide for the issuance of
      nonqualified and incentive stock options to acquire up to 12,979,444 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 shall 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 addition,
      every non-employee member of our Board of Directors receives an annual
      nonqualified stock option grant and these options vest over a 12 month period
      provided they continue service to us. Stock option exercises are fulfilled
      through the issuance of new shares of common stock.





Effective
      January 1, 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 adopted SFAS No. 123R using the modified prospective
      application method and recognized $221,000 of stock-based compensation expense
      in the first quarter of 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, 2006, we classified $125,000 as research and development expense
      and $96,000 as general and administrative expense. As
      of
      March 31, 2006, total unrecognized compensation cost related to unvested options
      was approximately $800,000, net of estimated forfeitures, which we expect to
      recognize over a weighted average period of approximately 11 months.





6


Prior
      to
      January 1, 2006, we had adopted the pro forma disclosure feature of SFAS No.
      123, “ *Accounting
      for Stock-Based Compensation,* ”
      accounted for stock options under Accounting Principles Board No. 25, *“Accounting
      for Stock Issued to Employees,”* which
      uses the intrinsic value method and generally recognizes no compensation cost
      for employee stock option grants. The following table illustrates the effect
      on
      net loss and loss per share amounts if we had applied the fair value recognition
      provisions of SFAS No. 123 to stock-based employee compensation for the three
      months ended March 31, 2005:




**Three
                  months
                  ended****March
                  31, 2005**Net
                  loss:As
                  reported
              
              $
              (4,672,000
              )Pro
                  forma stock-based compensation expense
              
              
              (464,000
              )Pro
                  forma
              
              $
              (5,136,000
              )Basic
                  and diluted net loss per share:As
                  reported
              
              $
              (0.05
              )Pro
                  forma
              
              
              (0.06
              )


Following
      is a summary of stock option activity and related prices for the first quarter
      of 2006:





**Shares**
            
            **Weighted**
              **Average**
              **Exercise**
              **Price**Balance,
                December 31, 2005
            
            
            7,040,870
            
            
            2.09Granted
            
            
            12,000
            
            
            0.46Exercised
            
            
            (16,000
            )
            
            0.40Expired
            
            
            —
            
            
            —Forfeited
            
            
            (705,174
            )
            
            1.74Balance,
                March 31, 2006
            
            
            6,331,696
            
            
            2.13





Stock
      options outstanding and exercisable as of March 31, 2006 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**$
            0.29
                -$0.49
            
            
            568,117
            
            $
            0.38
            
            
            7.05
            
            
            522,992
            
            $
            0.370.60
                -  0.84
            
            
            609,804
            
            
            0.75
            
            
            7.64
            
            
            335,569
            
            
            0.780.91
                -  1.28
            
            
            1,119,554
            
            
            0.95
            
            
            8.46
            
            
            313,122
            
            
            1.051.31
                -  1.31
            
            
            1,797,262
            
            
            1.31
            
            
            8.14
            
            
            887,407
            
            
            1.311.32
                -  2.53
            
            
            845,890
            
            
            1.89
            
            
            3.62
            
            
            789,668
            
            
            1.912.57
                -  14.88
            
            
            1,391,069
            
            
            5.58
            
            
            4.73
            
            
            1,362,694
            
            
            5.64Balance,
                March 31, 2006
            
            
            6,331,696
            
            
            2.13
            
            
            6.69
            
            
            4,211,452
            
            
            2.65





The
      total
      intrinsic value of stock options is summarized as follows:





**Number
                of**
              **Option
                Shares**
            
            **Aggregate**
              **Intrinsic
                Value**Options
                outstanding at March 31, 2006
            
            
            6,331,696
            
            $
            32,000Options
                exercisable at March 31, 2006
            
            
            4,211,452
            
            $
            32,000Options
                exercised during the three months ended March 31, 2006
            
            
            16,000
            
            $
            1,000






7


The
      aggregate intrinsic value is determined using the closing price of our common
      stock on March 31, 2006 of $0.43 per share. 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 following are the weighted average assumptions for
      the
      periods noted:




**Three
                Months ended March 31,****2006**
            
            **2005**Expected
                dividend rate
            
            Nil
            
            NilExpected
                stock price volatility
            
            1.086
            
            1.122Risk-free
                interest rate range
            
            4.25%
            
            3.25-3.79%Expected
                life of options
            
            5
              years
            
            4
              years





The
      risk-free interest rate is based on the U.S. treasury security rate. The
      expected life of options and the expected volatility ranges are estimated based
      on our historical data.





