**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q/A**

 

**(Mark one)**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.** |
|------------|------------|------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended June 30, 2004**

 

**OR**

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

 

**For the transition periodfrom                    to                    **

 

**Commission File Number: 0-12798**

 

**CHIRON CORPORATION**

(Exactname 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 markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes ý    No o

 

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

 

Yes ý    No o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latest practicabledate.

 
| **Title of Class**             | ** ** | **Outstanding at July 30, 2004** |
|--------------------------------|------------|----------------------------------|
| Common  Stock, $0.01 par value |       | 187,718,517                      |

 

 

----

 

**EXPLANATORY NOTE**

 

This Form 10Q/A (the “Report”) is being filed to amendChiron Corporation’s (the “Company”) Quarterly Report on Form 10-Q filed onAugust 9, 2004  (the “Original Report”)for the quarterly period ended June 30, 2004 to reflect the restatement of theCompany’s previously issued financial statements as of and for the three andsix month periods ended June 30, 2004, and the notes related thereto, asdescribed below, and to make related changes. The information in this Reportpresented as of the date of the Original Report does not reflect subsequentresults, events or developments.  Suchsubsequent results, events or developments include, among others, theinformation and events subsequently described in our Quarterly Reports on Form10-Q, our Annual Reports on Form 10-K and our Current Reports on Form 8-K.  For a description of such subsequent results,events or developments, please read our Exchange Act Reports filed with theSecurities and Exchange Commission since the date of the Original Report, whichupdate and supersede information contained in the Original Report and thisReport.

 

Chiron has determined that certain sales of a travelvaccine recorded as revenues in the second quarter of 2004 should not have beenrecorded as revenue at that time, and that portions of those sales should havebeen recorded as revenues in the third and fourth quarters of 2004 and possiblyin later quarters.  See Note 1 to Chiron’sCondensed Consolidated Financial Statements, included herein, for additionaldiscussion.

 

Chiron has reflected the results of the restatementfor the fiscal year ended December 31, 2004 in its Annual Report on Form 10-Kfor such year, filed with the SEC on March 16, 2005, and has restated itsinterim financial statements in this Report and in an additional QuarterlyReport on Form 10-Q/A for the quarterly period ended September 30, 2004.

 

In 2004, the Emerging Issues Task Force (EITF) reached a consensus onEITF Issue No. 04-8 “The Effect of Contingently Convertible Instruments onDiluted Earnings per Share,” that the dilutive effect of contingently convertibledebt instruments (“CoCo’s”) must be included in diluted earnings per shareregardless of whether the triggering contingency has been satisfied, ifdilutive. Adoption of Issue No. 04-8 would be on a retroactive basis andwould require restatement of prior period diluted earnings per share. Chironadopted EITF Issue No. 04-08 in the fourth quarter of 2004.  The adoption of EITF Issue No. 04-08 did notresult in additional dilution to our diluted earnings per share from our$500.0 million convertible debentures due 2033 nor from our$385.0 million convertible debentures due 2034 for the three and sixmonths ended June 30, 2004, as discussed in Note 2 to Chiron’s CondensedConsolidated Financial Statements.

 

**CHIRON CORPORATION**

 

**TABLE OF CONTENTS**

 
| ** **                                                                                                                 | **Page  No.** |
|----------------------------------------------------------------------------------------------------------------------------|---------------|
| **PART I.  FINANCIAL INFORMATION**                                                                                         | ** **    |
| ** **                                                                                                                 | ** **    |
| **ITEM 1. Financial  Statements (Unaudited)**                                                                              |          |
|                                                                                                                       | ** **    |
| Condensed Consolidated  Balance Sheets at June 30, 2004 and December 31, 2003                                    | 3             |
|                                                                                                                       |          |
| Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2004 and 2003           | 5             |
|                                                                                                                       |          |
| Condensed  Consolidated Statements of Comprehensive Income for the three and six months  ended June 30, 2004 and 2003 | 6             |
|                                                                                                                       |          |
| Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2004 and 2003                     | 7             |
|                                                                                                                       |          |
| Notes  to Condensed Consolidated Financial Statements                                                                      | 8             |
|                                                                                                                       |          |
| **ITEM  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations**                   | 20            |
|                                                                                                                       |          |
| **ITEM 4. Controls and  Procedures**                                                                                       | 38            |
|                                                                                                                       |          |
| **ITEM 6. Exhibits**                                                                                                       | 39            |
|                                                                                                                       |          |
| **SIGNATURES**                                                                                                             | 40            |

