Edgar Filing: CHIRON CORP

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended June 30, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from to

Commission File Number: 0-12798

CHIRON CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	94-2754624
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
4560 Horton Street, Emeryville, California	94608
(Address of principal executive offices)	(Zip code)

(510) 655-8730

(Registrant’s telephone number, including area code)

Not Applicable

(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 such filing requirements for the past 90 days.

Yes x No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No o

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

Title of Class		Outstanding at August 3, 2005
Common Stock, $0.01 par value		187,879,648

CHIRON CORPORATION
TABLE OF CONTENTS

	Page No.
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets at June 30, 2005 and December 31, 2004		3
Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2005 and 2004		5
Condensed Consolidated Statements of Comprehensive Income (loss) for the three and six months ended June 30, 2005 and 2004		6
Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and 2004		7
Notes to Condensed Consolidated Financial Statements		8
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk		56
ITEM 4. Controls and Procedures		56
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings		58
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds		60
ITEM 3. Defaults Upon Senior Securities		60
ITEM 4. Submission of Matters to a Vote of Security Holders		60
ITEM 5. Other Information		60
ITEM 6. Exhibits		61
SIGNATURES		63

Item 1. Financial Statements

CHIRON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except share data)

	June 30, 2005			December 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	184,308			$	209,509
Short-term investments in marketable debt securities	399,675				394,112
Total cash, cash equivalents and short-term investments	583,983				603,621
Accounts receivable, net of allowances	338,168				402,094
Inventories, net of reserves	238,894				221,154
Assets held for sale	1,226				—
Current net deferred income tax asset	61,537				71,287
Derivative financial instruments	4,224				4,969
Other current assets	107,428				90,898
Total current assets	1,335,460				1,394,023
Non-current investments in marketable debt securities	435,287				409,421
Property, plant, equipment and leasehold improvements, at cost:
Land and buildings	379,539				379,861
Laboratory, production and office equipment	661,774				637,394
Leasehold improvements	133,140				125,858
Construction-in-progress	227,310				225,482
	1,401,763				1,368,595
Less accumulated depreciation and amortization	(593,385		)		(569,180		)
Property, plant, equipment and leasehold improvements, net	808,378				799,415
Purchased technologies, net	205,879				216,037
Goodwill	821,016				861,394
Other intangible assets, net	403,081				457,707
Investments in equity securities and affiliated companies	61,635				100,951
Non-current notes receivable	12,459				7,500
Other non-current assets	58,290				59,055
	$	4,141,485			$	4,305,503

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement.

CHIRON CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)
(Unaudited)
(In thousands, except share data)

	June 30, 2005			December 31, 2004
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	119,320			$	129,942
Accrued compensation and related expenses	72,119				79,113
Derivative financial instruments	—				10,395
Current portion of long-term debt and capital lease	1,577				2,687
Current portion of unearned revenue	51,961				35,651
Income taxes payable	793				16,363
Other current liabilities	178,542				160,293
Total current liabilities	424,312				434,444
Long-term debt	938,248				936,652
Long-term portion of capital lease	156,828				156,952
Non-current derivative financial instruments	—				156
Non-current net deferred income tax liability	37,108				60,427
Non-current unearned revenue	31,568				26,175
Other non-current liabilities	71,225				79,643
Minority interest	10,258				9,350
Total liabilities	1,669,547				1,703,799
Commitments and contingencies
Stockholders’ equity:
Common stock	1,917				1,917
Additional paid-in capital	2,536,828				2,527,709
Deferred stock compensation	(17,759		)		(13,825		)
Accumulated deficit	(44,861		)		(11,843		)
Accumulated other comprehensive income	186,248				330,491
Treasury stock, at cost (3,917,000 shares at June 30, 2005 and 4,804,000 shares at December 31, 2004)	(190,435		)		(232,745		)
Total stockholders’ equity	2,471,938				2,601,704
	$	4,141,485			$	4,305,503

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement.

CHIRON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
				Restated						Restated
Revenues:
Product sales, net	$	303,575		$	281,221		$	580,738		$	562,287
Revenues from joint business arrangement	31,003			28,532			67,061			58,893
Collaborative agreement revenues	3,453			3,828			7,980			10,343
Royalty and license fee revenues	76,522			55,196			156,583			109,988
Other revenues	4,204			10,975			13,751			17,913
Total revenues	418,757			379,752			826,113			759,424
Operating expenses:
Cost of sales (excludes amortization expense related to acquired developed products)	177,569			129,228			340,529			255,929
Research and development	107,472			100,326			217,311			198,736
Selling, general and administrative	128,492			106,857			260,400			211,597
Amortization expense of intangible assets acquired in business combinations and asset purchases	20,613			21,179			41,876			42,511
Other operating expenses	2,056			4,644			9,202			6,760
Total operating expenses	436,202			362,234			869,318			715,533
(Loss) income from operations	(17,445		)	17,518			(43,205		)	43,891
Interest expense	(8,094		)	(6,452		)	(15,173		)	(12,377		)
Interest and other income, net	26,298			19,809			47,745			35,883
Minority interest	(662		)	(459		)	(1,192		)	(1,079		)
Income (loss) from continuing operations before income taxes	97			30,416			(11,825		)	66,318
Provision for (benefit of) income taxes	48			7,604			(2,932		)	16,579
Income (loss) from continuing operations	49			22,812			(8,893		)	49,739
Gain from discontinued operations, net of taxes	—			12,459			—			25,304
Net income (loss)	$	49		$	35,271		$	(8,893	)	$	75,043
Basic earnings (loss) per share:
Income (loss) from continuing operations	$	—	*	$	0.12		$	(0.05	)	$	0.26
Net income (loss)	$	—	*	$	0.19		$	(0.05	)	$	0.40
Diluted earnings (loss) per share:
Income (loss) from continuing operations	$	—	*	$	0.12		$	(0.05	)	$	0.26
Net income (loss)	$	—	*	$	0.18		$	(0.05	)	$	0.39

* Less than $0.01 per share.

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement.

CHIRON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(In thousands)

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
				Restated						Restated
Net income (loss)	$	49		$	35,271		$	(8,893	)	$	75,043
Other comprehensive loss:
Change in foreign currency translation adjustment during the period	(73,577		)	(15,784		)	(124,139		)	(37,412		)
Unrealized losses from investments:
Net unrealized holding gains (losses) arising during the period, net of tax (provision) benefit of ($367) and $4,610 for the three months ended June 30, 2005 and 2004, respectively, and $1,679 and $2,112 for the six months ended June 30, 2005 and 2004, respectively	742			6,267			(2,449		)	7,544
Reclassification adjustment for net gains included in net income(loss), net of tax provision of $5,356 and $2,965 for the three months ended June 30, 2005 and 2004, respectively, and $10,909 and $9,353 for the six months ended June 30, 2005 and 2004, respectively	(8,668		)	(11,361		)	(17,655		)	(14,629		)
Net unrealized losses from investments	(7,926		)	(5,094		)	(20,104		)	(7,085		)
Other comprehensive loss	(81,503		)	(20,878		)	(144,243		)	(44,497		)
Comprehensive income (loss)	$	(81,454	)	$	14,393		$	(153,136	)	$	30,546

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement.

CHIRON CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

	Six Months Ended June 30,
	2005			2004
				Restated
Net cash provided by operating activities	$	94,688		$	74,730
Cash flows from investing activities:
Purchases of investments in marketable debt securities	(499,322		)	(218,815		)
Proceeds from sales of investments in marketable debt securities	141,410			353,595
Proceeds from maturities of investments in marketable debt securities	318,129			154,526
Capital expenditures	(97,802		)	(93,770		)
Purchases of equity securities and interests in affiliated companies	(2,467		)	(4,349		)
Proceeds from sale of equity securities and interests in affiliated companies	17,851			16,277
Cash paid for acquisitions, net of cash acquired	(2,122		)	(19,548		)
Proceeds from (issuance of) notes receivable	(4,959		)	1,000
Other, net	(4,706		)	(217		)
Net cash provided by (used in) investing activities	(133,988		)	188,699
Cash flows from financing activities:
Repayment of debt and capital leases	(351		)	(380,035		)
Payments to acquire treasury stock	—			(71,726		)
Proceeds from re-issuance of treasury stock	18,355			45,001
Proceeds from issuance of debt	1,002			2,317
Payment of bond issuance costs	—			(7,766		)
Proceeds from issuance of convertible debentures	—			385,000
Net cash provided by (used in) financing activities	19,006			(27,209		)
Effect of exchange rate changes on cash and cash equivalents	(4,907		)	(5,467		)
Net (decrease) increase in cash and cash equivalents	(25,201		)	230,753
Cash and cash equivalents at beginning of the period	209,509			364,270
Cash and cash equivalents at end of the period	$	184,308		$	595,023

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2005
(Unaudited)

Note 1—Basis of Presentation

The information presented in the Condensed Consolidated Financial Statements at June 30, 2005, and for the three and six months ended June 30, 2005 and 2004, is unaudited but includes all adjustments, consisting only of normal recurring adjustments, which Chiron Corporation believes to be necessary for fair presentation of the periods presented.