The
      weighted average fair value of stock options granted during the first quarter
      2006 was $0.37 and was $0.95 for the first quarter of 2005.




**5.  
      Other Comprehensive Loss**





Comprehensive
      loss is the total of net loss and all other non-owner changes in equity.
      Comprehensive loss includes unrealized gains and losses from investments and
      foreign currency translations, as presented in the following table:




**Three
                months ended**
              **March
                31,****2006**
            
            **2005**Net
                loss as reported
            
            $
            (3,732,000
            )
            $
            (4,672,000
            )Other
                comprehensive loss:Unrealized
                gain on available-for-sale securities
            
            
            8,000
            
            
            —Foreign
                currency translation adjustment
            
            
            16,000
            
            
            —Other
                comprehensive loss
            
            $
            (3,708,000
            )
            $
            (4,672,000
            )




**6.  
      Subsequent Event**





During
      April 2006, we signed a lease amendment with our landlord for a portion of
      our
      facilities in Seattle, Washington. This lease amendment reduces our leased
      space
      and extends the lease term on the remaining premises. This lease amendment
      is
      the continuation of our restructuring efforts that began in January 2006 in
      order to focus our cash resources on funding our inflammatory arthritis clinical
      trial. Upon the signing of the lease amendment, we paid a total of $117,000
      in
      lease termination fees, and we will pay an additional four consecutive monthly
      installments of $15,000 starting in May 2006. These expenses will be recorded
      as
      a restructuring charge in the second quarter of 2006.





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 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 “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 factors, risks and other
      information we provide in the reports we file from time to time with the
      Securities and Exchange Commission, or SEC.




**BUSINESS
      OVERVIEW**





Targeted
      Genetics Corporation is a clinical-stage biotechnology company, we are at the
      forefront of developing a new class of gene-based products. We believe that
      a
      wide range of diseases may be treated or prevented with gene-based products.
      In
      addition to treating diseases which have not had treatments in the past, we
      believe that there is also a significant opportunity to use gene-based products
      to more effectively treat diseases that are currently treated using other
      therapeutic classes of drugs including proteins, monoclonal antibodies, or
      small
      molecule drugs. We have multiple product candidates, two of which are currently
      in clinical trials. Our clinical-stage candidates are aimed at inflammatory
      arthritis and HIV/AIDS. Our preclinical product candidates are in development
      with a variety of collaboration partners and are aimed at congestive heart
      failure, HIV/AIDS and Huntington’s disease.





Our
      product candidates 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 delivery may be used to treat
      disease by replacing the missing or defective gene to facilitate the normal
      protein production or gene regulation capabilities of cells. In addition, gene
      delivery may be used to enable cells to perform additional roles in the body.
      Gene delivery may also be used to shut down cellular functions.





We
      are a
      leader in the preclinical and clinical development of adeno-associated viral
      vector, or AAV-based gene products and in the manufacture of AAV-vectors.
      Through our research and development activities, we have developed expertise
      and
      intellectual property related to gene delivery technologies. We have developed
      and applied processes to manufacture our potential products at a scale amenable
      to late-stage clinical development and expandable to large-scale commercial
      production. We have established broad capabilities in applying our AAV-based
      gene delivery technologies to several indications, and we have developed an
      infrastructure that allows us to expand these capabilities into multiple product
      opportunities. We have treated over 250 subjects using AAV-based products with
      no major safety concerns.





We
      are
      focused on the following product development programs:





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




9




We
      have
      financed our operations 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, through proceeds
      from the issuance of debt and loan funding under equipment financing
      arrangements. On March 10, 2006, we sold 12,791,611 shares of our common stock
      in a registered direct offering to institutional investors at a price of $0.39
      per share, from which we received net proceeds of approximately $4.8
      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 and accordingly, to an extent,
      we
      are able to reduce expenses and conserve our resources by reducing these
      activities. For example, in January 2006 we restructured our operations to
      concentrate our resources on generating data from the clinical trials of our
      inflammatory arthritis product candidate, maintaining our manufacturing
      capabilities and advancing our funded product development efforts. As part
      of
      this restructuring we eliminated 26 positions, which reduced our workforce
      by
      approximately 27%, including scientific, operations and administrative functions
      that were not required to support our programs. This restructuring primarily
      affected earlier-stage product discovery and preclinical product development
      efforts, small-scale vector manufacturing employees, management positions and
      operations and general and administrative support.





As
      of
      March 31, 2006, our accumulated deficit totaled $253.8 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.





Notwithstanding
      our January 2006 cost-cutting measures, 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.





Over
      the
      longer term, our business strategy is to leverage our technology assets,
      manufacturing capabilities and gene therapy product development expertise into
      multiple development programs and collaborations to maximize our opportunities
      to commercialize a product candidate. We believe that, if successful, our
      product candidates will have significant market potential. We intend to pursue
      product development programs that enable us to demonstrate the potential of
      our
      technology and eventually to commercialize gene-based therapeutics that address
      currently unmet medical needs.





The
      development of pharmaceutical products, including our potential inflammatory
      arthritis, prophylactic HIV/AIDS vaccine, 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 “Risk Factors” presented
      below.





**CRITICAL
      ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS**





***Stock-Based
      Compensation***





** Prior
      to
      January 1, 2006, we had applied the intrinsic value method of accounting for
      stock options granted to our employees and directors under the provisions of
      Accounting Principles Board Opinion No. 25, “ *Accounting
      for Stock Issued to Employees”* ,
      and
      related interpretations, as permitted by SFAS No. 123 “ *Accounting
      for Stock-Based Compensation.”* Accordingly, we did not recognize any compensation expense for options granted
      to employees or directors because we grant all options at fair market value
      on
      the date of grant.





On
      January 1, 2006, we adopted SFAS No. 123R “ *Share-Based
      Payment.”* We have
      adopted the SFAS No. 123R fair value recognition provisions using the modified
      prospective transition method. Under the modified prospective method ,
      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.Results
      for periods prior to January 1, 2006 have not been restated. As a result of
      adopting SFAS No. 123R, we recorded $221,000 of expense for stock-based
      compensation, of which $125,000 was classified as research and development
      and
      $96,000 was classified as general and administrative expense. The proforma
      cost
      of stock options compensation for the three months ended March 31, 2005 was
      $464,000, for which no expense was recorded as allowed under the provisions
      of
      APB Opinion No. 25. As of March 31, 2006, total unrecognized compensation cost
      related to unvested options was approximately $800,000, net of estimated
      forfeitures, which we expect to recognize over a weighted average period of
      approximately 11 months.





10


Determining
      the appropriate fair value model and calculating the fair value of share-based
      payment awards require the input of highly subjective assumptions, including
      the
      expected life of the share-based payment awards and stock price volatility.
      We
      based our volatility and expected life estimates based on our historical data.
      The assumptions used in calculating the fair value of share-based payment awards
      represent our best estimates, but these estimates involve inherent uncertainties
      and the application of judgment. As a result, if factors change and we use
      different assumptions, our stock-based compensation expense could be materially
      different in the future. In addition, we are required to estimate the expected
      forfeiture rate and only recognize expense for those shares expected to vest.
      If
      our actual forfeiture rate is materially different from our estimate, the
      stock-based compensation expense could be significantly different from what
      we
      have recorded in the current period. See Note 4 to the condensed consolidated
      financial statements for a further discussion on stock-based
      compensation.






**RESULTS
      OF OPERATIONS**





***Revenue***





Revenue
      increased to $2.4 million for the three months ended March 31, 2006 compared
      to
      $2.0 million for the same period in 2005. The increase in revenue reflects
      higher research and development activities under our collaboration with Celladon
      and our recently initiated research and development activities under the NIH
      grant, partially offset by decreased research and development activities from
      our collaboration with IAVI. We expect that our revenue for the remainder of
      2006 will consist primarily of research and development revenue earned under
      our
      collaborations with IAVI and Celladon and the contract from the NIH. For the
      next several years, our revenue will depend on the continuation of the current
      collaborations and our success with entering into and then performing under
      new
      collaborations.