The Condensed Consolidated Balance Sheet amounts at December 31, 2004, have been derived from audited financial statements. Historically, Chiron’s operating results have varied considerably from period to period due to the nature of Chiron’s collaborative, royalty and license arrangements and the seasonality of certain vaccine products. In addition, the mix of products sold and the introduction of new products will affect comparability from quarter to quarter. As a consequence, Chiron’s interim results in any one quarter are not necessarily indicative of results to be expected for a full year. This information should be read in conjunction with Chiron’s audited Consolidated Financial Statements as of and for the year ended December 31, 2004, which are included in the Annual Report on Form 10-K filed by Chiron with the Securities and Exchange Commission, or SEC.

Principles of Consolidation

The Condensed Consolidated Financial Statements include the accounts of Chiron and its majority-owned subsidiaries. For consolidated majority-owned subsidiaries in which Chiron owns less than 100%, Chiron records minority interest in the Condensed Consolidated Financial Statements to account for the ownership interest of the minority owner. Investments in limited partnerships and interests in which Chiron has an equity interest of 50% or less are accounted for using either the equity or cost method. All significant intercompany accounts and transactions have been eliminated in consolidation.

Restated Second-Quarter and Third-Quarter 2004 Financial Statements

During our 2004 year-end financial statement review, we determined that certain sales of the travel vaccine recorded as revenues in the second quarter of 2004 should not have been recorded as revenue at that time, and that portions of those sales should have been recorded as revenues in the third and fourth quarters of 2004 and possibly in later quarters. As a result, we restated the financial statements included in our Quarterly Reports on Form 10-Q for such quarters and filed amended Form 10-Q’s for such quarters on April 6, 2005.

Use of Estimates and Reclassifications

The preparation of financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to investments; inventories; derivatives; capital leases; intangible assets; goodwill; purchased in-process research and development; product discounts, rebates and returns; bad debts; collaborative, royalty and license arrangements; restructuring; pension and other post-retirement benefits; income taxes; and litigation and other contingencies. Chiron bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 1—Basis of Presentation (Continued)

which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions.

Chiron, prior to filing its financial statements on Form 10-Q, publicly releases an unaudited condensed consolidated balance sheet and statement of operations. Between the date of Chiron’s earnings release and the filing of Form 10-Q, reclassifications may be required. These reclassifications, when made, have no effect on income from continuing operations, net income or earnings per share. There has been no such reclassification in the second quarter of 2005.

Chiron currently owns certain manufacturing and inspection equipment which is no longer useful and became available for sale in 2005. Chiron has committed to a plan to sell these assets and is actively marketing these assets. These assets are classified as “Assets held for sale” in the Condensed Consolidated Balance Sheet at June 30, 2005.

Certain previously reported amounts have been reclassified to conform to the current year presentation.

Stock-Based Compensation

Chiron measures compensation expense for its stock-based employee compensation using the intrinsic value method. Compensation expense is based on the difference, if any, between the fair value of Chiron’s common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant. This amount is recorded as “Deferred stock compensation” in the Condensed Consolidated Balance Sheets and amortized as a charge to operations over the vesting period of the applicable options or share rights.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 1—Basis of Presentation (Continued)

The following table illustrates the effect on net income (loss) and related net income (loss) per share, had compensation cost for the stock-based employee compensation been determined based upon the fair value method:

		Three Months Ended June 30,					Six Months Ended June 30,
		2005			2004		2005			2004
					Restated					Restated
		(in thousands, except per share data)
Net income (loss):
As reported		$	49		$	35,271	$	(8,893	)	$	75,043
Add:	Stock-based employee compensation expense included in reported net income (loss), net of related tax effects	1,014			1,349		2,075			2,689
Less:	Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	19,062			22,769		35,736			44,277
	Pro forma	$	(17,999	)	$	13,851	$	(42,554	)	$	33,455
Basic net income (loss) per share:
As reported		$	—	*	$	0.19	$	(0.05	)	$	0.40
Pro forma		$	(0.10	)	$	0.07	$	(0.23	)	$	0.18
Diluted net income (loss) per share:
As reported		$	—	*	0.18		$	(0.05	)	$	0.39
Pro forma		$	(0.10	)	$	0.07	$	(0.23	)	$	0.18

* Less than $0.01 per share.

Note 2—New Accounting Standards

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)), which requires the cost resulting from all share-based payment transactions to be recognized in the consolidated financial statements. That cost will be measured based on the fair value of the equity instruments issued or on the fair value of liabilities incurred. Under SFAS 123(R), the fair-value-based method for recognition or disclosure of compensation expense will be applied using the modified prospective application transition method or the modified retrospective application transition method. Chiron currently measures compensation expense for its stock-based employee compensation under the intrinsic method. We are currently evaluating transition methods, option valuation methodologies and assumptions in light of SFAS 123(R) and, therefore, cannot estimate the impact of our adoption at this time, although we expect that its adoption will have a material impact on Chiron’s consolidated financial statements. Current option values determined using the Black-Scholes-Merton formula, used for purposes of proforma disclosure, may not be indicative of results from the valuation methodologies Chiron finally adopts. The effective date of SFAS 123(R) is the first reporting period beginning after June 15, 2005. However, on April 14, 2005, the

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 2—New Accounting Standards (Continued)

Securities and Exchange Commission (SEC) announced the adoption of a new rule that delays the effective date of SFAS 123(R) for registrants, such as Chiron, that are not small business issuers. The SEC’s new rule allows calendar year non-small business issuers to implement SFAS 123(R) at the beginning of 2006, which makes SFAS 123(R) effective for Chiron in the first quarter of 2006.

On October 22, 2004, the American Jobs Creation Act of 2004 (the Act) was signed into law. The Act includes a temporary incentive for U.S. multinationals to repatriate accumulated income earned outside the U.S. at an effective tax rate of 5.25%. On December 21, 2004, the FASB issued Staff Position 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provisions within the American Jobs Creation Act of 2004 (FSP 109-2). FSP 109-2 allows companies additional time to evaluate the effect of the law on whether unrepatriated foreign earnings continue to qualify for SFAS No. 109’s exception to recognizing deferred tax liabilities and would require explanatory disclosures from those who need the additional time. Through June 30, 2005, Chiron has not provided deferred taxes on foreign earnings because such earnings were intended to be indefinitely reinvested outside the U.S. Presently Chiron does not have any plan to repatriate earnings under the Act. Accordingly, Chiron has made no change in its current intention to indefinitely reinvest accumulated earnings of its foreign subsidiaries. If Chiron repatriates these earnings, a one-time tax charge to its consolidated results of operations could occur. Chiron will continue to evaluate the impact of this provision for the remainder of 2005.

Note 3—Inventories

Inventories, net of reserves, are stated at the lower of cost or market using the moving weighted-average cost method. Chiron maintains inventory reserves primarily for product failures, expiration and obsolescence. Inventory that is obsolete (inventory that will no longer be used in the manufacturing process), expired, or in excess of forecasted usage is written down to its market value, if lower than cost.

Inventories, net of reserves, consisted of the following:

	June 30, 2005		December 31, 2004
	(in thousands)
Finished goods	$	68,698		$	59,206
Work-in-process	117,901			116,660
Raw materials	52,295			45,288
	$	238,894		$	221,154

Note 4—Income Taxes

The effective tax rate was 24.8% and 25.0% of pretax income (loss) from continuing operations for the six months ended June 30, 2005 and 2004, respectively. The effective tax rate may be affected in future periods by changes in management’s estimates with respect to our deferred tax assets and other items affecting the overall tax rate.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 5—Comprehensive Income (Loss)

For the three and six months ended June 30, 2005 and 2004, the foreign currency translation component of comprehensive income (loss) relates to permanent investments in non-U.S. subsidiaries and, accordingly, was not adjusted for income taxes.