***Operating
      Expenses***





*Research
      and Development Expenses* .    Research
      and development expenses decreased to $3.7 million for the three months ended
      March 31, 2006 compared to $4.5 million for the same period in 2005.  This
      decrease reflects cost reductions from our restructuring efforts implemented
      in
      January 2006 and lower costs related to our HIV/AIDS vaccine collaboration
      with
      IAVI as a result of lower development costs. This decrease was partially offset
      by higher research and preclinical development program expenses in support
      of
      our congestive heart failure collaboration with Celladon and to a lesser extent,
      costs connected with the initiation of work with CRI and Children’s Hospital of
      Philadelphia as part of the NIAID HIV/AIDS vaccine project. We expect that
      our
      research and development expenses for the remainder of 2006 will vary depending
      on the timing of outside services necessary to support our clinical programs,
      our collaboration with Celladon and collaboration with CRI and Children’s
      Hospital of Philadelphia in support of the NIAID HIV/AIDS vaccine project.





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,****2006**
            
            **2005**Programs
                in clinical development:Inflammatory
                arthritis
            
            $
            558,000
            
            $
            586,000HIV/AIDS
                vaccine
            
            
            317,000
            
            
            1,124,000Cystic
                fibrosis
            
            
            18,000
            
            
            189,000Indirect
                costs
            
            
            329,000
            
            
            1,511,000Total
                clinical development program expense
            
            
            1,222,000
            
            
            3,410,000Research
                and preclinical development program expense
            
            
            2,455,000
            
            
            1,129,000Total
                research and development expense
            
            $
            3,677,000
            
            $
            4,539,000








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. As a result, we do not include
      those costs in our research and development expenses.





11


Costs
      attributed to research and preclinical programs represent our earlier-stage
      development activities and include costs incurred for the HIV/AIDS vaccine
      development activities under the NIH grant 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 decreased to $1.5 million for the three months
      ended
      March 31, 2006 from $1.9 million for the same period in 2005. The decrease
      reflects the lower patent and payroll expenses as a result of the January 2006
      restructuring, offset partially by stock-based compensation expense for general
      and administrative employees.





*Restructure
      Charges.* Restructure
      charges increased to $1,042,000 for the three months ended March 31, 2006,
      compared to $219,000 for the same period in 2005. Restructuring charges in
      both
      periods include charges of $639,000 in 2006 and $100,000 in 2005 related to
      changes in our expectations regarding market conditions for the Bothell facility
      subleasing market. Restructuring charges also include accretion expense of
      $184,000 in the period ended March 31, 2006 and $119,000 in the period ended
      March 31, 2005. In January 2006, we recorded a $219,000 charge related to the
      employee termination benefits of our restructuring efforts to realign our
      resources to advance our lead inflammatory arthritis product through clinical
      trials.





***Other
      Income and Expense***





*Investment
      Income* .    Investment
      income increased to $151,000 for the three month period ended March 31, 2006
      compared to $100,000 for the same period in 2005. Interest income reflects
      interest income earned on our short term investments and for the three month
      period ended March 31, 2005 also reflects a $63,000 charge related to the
      write-off of a debenture that we received from Chromos Molecular Systems as
      part
      of merger consideration for the July 2004 sale of CellEySys, our majority-owned
      subsidiary.





*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 decreased to $113,000 for the three
      months ended March 31, 2006, compared to $129,000 for the same period in 2005.
      The decrease primarily reflects lower interest charges on decreased principal
      amounts outstanding under our equipment financing arrangements.




**Liquidity
      and Capital Resources**




We
      had
      cash and cash equivalents balances of $16.0 million as of March 31, 2006
      compared to $14.1 million as of December 31, 2005. Our cash and cash equivalents
      increased in the first quarter of 2006 reflecting net proceeds of $4.8 million
      from our March 10, 2006 sale of 12.8 million shares of our common stock offset
      by our net loss of $3.7 million for the quarter and the resulting cash used
      in
      operations of $2.9 million. Our shareholders’ equity increased to
      $31.9 **** million
      at March 31, 2006, compared to $30.6 million at December 31, 2005 also
      reflecting our March sale of common stock offset by our year-to-date cash used
      in operations.