Note 6—Treasury Stock

Treasury stock is stated at cost. Gains on reissuance of treasury stock are credited to “Additional paid-in capital.” Losses on reissuance of treasury stock are charged to “Additional paid-in capital” to the extent of available net gains on reissuance of treasury stock. Otherwise, losses are charged to “Accumulated deficit.” Chiron charged losses of $10.5 million and $24.1 million for the three and six months ended June 30, 2005, respectively, and $4.7 million and $30.1 million for the three and six months ended June 30, 2004, respectively, to “Accumulated deficit” in the Condensed Consolidated Balance Sheets.

Note 7—Earnings (Loss) Per Share

Basic earnings per share is based upon the weighted-average number of common shares outstanding. Diluted earnings per share is based upon the weighted-average number of common shares and dilutive potential common shares outstanding. Dilutive potential common shares could result from (i) the assumed exercise of outstanding stock options and equivalents, which are included under the treasury-stock method; (ii) performance based share rights awards to the extent that dilutive shares are assumed issuable; (iii) the assumed exercise of outstanding put options, which are included under the reverse treasury-stock method; and (iv) convertible notes and debentures, which are included under the if-converted method, if applicable. Due to rounding, quarterly amounts may not sum to full year amounts.

Contingently convertible debt instruments (“CoCos”) are included in diluted earnings per share, if dilutive. For the three and six months ended June 30, 2005 and 2004, Chiron’s $500.0 million contingently convertible debentures due 2033 (“2033 Debentures”) and Chiron’s $385.0 million contingently convertible debentures due 2034 (“2034 Debentures”) were excluded from the computations of diluted earnings per share as the inclusion of each of these CoCos would be antidilutive.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 7—Earnings (Loss) Per Share (Continued)

The following table sets forth the computations for basic and diluted earnings (loss) per share on income (loss) from continuing operations (in thousands, except per share data):

	Three Months Ended June 30,					Six Months Ended June 30,
	2005			2004		2005			2004
				Restated					Restated
Income (loss) (Numerator):
Income (loss) from continuing operations	$	49		$	22,812	$	(8,893	)	$	49,739
Shares (Denominator):
Weighted-average common shares outstanding	187,532			188,275		187,321			187,952
Effect of dilutive securities:
Stock options and equivalents	1,436			2,710		—			3,450
Weighted-average common shares outstanding, plus impact from assumed conversions	188,968			190,985		187,321			191,402
Basic earnings (loss) per share	$	—	*	$	0.12	$	(0.05	)	$	0.26
Diluted earnings (loss) per share	$	—	*	$	0.12	$	(0.05	)	$	0.26

* Less than $0.01 per share.

The following table sets forth the computations for basic and diluted earnings (loss) per share on net income (loss) (in thousands, except per share data):

	Three Months Ended June 30,					Six Months Ended June 30,
	2005			2004		2005			2004
				Restated					Restated
Income (loss) (Numerator):
Net income (loss)	$	49		$	35,271	$	(8,893	)	$	75,043
Shares (Denominator):
Weighted-average common shares outstanding	187,532			188,275		187,321			187,952
Effect of dilutive securities:
Stock options and equivalents	1,436			2,710		—			3,450
Weighted-average common shares outstanding, plus impact from assumed conversions	188,968			190,985		187,321			191,402
Basic earnings (loss) per share	$	—	*	$	0.19	$	(0.05	)	$	0.40
Diluted earnings (loss) per share	$	—	*	$	0.18	$	(0.05	)	$	0.39

* Less than $0.01 per share.

Stock options to purchase 21.0 million shares and 11.8 million shares with exercise prices greater than the average market prices of common stock were outstanding during the three months ended June 30, 2005

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 7—Earnings (Loss) Per Share (Continued)

and 2004, respectively, and 22.0 million shares and 7.6 million shares, respectively, for the six months ended June 30, 2005 and 2004. These options were excluded from the respective computations of diluted earnings per share, as their inclusion would be antidilutive.

The dilutive effect of CoCos must be included in diluted earnings per share regardless of whether the triggering contingency has been satisfied, if dilutive. For the three and six months ended June 30, 2005 and 2004, 7.3 million shares of common stock issuable upon conversion of the 2033 Debentures were excluded from the computations of diluted earnings per share as their inclusion would be antidilutive.

If the 2034 Debentures are tendered for conversion, the value (“Conversion Value”) of cash and shares of Chiron’s common stock, if any, to be received by a holder converting $1,000 principal amount of the debentures will be determined by multiplying the applicable conversion rate by a weighted average price. Chiron will deliver the Conversion Value to debenture holders as follows: (1) an amount in cash (“Principal Return”) equal to the lesser of (a) the aggregate Conversion Value of the debentures to be converted and (b) the aggregate principal amount of the debentures to be converted and (2) if the aggregate Conversion Value of the debentures to be converted is greater that the Principal Return, an amount in shares (“Net Shares”) equal to the aggregate Conversion Value less the Principal Return (“Net Share Amount”). The number of Net Shares to be paid will be determined by dividing the Net Share Amount by a weighted average price. If dilutive, common shares to be added to the diluted shares outstanding would be determined by the net share settlement of the 2034 Debentures. For the three and six months ended June 30, 2005 and 2004, the assumed conversion of the 2034 Debentures was not dilutive.

In addition, for the three and six months ended June 30, 2005, 0.6 million shares of common stock issuable upon conversion of the Liquid Yield Option Notes were excluded from the computations of diluted earnings per share as their inclusion would be antidilutive. For the three and six months ended June 30, 2004, 4.1 million and 6.2 million shares of common stock issuable upon conversion of the Liquid Yield Option Notes were excluded from the computations of diluted earnings per share as their inclusion would be antidilutive.

All potential common shares have been excluded from the computation of diluted loss per share for the six months ended June 30, 2005, as their inclusion would be antidilutive. These potential common shares included stock options to purchase 1.3 million shares of common stock, 0.6 million shares of common stock issuable upon conversion of the Liquid Yield Option Notes and 7.3 million shares issuable upon conversion of the Convertible Debentures.

Note 8—Discontinued Operations

In a strategic effort to focus on our core businesses of blood-testing, vaccines and biopharmaceuticals, we completed the sale of Chiron Diagnostics to Bayer Corporation, or Bayer, in 1998.

In the second quarter of 2004, Chiron and the IRS entered into a settlement agreement closing the open tax years 1996 to 1998. Pursuant to this settlement, Chiron recognized a tax benefit of approximately $12.5 million for the three and six months ended June 30, 2004.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 8—Discontinued Operations (Continued)

Chiron and Bayer were involved in a dispute with respect to their respective rights to certain royalty refunds receivable for which a settlement was reached in 2004. Under this settlement agreement, Chiron made a settlement payment to Bayer in 2004. This settlement includes an agreement that all outstanding items with Bayer related to the sale of Chiron Diagnostics are resolved and no future indemnity obligations are required. Chiron released previously established reserves deemed to be in excess following this settlement. This settlement resulted in a net gain of $12.8 million for the six months ended June 30, 2004. This net gain primarily relates to a tax benefit as a result of the settlement payment to Bayer.

Note 9—Intangible Assets

Intangible assets subject to amortization consisted of the following (in thousands):

	June 30, 2005								December 31, 2004
	Gross Carrying Value		Accumulated Amortization			Net Carrying Value			Gross Carrying Value		Accumulated Amortization			Net Carrying Value
Purchased technologies	$	332,325		$	126,446		$	205,879	$	333,085		$	117,048		$	216,037
Patents	$	137,016		$	75,639		$	61,377	$	132,385		$	71,616		$	60,769
Trademarks	60,512			25,106			35,406		65,609			25,450			40,159
Licenses and technology rights	44,172			32,335			11,837		47,745			34,079			13,666
Developed product technologies	352,983			98,868			254,115		374,025			77,253			296,772
Customer relationships	27,859			11,808			16,051		31,234			12,421			18,813
Know how(1)	12,652			7,188			5,464		14,185			7,548			6,637
Databases	7,100			2,248			4,852		7,100			2,012			5,088
Other	24,700			10,721			13,979		34,893			19,090			15,803
Total other intangible assets	$	666,994		$	263,913		$	403,081	$	707,176		$	249,469		$	457,707
Total intangible assets subject to amortization	$	999,319		$	390,359		$	608,960	$	1,040,261		$	366,517		$	673,744

(1) Upon acquisition of a 100% interest in Chiron Behring by the second quarter 1998, Chiron acquired a portfolio of products that were created by Behring and are currently being sold internationally. These products embody Chiron Behring’s proprietary “know-how” consisting of unpatented technology and trade secrets. Since the unpatented technology and trade secrets meet the separability criterion, Chiron has recognized them collectively as a separate intangible asset apart from goodwill in accordance with SFAS No. 141, Business Combinations.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 9—Intangible Assets (Continued)

Aggregate future amortization expense is expected to be as follows (in thousands):

For the six months ended June 30, 2005	$	48,447
For the remaining six months in the year ended December 31, 2005	$	48,440
For the year ended December 31, 2005	$	96,887
For the year ended December 31, 2006	$	107,222
For the year ended December 31, 2007	$	105,456
For the year ended December 31, 2008	$	79,922
For the year ended December 31, 2009	$	54,899
For the year ended December 31, 2010	$	53,397

The changes in the carrying value of goodwill by reporting unit consisted of the following (in thousands):

	Biopharmaceuticals			Vaccines			Total
Balance as of December 31, 2004		$	192,186	$	669,208		$	861,394
Effect of exchange rate changes		—		(40,378		)	(40,378		)
Balance as of June 30, 2005		$	192,186	$	628,830		$	821,016

Note 10—Segment Information

Chiron is organized based on the products and services that it offers. Under this organizational structure, there are three reportable segments: (i) blood-testing, (ii) vaccines and (iii) biopharmaceuticals. The blood-testing segment consists of an alliance with Gen-Probe and Chiron’s one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics. Chiron’s alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection. Chiron’s joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity. Through Chiron’s joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection. The blood-testing segment also earns royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing Chiron’s hepatitis C virus and HIV-related patents, for use in blood screening and plasma fractionation markets. The vaccines segment consists principally of adult and pediatric vaccines for viral and bacterial infections. Chiron sells these vaccines primarily in the U.S., Germany, Italy, and the United Kingdom, as well as in other international markets. The vaccines segment is also involved in the development of novel vaccines and vaccination technology. The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious and pulmonary diseases, using the development and acquisition of technologies related to therapeutic proteins, antibodies and small molecules. The biopharmaceuticals segment earns royalties on third party sales of several products, including BETAFERON^® interferon

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 10—Segment Information (Continued)

beta-1b, and earns license fees for technologies, such as hepatitis C virus-related patents, used by third parties to develop therapeutic products.

Revenues and expenses associated with Chiron’s research and development activities specifically benefit each of the reportable segments and, as such, have been included in the results of operations of the respective reportable segment.

Chiron views certain other revenues and expenses, particularly certain royalty and license fee revenues primarily related to HIV and hepatitis C virus related patents, and unallocated corporate expenses, as not belonging to any one reportable segment. As a result, Chiron has aggregated these items into an “Other” segment.

The accounting policies of Chiron’s reportable segments are the same as those described in Chiron’s Annual Report on Form 10-K for the year ended December 31, 2004. Chiron evaluates the performance of its segments based on each segment’s income (loss) from continuing operations.

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 10—Segment Information (Continued)

The following segment information excludes all significant intersegment transactions as these transactions are eliminated for management reporting purposes (in thousands):

	Three Months Ended June 30,						Six Months Ended June 30,
	2005			2004			2005			2004
				Restated						Restated
Revenues
Blood-testing:
Product sales, net:
PROCLEIX® products	$	66,104		$	60,589		$	130,535		$	122,475
Ortho-Clinical Diagnostics	7,988			6,608			14,450			12,842
Total product sales, net	74,092			67,197			144,985			135,317
Revenues from joint business arrangement	31,003			28,532			67,061			58,893
Collaborative agreement revenues	2,128			2,325			4,010			4,389
Royalty and license fee revenues	25,990			16,267			51,194			32,701
Other revenues	200			235			275			430
Total blood-testing revenues	133,413			114,556			267,525			231,730
Vaccines:
Product sales, net:
Influenza vaccines	(492		)	8,207			3,079			15,912
Meningococcal vaccines	13,605			5,016			22,758			9,565
Travel vaccines	45,014			26,261			88,773			49,271
Pediatric and other vaccines	39,127			47,619			69,620			98,802
Total product sales, net	97,254			87,103			184,230			173,550
Collaborative agreement revenues	999			1,214			3,241			5,180
Royalty and license fee revenues	769			25			2,185			2,675
Other revenues	2,480			5,914			5,756			9,556
Total vaccines revenues	101,502			94,256			195,412			190,961
Biopharmaceuticals:
Product sales, net
BETASERON® interferon beta-1b	38,132			31,626			64,766			61,762
TOBI® tobramycin	56,600			51,342			109,535			103,866
PROLEUKIN® aldesleukin	31,727			35,057			61,262			66,925
Other	5,770			8,896			15,960			20,867
Total product sales, net	132,229			126,921			251,523			253,420
Collaborative agreement revenues	326			289			729			774
Royalty and license fee revenues	19,792			15,183			38,418			32,480
Other revenues	1,524			4,826			7,720			7,927
Total biopharmaceuticals revenues	153,871			147,219			298,390			294,601
Other:
Royalty and license fee revenues	29,971			23,721			64,786			42,132
Total revenues	$	418,757		$	379,752		$	826,113		$	759,424
Income (loss) from continuing operations:
Blood-testing	$	70,776		$	59,208		$	145,135		$	122,848
Vaccines	(81,734		)	(46,313		)	(167,133		)	(96,352		)
Biopharmaceuticals	2,597			8,777			(3,511		)	28,026
Other	(9,084		)	(4,154		)	(17,696		)	(10,631		)
Segment (loss) income from operations	(17,445		)	17,518			(43,205		)	43,891
Interest expense	(8,094		)	(6,452		)	(15,173		)	(12,377		)
Interest and other income, net	26,298			19,809			47,745			35,883
Minority interest	(662		)	(459		)	(1,192		)	(1,079		)
Income (loss) from continuing operations before income taxes	$	97		$	30,416		$	(11,825	)	$	66,318

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 11—Commitments and Contingencies

In October 2004, the U.K. regulatory body, the Medicines and Healthcare products Regulatory Agency, or MHRA, suspended Chiron’s license to manufacture FLUVIRIN^® at our Liverpool, U.K. facility. Subsequently, Chiron received a warning letter from the Food and Drug Administration, or FDA, citing violations of good manufacturing practices. The FDA later informed Chiron that implementation and effectiveness of our corrective actions and overall compliance would be evaluated in a subsequent inspection. As a result of the suspension of our license, Chiron did not release any FLUVIRIN^® vaccine during the 2004-2005 influenza season.

On March 2, 2005, the MHRA notified Chiron that it had lifted the license suspension, giving Chiron clearance to initiate full production of FLUVIRIN^® vaccine, conditioned on the understanding that Chiron’s commitment to its remediation plan will continue and will be subject to further inspections by the MHRA. In July 2005, the FDA completed an on-site inspection of our Liverpool facility. Consistent with FDA process, at the conclusion of the on-site inspection, Chiron received a list of observations on a Form 483. Chiron expects to complete its response to these observations in early August 2005. If the FDA finds that Chiron has failed to adequately address the matters discussed in its prior warning letter or any other serious violations, the FDA may modify Chiron’s U.S. license in an adverse manner, take action that could result in imposition of fines, require temporary or permanent cessation of future selling of FLUVIRIN^® vaccine or take other action that could reduce our ability to market FLUVIRIN^® vaccine. In addition to the facility inspection, Chiron will need to receive supplemental approvals for changes in our FLUVIRIN^® vaccine from the MHRA and the FDA because of variations to our manufacturing process.