On
      March
      10, 2006, we sold 12,791,611 shares of our common stock in a public offering
      at
      a price of $0.39 per share and received net proceeds of approximately $4.8
      million. 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
      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.





12


Since
      implementing a reduction in force in January 2006, we have focused our
      development funding on our inflammatory arthritis product candidate which is
      in
      clinical trials. During 2005, we spent approximately $2.4 million on this
      program in outside costs and allocated staff costs to support research and
      development activities and clinical trial costs, and we expect to spend
      approximately $3 million to $4 million in 2006 on this program, largely for
      clinical trial expenses. 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 outstanding debt, lease
      commitments and long-term obligations which draw on our cash resources. Our
      most
      significant obligations are approximately $14.3 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 long-term debt to Biogen Idec of $8.2
      million. Under our modified loan agreements with Biogen Idec, we are obligated
      to make scheduled payments of $3.2 million of principal plus accrued interest
      on
      August 1, 2007 and $2.5 million of principal plus accrued interest on August
      1,
      2008 and August 1, 2009. In addition, we have agreed to 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.
      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.





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 often extends for multiple years and
      is
      subject to termination or extension. For example, when the IAVI collaboration
      was initiated in 2000, it originally had a three-year term and our most recent
      extension to the IAVI collaboration extended the agreement through December
      2006. In 2005 we extended the scope of our HIV/AIDS vaccine program via a
      collaboration between Children’s Hospital of Philadelphia, Children’s Research
      Institute and us under a contract awarded by the NIAID. Our portion of the
      funding for this new collaboration could be up to $18 million over the next
      five
      years.





The
      funding from each of our collaborative partners fully offsets our incremental
      program costs from each collaboration and also partially funds development
      of
      our inflammatory arthritis product candidate, overhead and fixed costs. Our
      revenue from collaborative agreements totaled $6.9 million in 2005 and $9.7
      million in 2004 and assuming that we complete all of the planned development
      activities for each of these funded projects, we expect to earn revenue of
      up to
      approximately $9 million in 2006.





13




Our
      partners have the right to terminate our collaborations and their obligation
      to
      provide research funding at any time for any reason. For example IAVI can
      terminate our HIV/AIDS vaccine collaboration with 90 days notice. If we were
      to
      lose the collaborative funding expected from our IAVI collaboration, our NIAID
      collaboration with Children’s Hospital of Philadelphia and Children’s Research
      Institute or our Celladon collaboration and were unable to obtain alternative
      sources of funding for the product candidate under development in that
      collaboration, we may be unable to continue our research and development program
      for that product candidate.





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.  In addition, we intend to manage our
      cash by focusing on advancing our inflammatory product candidate through
      clinical testing. Our financing strategy is focused around the advancement
      of
      our two programs in clinical development, advancement of our newer development
      collaborations and leveraging value out of our other intellectual assets and
      capabilities. Our ability to raise capital depends in part on clinical trial
      success. For example, in March 2005 we announced the initial results of a Phase
      II clinical trial of tgAAVCF for the treatment of cystic fibrosis, and our
      decision to discontinue the development of that product candidate based on
      those
      results. The termination of our cystic fibrosis program reduced the resources
      available to fund our operations and affected our ability to raise additional
      capital in 2005.





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





•
            issuing
                equity in the public or private markets;





•
            extending
                or expanding our current
                collaborations;





•
            entering
                into additional product development
                collaborations;





•
            selling
                or licensing our technology or product candidates;





•
            borrowing
                under loan or equipment financing arrangements; or





•
            issuing
                debt.





We
      expect
      that our total cash requirements for 2006 will range from **$** 13
      million to $16 million and that our cash and cash equivalents at March 31,
      2006,
      plus the funding from our product development collaborations and contracts
      will
      be sufficient to fund our operations into the first 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.





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 million. 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.