Chiron received a grand jury subpoena issued by the U.S. Attorney’s Office for the Southern District of New York in October 2004 requesting production of certain documents relating to FLUVIRIN^® vaccine and the suspension by the MHRA of Chiron’s license. In February 2005, after having previously commenced an informal inquiry, the Securities and Exchange Commission, or SEC, notified Chiron that it would commence a formal investigation into whether Chiron or Chiron employees violated any federal securities laws in connection with these developments regarding FLUVIRIN^® vaccine, and Chiron subsequently received subpoenas from the SEC requesting production of certain documents relating to our Liverpool facility and FLUVIRIN^® vaccine. Chiron also received a voluntary request for information from the United States House of Representatives, Energy and Commerce Committee, Subcommittee on Oversight and Investigations requesting production of certain documents. Numerous documents have been collected and produced in response to these requests, and several witnesses have been interviewed by the U.S. Attorney’s Office, the SEC staff and Congressional staff and additional interviews are anticipated. Additional investigations regarding these matters may arise.

In addition, Chiron and certain of its officers and directors have also been named as defendants in several putative shareholder class action and derivative lawsuits alleging various claims arising out of or relating to these developments regarding FLUVIRIN^® vaccine. Certain distributors and other parties with whom Chiron had contracted to supply FLUVIRIN^® vaccine are considering or have communicated claims against Chiron as a result of our inability to supply FLUVIRIN^® vaccine, and additional parties may do so in the future. On January 27, 2005, the U.S. Centers for Disease Control and Prevention, or CDC, terminated its contracts with Chiron for the supply of FLUVIRIN^® vaccine for default on the basis of Chiron’s failure to supply such vaccine to the U.S. government for the 2004-2005 influenza season. The CDC has reserved the right to hold Chiron liable for any excess costs it may have incurred in replacing any

CHIRON CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
June 30, 2005
(Unaudited)

Note 11—Commitments and Contingencies (Continued)

FLUVIRIN^® vaccine that Chiron failed to deliver and further has reserved all other remedies provided under the contract. It is not possible to predict whether any of these claims will be pursued and, if so, whether those claims will be upheld. Investigations, litigation and disputes have caused us to incur substantial expense and have required significant time and attention from Chiron management and will continue to do so in the future and could result in civil action and/or criminal proceedings against Chiron. The results of any such investigations, proceedings or disputes could have a material adverse effect on Chiron’s consolidated financial position and results of operations and/or cash flow.

Although the MHRA has lifted its suspension of Chiron’s license to manufacture FLUVIRIN^® vaccine, Chiron expects to incur additional expenses in connection with ongoing FLUVIRIN^® vaccine matters, which could be material, including in connection with (1) our continuing remediation efforts at our Liverpool facility; and (2) responding to the U.S. Attorney for the Southern District of New York, the SEC, the United States House of Representatives, Energy and Commerce Committee, Subcommittee on Oversight and Investigations and the private lawsuits and other claims and investigations that exist or may arise.

In July 2005, Chiron reported that it would be unable to supply any BEGRIVAC™ vaccine doses for the 2005-2006 influenza season due to a product sterility issue and wrote off its existing product inventory resulting in a $15.0 million charge to cost of sales for the three and six months ended June 30, 2005. BEGRIVAC™ vaccine is manufactured at Chiron’s facility in Marburg, Germany. Chiron’s inability to supply BEGRIVAC™ vaccine as planned to non-U.S. markets for the 2005-2006 season or future seasons could have a material adverse affect on its business and results of operations. In addition, it is possible that distributors and other parties with whom Chiron had contracted to supply influenza vaccine may make claims against Chiron as a result of Chiron not supplying influenza vaccine. Any such claims may cause Chiron to incur substantial expense and require significant time and attention from Chiron management. The results of any such claims could have a material adverse effect on Chiron’s consolidated financial position and results of operations and/or cash flow.

In addition to the investigations, inquiry and lawsuits related to the recent FLUVIRIN^® vaccine developments, Chiron is party to various claims, investigations and legal proceedings arising in the ordinary course of business. These claims, investigations and legal proceedings relate to intellectual property rights, contractual rights and obligations, employment matters, claims of product liability and other issues. While it is possible that an adverse determination of any of such ordinary course matters could have a material adverse impact in any future period, management does not believe, based upon information known to it, that the final resolution of any of these ordinary course matters will have a material adverse effect upon Chiron’s consolidated financial position and results of operations or cash flows.

Chiron’s tax filings are presently under examination in several domestic and international tax jurisdictions. While there is no assurance that Chiron will prevail in all tax examinations in the event the taxing authorities disagree with Chiron’s interpretation of the tax law, Chiron’s management does not believe, based upon information known to it, that the final resolution of any of these audits will have a material adverse effect upon Chiron’s consolidated financial position and results of operations or cash flows. Adequate provisions have been made for these tax examinations.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This Form 10-Q contains forward-looking statements regarding our expectations, hopes or intentions regarding the future, including statements relating to sales growth, product development initiatives, new product marketing, acquisitions, competition, and licensing activities that involve risks and uncertainties and are subject to change. The forward-looking statements contained in this Form 10-Q reflect our current expectations on the date of this Form 10-Q. Actual results, performance or outcomes may differ materially from current expectations. Our actual performance may differ from current expectations due to many factors, including additional adverse developments resulting from the suspension from October 5, 2004 through March 2, 2005 of our UK license to manufacture FLUVIRIN^® influenza virus vaccine, the announcement of such suspension and the litigation and investigations relating to those matters, the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, litigation, stock price and interest rate volatility, marketing effectiveness and the severity of the 2005-2006 influenza season. In particular, there can be no assurance that we will increase sales of existing products, successfully develop and receive approval to market new products, or achieve market acceptance for such new products. No assurances can be given that additional issues with respect to BEGRIVAC™ or FLUVIRIN^® vaccines or our manufacturing generally will not arise in the future, that we will be able to cover vaccine shortfalls, or that we will successfully address matters raised in a warning letter from the U.S. Food and Drug Administration with respect to our FLUVIRIN^® vaccine manufacturing facility or resume sale of FLUVIRIN^® vaccine for the 2005-2006 influenza season or BEGRIVAC™ vaccine for the 2006-2007 influenza season. In addition, we may face additional competition in the influenza market in the future and challenges in distribution arrangements as a result of recent BEGRIVAC™ and FLUVIRIN^® vaccine developments. There can be no assurance that our out-licensing activity will generate significant revenue, or that our in-licensing activities will fully protect us from claims of infringement by third parties. In addition, we may engage in business opportunities, the successful completion of which is subject to certain risks, including approval by Novartis, stockholder and regulatory approvals and the integration of operations. We have discussed the important factors, which we believe could cause actual results to differ from what is expressed in the forward-looking statements, under the caption “Factors That May Affect Future Results” in this Form 10-Q. We do not undertake an obligation to update the forward-looking information contained in this Form 10-Q.

Introduction

We are a global biopharmaceutical company that participates in three healthcare markets: blood-testing, vaccines, and biopharmaceuticals. Our research and development efforts are focused on developing products for cancer and infectious and pulmonary disease.

Our blood-testing segment is dedicated to preventing the spread of infectious diseases through the development and sale of novel blood-screening assays and equipment that protect the world’s blood supply. We are the world leader in nucleic acid testing, or NAT, blood screening with leading market share in the U.S, a strong presence in Europe, and sales in Asia. Our blood-testing segment consists of two separate collaborations: an alliance with Gen-Probe Incorporated for NAT products, and a joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc, a Johnson & Johnson company for immunodiagnostic products. Our collaboration with Gen-Probe is focused on developing and commercializing NAT products to screen donated blood, plasma, organs and tissue for viral infection. We sell the collaboration’s assays and instruments to blood banks under the PROCLEIX^® brand name. Under a joint business contractual arrangement, Ortho-Clinical Diagnostics manufactures and sells immunodiagnostic tests to detect retroviruses and hepatitis viruses in blood. Our blood-testing segment also earns royalties and license fees from third parties based on their sales of immunodiagnostic and

nucleic acid testing probe diagnostic products utilizing our hepatitis C virus and HIV-related patents, for use in blood screening and plasma fractionation markets.

Our vaccines segment is the fifth largest vaccines business in the world. We offer more than 20 pediatric and adult vaccines including influenza, meningococcal, travel and pediatric vaccines. These vaccines have protected millions of people globally from potentially fatal diseases such as polio, measles and meningococcal disease. We market our vaccines primarily in the United States, Germany, Italy and the United Kingdom. We acquired a number of vaccines including FLUVIRIN^® vaccine as part of our July 8, 2003 acquisition of PowderJect. Our vaccines segment research and development is focused on developing next generation influenza manufacturing capability, developing new vaccines for pandemic preparedness, and broadening our meningococcal franchise.

Our biopharmaceuticals segment discovers, develops, manufactures and markets a range of therapeutic products for cancer and infectious and pulmonary disease. Our marketed products include TOBI^® tobramycin solution for inhalation for pseudomonal lung infections in cystic fibrosis patients; PROLEUKIN^®(aldesleukin) for injection for metastatic melanoma and renal cell carcinoma; and BETASERON^® (interferon beta-1b) for SC injection for multiple sclerosis. In 2005, we received an action letter from the U.S. Food and Drug Administration (FDA) stating that the company’s New Drug Application (NDA) for PULMINIQ^TM (cyclosporine, USP) inhalation solution is “approvable” but that an additional pre-approval study is required to confirm the efficacy of the drug. Chiron is evaluating possible next steps for PULMINIQ. In 2004, we filed for marketing approval for CUBICIN^® (daptomycin for injection) for complicated skin and soft tissue infections.

Research and development efforts include advancing clinical programs and product improvements in oncology and pulmonary and infectious disease, including the use of PROLEUKIN^® to enhance the benefit of monoclonal antibodies in cancer treatment, the development of new formulations of TOBI^® and the clinical advancement of tifacogin for treatment of severe community-acquired pneumonia, CHIR-258, a growth factor kinase inhibitor, and CHIR-12.12, a monoclonal antibody.

We earn royalty and license fee revenue in all three segments by licensing some of our key intellectual property in areas such as hepatitis C and HIV. In addition, we generate royalties through agreements with development and marketing partners, including royalties from Schering AG’s sales of BETAFERON^® (interferon beta-1b) for SC injection in Europe. Some royalties and license fees are not considered to be associated with any particular business segment and are recorded separately in the segment data as Other Royalty and License Fee Revenues.

We view certain other revenues and expenses as not belonging to any one segment. As a result, we have aggregated these items into an “Other” segment.

Influenza Virus Vaccines Recent Events

In October 2004, the U.K. regulatory body, the Medicines and Healthcare products Regulatory Agency, or MHRA, suspended our license to manufacture FLUVIRIN^® at our Liverpool, U.K. facility. Subsequently, we received a warning letter from the Food and Drug Administration, or FDA, citing violations of good manufacturing practices. The FDA later informed us that implementation and effectiveness of our corrective actions and overall compliance would be evaluated in a subsequent inspection. As a result of the suspension of our license, we did not release any FLUVIRIN^® vaccine during the 2004-2005 influenza season.

On March 2, 2005, the MHRA notified us that it had lifted the license suspension, giving Chiron clearance to initiate full production of FLUVIRIN^® vaccine, conditioned on the understanding that Chiron’s commitment to its remediation plan will continue and will be subject to further inspections by the MHRA. In July 2005, the FDA completed an on-site inspection of our Liverpool facility. Consistent with

FDA process, at the conclusion of the on-site inspection, Chiron received a list of observations on a Form 483. Chiron expects to complete its response to these observations in early August 2005. If the FDA finds that we have failed to adequately address the matters discussed in its prior warning letter or any other serious violations, the FDA may modify our U.S. license in an adverse manner, take action that could result in imposition of fines, require temporary or permanent cessation of future selling of FLUVIRIN^® vaccine or take other action that could reduce our ability to market FLUVIRIN^® vaccine. In addition to the facility inspection, we will need to receive supplemental approvals for changes in our FLUVIRIN^® vaccine from the MHRA and the FDA because of variations to our manufacturing process.

We received a grand jury subpoena issued by the U.S. Attorney’s Office for the Southern District of New York in October 2004 requesting production of certain documents relating to FLUVIRIN^® vaccine and the suspension by the MHRA of our license. In February 2005, after having previously commenced an informal inquiry, the Securities and Exchange Commission, or SEC, notified us that it would commence a formal investigation into whether we or our employees violated any federal securities laws in connection with these developments regarding FLUVIRIN^® vaccine, and Chiron subsequently received subpoenas from the SEC requesting production of certain documents relating to our Liverpool facility and FLUVIRIN^® vaccine. We also received a voluntary request for information from the United States House of Representatives, Energy and Commerce Committee, Subcommittee on Oversight and Investigations requesting production of certain documents. Numerous documents have been collected and produced in response to these requests, and several witnesses have been interviewed by the U.S. Attorney’s Office, the SEC staff and Congressional staff and additional interviews are anticipated. Additional investigations regarding these matters may arise.

In addition, we and certain of our officers and directors have also been named as defendants in several putative shareholder class action and derivative lawsuits alleging various claims arising out of or relating to these developments regarding FLUVIRIN^® vaccine which are described below in Part II, Item 1, “Legal Proceedings.” Certain distributors and other parties with whom we had contracted to supply FLUVIRIN^® vaccine are considering or have communicated claims against us as a result of our inability to supply FLUVIRIN^®vaccine, and additional parties may do so in the future. On January 27, 2005, the U.S. Centers for Disease Control and Prevention, or CDC, terminated its contracts with us for the supply of FLUVIRIN^®vaccine for default on the basis of our failure to supply such vaccine to the U.S. government for the 2004-2005 influenza season. The CDC has reserved the right to hold us liable for any excess costs it may have incurred in replacing any FLUVIRIN^® vaccine that we failed to deliver and further has reserved all other remedies provided under the contract. It is not possible to predict whether any of these claims will be pursued and, if so, whether those claims will be upheld. Investigations, litigation and disputes have caused us to incur substantial expense and have required significant time and attention from our management and will continue to do so in the future and could result in civil action and/or criminal proceedings against us. The results of any such investigations, proceedings or disputes could have a material adverse effect on our consolidated financial position and results of operations and/or cash flow.

Although the MHRA has lifted its suspension of our license to manufacture FLUVIRIN^® vaccine, we expect to incur additional expenses in connection with ongoing FLUVIRIN^® vaccine matters, which could be material, including in connection with (1) our continuing remediation efforts at our Liverpool facility; and (2) responding to the U.S. Attorney for the Southern District of New York, the SEC, the United States House of Representatives, Energy and Commerce Committee, Subcommittee on Oversight and Investigations and the private lawsuits and other claims and investigations that exist or may arise.

In July 2005, we reported that we would be unable to supply any BEGRIVAC™ vaccine doses for the 2005-2006 influenza season due to a product sterility issue and wrote off our existing product inventory resulting in a $15.0 million charge to cost of sales for the three and six months ended June 30, 2005. BEGRIVAC™ vaccine is manufactured at our facility in Marburg, Germany. Our inability to supply BEGRIVAC™ vaccine as planned to non-U.S. markets for the 2005-2006 influenza season or future

seasons could have a material adverse affect on our business and results of operations. In addition, it is possible that distributors and other parties with whom we had contracted to supply influenza vaccine may make claims against us as a result of Chiron not supplying influenza vaccine. Any such claims may cause us to incur substantial expense and require significant time and attention from our management. The results of any such claims could have a material adverse effect on our consolidated financial position and results of operations and/or cash flow.

Our inability to supply influenza vaccine may also lead to loss of market share in the 2005-2006 influenza season and future seasons. Following the announcement of our FLUVIRIN^® license suspension, competitors announced plans to introduce influenza vaccine products in the United States and sought expedited regulatory approval to do so. Even though the license suspension has been lifted, some of our customers may choose to purchase influenza vaccine from other providers as their products become available in the United States. Loss of market share in the United States or foreign markets could have a material adverse effect on our business and results of operations.

Delays in start-up procedures for ramping up to full production and normal manufacturing issues inherent in the complexity of influenza vaccine production, have adversely affected the amount of FLUVIRIN^® vaccine that Chiron is able to produce for the 2005-2006 influenza season and may result in further loss of market share.

For additional information concerning the risks we face as a result of these influenza vaccine developments, see “Factors That May Affect Future Results—Developments with respect to influenza vaccines over the past nine months will harm our business and results of operations. “ For additional information on the U.S. Attorney’s investigation, SEC investigation and private lawsuits and other claims, see Part II, Item 1. “Legal Proceedings” of this report on Form 10-Q.

Restated Second-Quarter and Third-Quarter 2004 Financial Statements

In light of the fact that we were already in contact with the SEC in relation to their investigation described above under “Influenza Virus Vaccines Recent Events,” we informed the SEC of these matters, and adjustments we made after January 26, 2005 to the fourth quarter and full-year 2004 financial information we released on January 26, 2005, and have been providing the SEC information.