**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, 2006, we
                  held
                  $16.0 million in cash and cash equivalents, which are 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, 2006, 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
                  2006.
  ·
              *Notes
                  payable:*Our results of operations are affected by changes in short-term
                  interest
                  rates as a result of a loan from Biogen which contains a variable
                  interest
                  rate. Interest payments on this loan are established quarterly
                  based upon
                  the one-year London Interbank Offered Rate, or LIBOR, plus 1%.
                  As of March
                  31, 2006, we were accruing interest on the note at a rate of 4.94%.
                  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,
                  2006,
                  about our obligations that are sensitive to changes in interest
                  rate
                  fluctuations:
 
 **Expected
                  Maturity Date****2006**
              
              **2007**
              
              **2008**
              
              **2009**
              
              **2010**
              
              **Total**Variable
                  rate note
              
              $
              —
              
              $
              2,500,000
              
              $
              2,500,000
              
              $
              2,500,000
              
              $
              —
              
              $
              7,500,000
 
 *Items
        with market and foreign currency exchange risk:*
 
 ·
              *Investment
                  in Chromos Molecular Systems, Inc.:*At
                  March 31, 2006, we held 2.5 million shares of Chromos Molecular
                  Systems,
                  Chromos, common shares with a market value of $0.18 per common
                  share
                  denominated in Canadian dollars. As of March 31, 2006 the Canadian
                  to US
                  exchange rate was US $0. 8568 per CA $1.00. As of March 31, 2006,
                  the
                  investment is recorded at $391,000 with a $24,000 unrealized gain
                  and is
                  classified within prepaid expenses and other. 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 205,000 shares
                  of
                  Chromos stock in 2006, we recorded $5,000 of net realized gains
                  and
                  received $36,000 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.


14


**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.




**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 the Company’s
      Annual Report on Form 10-K for the year ended December 31, 2005. The three
      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,
      2006.





***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.
  We
        expect
        that our cash and cash equivalents at March 31, 2006, plus the funding from
        our
        partners will be sufficient to fund our operations into the first 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. In addition, we owe approximately $8.2 million in aggregate
        principal amount under two notes payable to Biogen Idec. The terms of the
        notes
        require us to make scheduled principal payments of $3.2 million in August
        2007
        and $2.5 million in each of August 2008 and 2009. We will need to raise
        additional capital to make the scheduled payments and to repay these notes.
        Additional sources of financing could involve one or more of the following:





·
              issuing
                  equity in the public or private markets;





·
              extending
                  or expanding our current
                  collaborations;





·
              entering
                  into additional product development
                  collaborations;





·
              selling
                  or licensing our technology or product candidates;





·
              borrowing
                  under loan or equipment financing arrangements; or





·
              issuing
                  debt.





15





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 our outstanding common stock held by non-affiliates
      is
      less than $75 million.





The
      perceived risk associated with the possible sale of a large number of shares
      could cause some of our stockholders 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 collaboration 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 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, 2006, we had an accumulated deficit of
      $253.8 million. We may never generate profits and, if we do become
      profitable, we may be unable to sustain or increase profitability.





***If
      we are unable to comply with the minimum requirements for quotation on the
      NASDAQ Capital Market and we may be delisted from the NASDAQ Capital Market,
      the
      liquidity and market price of our common stock would
      decline.***





Our
      stock is listed on the NASDAQ Capital Market. In order to continue to be listed
      on the NASDAQ Capital Market, we must meet specific quantitative standards,
      including maintaining a minimum bid price of $1.00 for our common stock. On
      May
      31, 2005, we received a notice from the NASDAQ Stock Market informing us that
      for 30 consecutive business days the bid price of our common stock had closed
      below the minimum $1.00 per share requirement for continued inclusion under
      Marketplace Rule 4310(c)(4). The letter stated that under Marketplace Rule
      4310(c)(8)(d), we were provided with 180 calendar days, or until November 28,
      2005, to regain compliance with Marketplace Rule 4310(c)(4). To regain
      compliance, the bid price of our common stock must close at $1.00 per share
      or
      more for a minimum of 10 consecutive business days. As of November 28, 2005,
      we
      had not regained compliance with Market place Rule 4310(c). However, since
      we
      met all of the NASDAQ Stock Market’s criteria set forth in Marketplace Rule
      4310(c), except for the bid price requirement, the NASDAQ provided us with
      an
      additional 180 calendar day compliance period, or until May 26, 2006, to
      demonstrate full compliance and maintain our listing on the NASDAQ Capital
      Market. To date, we have not achieved the required minimum bid price. At our
      annual meeting of shareholders, our shareholders will consider a proposal to
      approve the amendment and restatement the Restated Articles to (i) effect a
      reverse stock split of our stock in a ratio of one-for-five, one-for-seven,
      or
      one-for-ten, the final ratio to be determined by the Board of Directors, if
      and
      at such specific ratio as determined by the Board of Directors at any time
      before the 2007 annual meeting of shareholders, and (ii) establish,
      depending on the ratio of the reverse stock split, the authorized shares of
      Common Stock at 36,000,000, 25,714,286 or 18,000,000 shares, respectively,
      and the authorized shares of Preferred Stock at 1,200,000, 857,143 or
      600,000 shares, respectively, (of which 360,000, 257,143 or
      180,000 shares, respectively, shall be designated Series A
      Participating Cumulative Preferred Stock) after giving effect to the reverse
      stock split. We are seeking to effect a reverse stock split to decrease the
      number of outstanding shares of Common Stock and increase the per share market
      price of our Common Stock, which we believe will assist in our efforts to
      maintain compliance with the continued listing requirements of the Nasdaq
      Capital Market. However, there is no assurance that the per share market price
      of our Common Stock will increase following any reverse stock split. If we
      have
      not regained compliance by May 26, 2006, the NASDAQ Staff will provide written
      notification that our securities will be delisted.