Summary Consolidated Financial Data

Following is an analysis and discussion of our operating results on a consolidated basis, which is followed by a description of our most critical accounting policies and use of estimates and more detailed analysis and discussion of our operating results by segment and our liquidity and capital resources.

	Three Months Ended						Six Months Ended
	June 30,						June 30,						$ Change						% Change
	2005			2004			2005			2004			Three Months			Six Months			Three Months		Six Months
				(Restated)						(Restated)
	($ in 000’s, except per share data)
Product sales, net	$	303,575		$	281,221		$	580,738		$	562,287		$	22,354		$	18,451		7.9	%	3.3	%
Royalty and license fee revenues	76,522			55,196			156,583			109,988			21,326			46,595			38.6	%	42.4	%
Total revenues	418,757			379,752			826,113			759,424			39,005			66,689			10.3	%	8.8	%
Gross profit margin	42		%	54		%	41		%	54		%
Research and development expenses	107,472			100,326			217,311			198,736			7,146			18,575			7.1	%	9.3	%
Selling, general and administrative expenses	128,492			106,857			260,400			211,597			21,635			48,803			20.2	%	23.1	%
Income (loss) from continuing operations	49			22,812			(8,893		)	49,739			(22,763		)	(58,632		)	(99.8	)%	(117.9	)%
Diluted earnings (loss) per share:
Income (loss) from continuing operations	$	—	*	$	0.12		$	(0.05	)	$	0.26		$	(0.12	)	$	(0.31	)	(100.0	)%	(119.2	)%

* Diluted earnings per share is less than $0.01 per share.

Income from continuing operations was $49 thousand or less than $0.01 per diluted share and $22.8 million or $0.12 per diluted share for the three months ended June 30, 2005 and 2004, respectively. Loss from continuing operations was $8.9 million or $0.05 per diluted share for the six months ended June 30, 2005. Income from continuing operations was $49.7 million or $0.26 per diluted share for the six months ended June 30, 2004. For the three months ended June 30 2005, we incurred $8.0 million of FLUVIRIN^® vaccine remediation costs and $5.0 million of legal costs associated with the FLUVIRIN^® vaccine-related developments. For the six months ended June 30 2005, we incurred $24.0 million of FLUVIRIN^® vaccine remediation costs and $15.0 million of legal costs associated with the FLUVIRIN^® vaccine-related developments. In addition, our Liverpool facility had limited influenza vaccine production during the first six months of 2005. For the three months ended June 30, 2005 as compared with the three months ended June 30, 2004, idle facility costs from our Liverpool facility increased by $14.0 million. For the six months ended June 30, 2005 as compared with the six months ended June 30, 2004, idle facility costs from our Liverpool facility increased by $27.0 million. In addition, BEGRIVAC™ product inventory has been written off as a result of the matters described above under “Influenza Virus Vaccines Recent Events”, resulting in a $15.0 million charge to cost-of-sales for the three and six months ended June 30, 2005.

Total revenues were $418.8 million and $826.1 million for the three and six months ended June 30, 2005, and $379.8 million and $759.4 million for the three and six months ended June 30, 2004, respectively.

Revenues increased for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 primarily due to increased product sales and royalty and license fee revenues. The increase in total revenues was attributable in part to the movement in exchange rates, in particular the movements in the Euro and British Pound against the U.S. dollar. The movement in exchange rates added approximately 1% to our total revenues for the three months ended June 30, 2005. However, since our Euro and British Pound denominated expenses have also increased due to the movement in exchange rates, our income per share from continuing operations decreased approximately $0.01 per diluted share for the three months ended June 30, 2005, due to higher expenses compared to revenues denominated in Euros and British Pounds.

Revenues increased for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 primarily due to increased royalty and license fee revenues and increased product sales. The increase in total revenues was attributable in part to the movement in exchange rates, in particular the movements in the Euro and British Pound against the U.S. dollar. The movement in exchange rates added approximately 1% to our total revenues for the six months ended June 30, 2005. However, since our Euro and British Pound denominated expenses have also increased due to the movement in exchange rates, our loss per share from continuing operations increased $0.02 per diluted share for the six months ended June 30, 2005, due to higher expenses compared to revenues denominated in Euros and British Pounds.

For the three months ended June 30, 2005 , product sales increased compared with the three months ended June 30, 2004 primarily due to increases in sales of our travel vaccines, Meningococcal vaccines, BETASERON^® interferon beta-1b, Procleix^® product sales and TOBI^® tobramycin, offset primarily by decreases in sales of our influenza vaccines, pediatric and other vaccines, and PROLEUKIN^® (aldesleukin), as discussed below.

For the six months ended June 30, 2005 , product sales increased compared with the six months ended June 30, 2004 primarily due to increases in sales of our travel vaccines, Meningococcal vaccines, PROCLEIX^® product sales and TOBI^® tobramycin, offset primarily by decreases in sales of our influenza vaccines and pediatric and other vaccines as discussed below.

For the three and six months ended June 30, 2005 as compared with the three and six months ended June 30, 2004, royalty and license fee revenues increased, primarily due to our September 2004 settlement agreement with Roche regarding our HIV patent in the United States, increased BETAFERON^® product royalties, our settlement with the Scottish National Blood Transfusion Service in the current quarter and royalties from our licensing agreement in 2004 with Laboratory Corporation of America Holdings for our HCV intellectual property for nucleic acid testing.

The decline in gross profit margins for the three and six months ended June 30, 2005 as compared with the three and six months ended June 30, 2004 was primarily due to increased idle facility costs as a result of the delay in commercial production of FLUVIRIN^® vaccine for the 2005-2006 influenza season, FLUVIRIN^® vaccine remediation costs and the write-off of the BEGRIVAC™ product inventory, as discussed above. Also, contributing to the decrease was planned idle facility time and ongoing process improvement efforts related to Biopharmaceuticals manufacturing. Gross profit margins do not include amortization expense of intangible assets from acquired developed products related to business combinations.

The main components of the increase in research and development expenses for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 relate to development efforts in the oncology franchise, meningococcal franchise and for CUBICIN^® (daptomycin for injection). This increase was partially offset by eliminated costs from research and development programs that were discontinued prior to the second quarter of 2005. In addition, the second quarter of 2004 included higher costs for the Phase III CAPTIVATE trial for tifacogin which commenced in the second quarter of 2004, due to production of clinical materials.

The main components of the increase in research and development expenses for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 relate to development efforts in our oncology franchise, development efforts for CUBICIN^® (daptomycin for injection), blood-testing programs, meningococcal vaccines franchise, flu cell culture and development of new processes and procedures in existing manufacturing facilities for BETAFERON interferon beta-1b. This increase was partially offset by research and development programs that have been discontinued or disposed of prior to the first six months of 2005.

The increase in selling, general and administrative expenses for the three and six months ended June 30, 2005 as compared with the three and six months ended June 30, 2004 was due partially to legal expenses associated with the FLUVIRIN^® developments discussed above under “Influenza Virus Vaccines Recent Events.” Such legal expenses were $5.0 million and $15.0 million for the three and six months ended June 30, 2005, respectively. The increase also reflects $2.0 million and $5.0 million for the three and six months ended June 30, 2005, respectively due to the movement in the Euro and British Pound exchange rates. The remaining increase in selling, general and administrative expenses reflects a broad range of activities, significant among them being on-going marketing and pre-launch programs to support the continued growth of our business, investment in geographic penetration and corporate governance costs.

Critical Accounting Policies and the Use of Estimates

Our critical accounting policies, which incorporate our more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements, are the same as those described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2004.

The preparation of financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to investments; inventories; derivatives; capital leases; intangible assets; goodwill; purchased in-process research and development; product discounts, rebates and returns; bad debts; collaborative, royalty and license arrangements; restructuring; pension and other post-retirement benefits; income taxes; and litigation and other contingencies. We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions.