16




Upon
      delisting from the NASDAQ Capital Market, trading, if any, in our shares may
      continue to be conducted on the OTC Bulletin Board or in a non-NASDAQ
      over-the-counter market, such as the “pink sheets.” Delisting of our shares
      would result in limited release of the market price of those shares and limited
      analyst coverage and could restrict investors’ interest in our securities. Also,
      a delisting could have a material adverse effect on the trading market and
      prices for our shares and our ability to issue additional securities or to
      secure additional financing. In addition, if our shares were not listed and
      the
      trading price of our shares was less than $5 per share, our shares could be
      subject to Rule 15g-9 under the Securities Exchange Act of 1934 which, among
      other things, requires that broker/dealers satisfy special sales practice
      requirements, including making individualized written suitability determinations
      and receiving a purchaser’s written consent prior to any transaction. In such
      case, our securities could also be deemed to be a “penny stock” under the
      Securities Enforcement and Penny Stock Reform Act of 1990, which would require
      additional disclosure in connection with trades in those shares, including
      the
      delivery of a disclosure schedule explaining the nature and risks of the penny
      stock market. Such requirements could severely limit the liquidity of our
      securities.





**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.




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
              3,
              2006
            By:
            /s/
              H.
              STEWARTPARKER**H.
              Stewart Parker,****President,
                Chief Executive Officer and Director**
              **(Principal
                  Executive Officer)**




Date: May
              3, 2006
            By:
            /s/
              DAVID J. POSTON**David
              J. Poston,****Chief
                Financial Officer**
              **(Principal
                  Financial and Accounting
                  Officer)**





18





**INDEX
      TO EXHIBITS**




**Incorporated
                by Reference****Exhibit No.**
            
            **Exhibit
                Description**
            
            **Form**
            
            **Date**
            
            **Number**
            
            **Filed
                Herewith**3.1
            
            Amended
                and Restated Articles of Incorporation
            
            8-K
            
            05/26/2005
            
            3.13.2
            
            Amended
                and Restated Bylaws
            
            10-K
            
            12/31/1996
            
            3.210.1
            
            Form
                of Indemnification Agreement between Targeted Genetics and its officers
                and directors
            
            10-K
            
            12/31/1999
            
            10.110.2
            
            Form
                of Senior Management Employment Agreement between the registrant
                and its
                executive officers
            
            10-K
            
            12/31/1996
            
            10.210.3
            
            Agreement
                Under an NIH Prime Award, dated February 8, 2006, between The Children’s
                Hospital of Philadelphia and Targeted Genetics*
            
            10-K
            
            12/31/2005
            
            10.36X10.4
            
            Sixth
                Lease Amendment, dated April 25, 2006, between Targeted Genetics
                and
                Walton Corporation31.1
            
            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 these exhibits have been omitted based on a grant of or application
                for
                confidential treatment from the SEC. The omitted portions of these
                exhibits have been filed separately with the
                SEC.




19