Results of Operations

Blood-testing

	Three Months Ended						Six Months Ended
	June 30,						June 30,						$ Change						% Change
	2005			2004			2005			2004			Three Months			Six Months			Three Months			Six Months
	($ in 000’s, except percentages)
Product sales, net:
PROCLEIX^® products	$	66,104		$	60,589		$	130,535		$	122,475		$	5,515		$	8,060			9.1	%		6.6	%
Ortho-Clinical Diagnostics	7,988			6,608			14,450			12,842			1,380			1,608				20.9	%		12.5	%
	74,092			67,197			144,985			135,317			6,895			9,668				10.3	%		7.1	%
Revenue from joint business arrangement	31,003			28,532			67,061			58,893			2,471			8,168				8.7	%		13.9	%
Collaborative agreement revenues	2,128			2,325			4,010			4,389			(197		)	(379		)		(8.5	)%		(8.6	)%
Royalty and license fee revenues	25,990			16,267			51,194			32,701			9,723			18,493				59.8	%		56.6	%
Other revenues	200			235			275			430			(35		)	(155		)		(14.9	)%		(36.0	)%
Total blood-testing revenues	$	133,413		$	114,556		$	267,525		$	231,730		$	18,857		$	35,795			16.5	%		15.4	%
Gross profit margin	40		%	42		%	42		%	42		%
Research and development expenses	$	6,922		$	6,258		$	14,726		$	11,367		$	664		$	3,359			10.6	%		29.6	%
Selling, general and administrative expenses	$	10,928		$	10,323		$	22,703		$	19,580		$	605		$	3,123			5.9	%		15.9	%

Product sales

PROCLEIX^® Products On February 27, 2002, the U.S. Food and Drug Administration approved the PROCLEIX^® HIV-1/ HCV Assay. We have marketed the PROCLEIX^® HIV-1/HCV Assay in Europe since 1999. On January 15, 2004, the PROCLEIX^® ULTRIO™ HIV-1/HCV/HBV Assay received European CE marking for use on the semi-automated PROCLEIX^® System, and on December 14, 2004 the PROCLEIX ULTRIO Assay received European CE marking for use on the fully automated, high throughput PROCLEIX^®TIGRIS^® System. Under a collaboration agreement with Gen-Probe, we market and sell the PROCLEIX^® HIV-1/ HCV Assay, the PROCLEIX ULTRIO™ Assay and related instrument systems. In addition to selling directly in the U.S., we also sell in various international markets, directly and through distributors. We record revenue based upon the reported results obtained from the customer from the use of assays to screen donations or upon sale and delivery of the assays, depending on the underlying contract. In the case of equipment sales or leases, we record revenue upon the sale and transfer of the title of the instrument or ratably over the life of the lease term, respectively. For provision of service on the instruments, we recognize revenue ratably over the life of the service agreement.

The increase in product sales for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 was primarily due to $4.3 million from the conversion to the PROCLEIX^® ULTRIO™ Assay from the PROCLEIX^® HIV-1/HCV Assay outside of the U.S. and continued penetration into several markets abroad. The increase in product sales for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 was primarily due to $8.1 million from the conversion to the PROCLEIX^® ULTRIO™ Assay from the PROCLEIX^® HIV-1/HCV Assay outside the U.S. and from continued penetration into several markets abroad.

Revenue from joint business arrangement The increase in revenue from the joint business arrangement for the three months ended June 30, 2005 as compared with the three months ended June 30,

2004 was primarily due to $2.5 million from an increase in profitability realized by the joint business arrangement. The increase in revenue from the joint business arrangement for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 was primarily due to higher profitability realized by the joint business arrangement.

Collaborative agreement revenues Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and the achievement of milestones. Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the future. Our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners.

Royalty and license fee revenues Our blood-testing segment earns royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing our hepatitis C virus (HCV) and HIV-related (HIV) patents, for use in the blood screening and plasma fractionation markets. Our blood-testing segment also earns license fees related to our HCV and HIV patents for technologies used by third parties to develop products for use in the blood screening and plasma fractionation markets.

The increase in royalty and license fee revenues for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 was primarily due to (i) $2.7 million from a settlement with the Scottish National Blood Transfusion Service (SNBTS) regarding our HCV and HIV patents, (ii) $2.7 million from the Roche settlement reached in September 2004 as discussed below under “Other—Royalty and license fee revenues—Roche Settlement,” (iii) $2.5 million from increased royalties from Roche due to rate increases resulting from certain countries entering the European Union (EU) and an increase in reported donations and (iv) $1.2 million in royalties from our licensing agreement reached in 2004 with Laboratory Corporation of America Holdings (LabCorp) for our HCV intellectual property for nucleic acid testing.

The increase in royalty and license fee revenues for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 was primarily due to (i) $8.0 million from the Roche settlement, (ii) $3.3 million in royalties from Roche due to rate increases resulting from certain countries entering the EU and an increase in reported donations, (iii) $3.2 million in fees and royalties from our licensing agreement with LabCorp, (iv) $2.7 million from a settlement with the SNBTS regarding our HCV and HIV patents and (v) $1.3 million in royalty fees from the blood transfusion centers of the German Red Cross.

Royalty and license fee revenues may fluctuate based on the nature of the related agreements, the timing of receipt of license fees and the expiration of patents. Results in any one period are not necessarily indicative of results to be achieved in the future. Also, the license agreements typically provide for certain milestone payments and various royalties on future product sales if the licensee commercializes a product using our technology. However, we have no assurance that the licensee will meet their development objectives or commercialize a product using our technology. In addition, our ability to generate additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies.

Gross profit margin The decrease in gross profit margin for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 was primarily due to additional support and service costs associated with our fully automated, high throughput PROCLEIX^®TIGRIS^® System. Gross profit margin was consistent for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004.

Blood-testing gross profit margin may fluctuate in future periods as the blood-testing product and customer mix changes.

Research and development expenses The increase in research and development expenses for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004 was primarily due to $1.8 million for research activities focused primarily on variant Creutzfeldt-Jakob disease (vCJD), primarily offset by a $0.9 million decrease in costs relating to our nucleic acid testing products. The increase in research and development expenses for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 was primarily due to $4.4 million for research activities focused primarily on vCJD primarily offset by a $0.9 million decrease in costs relating to our nucleic acid testing products.

Research and development expenses may fluctuate from period to period depending upon the stage of certain projects and the level of pre-clinical and clinical trial-related activities.

Selling, general, and administrative expenses Selling, general, and administrative expenses were consistent for the three months ended June 30, 2005 as compared with the three months ended June 30, 2004. The increase in selling, general and administrative expenses for the six months ended June 30, 2005 as compared with the six months ended June 30, 2004 was primarily due to $2.5 million from the geographic expansion of our customer base for the PROCLEIX^® HIV-1/HCV Assay in international markets.

We expect continued growth in selling, general and administrative expenses related to nucleic acid testing technology and products as our sales opportunities expand in new markets through anticipated additional nucleic acid testing adoption.

Vaccines

	Three Months Ended						Six Months Ended
	June 30,						June 30,						$ Change						% Change
	2005			2004			2005			2004			Three Months			Six Months			Three Months		Six Months
				Restated						Restated
	($ in 000’s, except percentages)
Product sales, net:
Influenza vaccines:
Other Influenza vaccines	$	(492	)	$	8,207		$	3,079		$	13,467		$	(8,699	)	$	(10,388	)	(106.0	)%	(77.1	)%
FLUVIRIN^® vaccine	—			—			—			2,445			—			(2,445		)	—		(100.0	)%
Influenza vaccines	(492		)	8,207			3,079			15,912			(8,699		)	(12,833		)	(106.0	)%	(80.6	)%
Meningococcal vaccines	13,605			5,016			22,758			9,565			8,589			13,193			171.2	%	137.9	%
Travel vaccines	45,014			26,261			88,773			49,271			18,753			39,502			71.4	%	80.2	%
Pediatric and other vaccines	39,127			47,619			69,620			98,802			(8,492		)	(29,182		)	(17.8	)%	(29.5	)%
	97,254			87,103			184,230			173,550			10,151			10,680			11.7	%	6.2	%
Collaborative agreement revenues	999			1,214			3,241			5,180			(215		)	(1,939		)	(17.7	)%	(37.4	)%
Royalty and license fee revenues	769			25			2,185			2,675			744			(490		)	2,976.0	%	(18.3	)%
Other revenues	2,480			5,914			5,756			9,556			(3,434		)	(3,800		)	(58.1	)%	(39.8	)%
Total Vaccines revenues	$	101,502		$	94,256		$	195,412		$	190,961		$	7,246		$	4,451		7.7	%	2.3	%
Gross profit margin	7		%	34		%	2		%	34		%
Research and development expenses	$	34,387		$	31,918		$	67,943		$	66,328		$	2,469		$	1,615		7.7	%	2.4