 

2

----

 

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

 

**CHIRON CORPORATION**

 

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 

**(Unaudited)**

 

**(In thousands, except share data)**

 
| ** **                                                       | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                       | ** ** | **Restated**       | ** ** | ** **             | ** ** |
| **ASSETS**                                                       |       |               |       |                   |       |
| Current assets:                                                  |       |               |       |                   |       |
| Cash and cash  equivalents                                       |       | $                  | 595,023    |                   | $          | 364,270 |   |
| Short-term  investments in marketable debt securities            |       | 235,964            |       | 174,212                |       |
| Total cash and  short-term investments                           |       | 830,987            |       | 538,482                |       |
| Accounts  receivable, net of allowances                          |       | 329,856            |       | 382,933                |       |
| Current portion  of notes receivable                             |       | 500                |       | 1,479                  |       |
| Inventories, net  of reserves                                    |       | 275,574            |       | 199,625                |       |
| Assets held for  sale                                            |       | 3,044              |       | 2,992                  |       |
| Current net  deferred income tax assets                          |       | 59,992             |       | 50,204                 |       |
| Derivative  financial instruments                                |       | 3,871              |       | 9,463                  |       |
| Other current  assets                                            |       | 78,217             |       | 72,471                 |       |
| Total current  assets                                            |       | 1,582,041          |       | 1,257,649              |       |
| Noncurrent  investments in marketable debt securities            |       | 202,979            |       | 560,292                |       |
| Property, plant,  equipment and leasehold improvements, at cost: |       |               |       |                   |       |
| Land and  buildings                                              |       | 368,791            |       | 366,275                |       |
| Laboratory,  production and office equipment                     |       | 614,178            |       | 615,814                |       |
| Leasehold  improvements                                          |       | 114,377            |       | 112,200                |       |
| Construction-in-progress                                         |       | 175,956            |       | 144,162                |       |
|                                                             |       | 1,273,302          |       | 1,238,451              |       |
| Less accumulated  depreciation and amortization                  |       | (544,635           | )          | (548,701               | )          |
| Property, plant,  equipment and leasehold improvements, net      |       | 728,667            |       | 689,750                |       |
| Purchased  technologies, net                                     |       | 226,297            |       | 236,707                |       |
| Goodwill                                                         |       | 806,759            |       | 787,587                |       |
| Other intangible  assets, net                                    |       | 464,695            |       | 486,889                |       |
| Investments in  equity securities and affiliated companies       |       | 114,633            |       | 121,576                |       |
| Equity method  investments                                       |       | 889                |       | 953                    |       |
| Noncurrent notes  receivable                                     |       | 7,500              |       | 7,500                  |       |
| Noncurrent  derivative financial instruments                     |       | —             |       | 7,391                  |       |
| Other noncurrent  assets                                         |       | 51,030             |       | 38,875                 |       |
|                                                             |       | $                  | 4,185,490  |                   | $          | 4,195,169 |   |

 

Theaccompanying Notes to Condensed Consolidated Financial Statements are integralto this statement.

 

3

----

 

**CHIRON CORPORATION**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (Continued)**

 

**(Unaudited)**

 

**(In thousands, except share data)**

** **
| ** **                                                                                                        | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                        | ** ** | **Restated**       | ** ** | ** **             | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                     |       |               |       |                   |       |
| Current  liabilities:                                                                                             |       |               |       |                   |       |
| Accounts payable                                                                                                  |       | $                  | 112,778    |                   | $          | 102,201 |   |
| Accrued  compensation and related expenses                                                                        |       | 64,296             |       | 83,311                 |       |
| Current portion  of capital lease                                                                                 |       | 244                |       | 570                    |       |
| Current portion  of unearned revenue                                                                              |       | 72,681             |       | 47,873                 |       |
| Income taxes  payable                                                                                             |       | 13,099             |       | 15,270                 |       |
| Other current  liabilities                                                                                        |       | 124,940            |       | 187,688                |       |
| Total current  liabilities                                                                                        |       | 388,038            |       | 436,913                |       |
| Long-term debt                                                                                                    |       | 938,087            |       | 926,709                |       |
| Capital lease                                                                                                     |       | 157,075            |       | 157,677                |       |
| Noncurrent  derivative financial instruments                                                                      |       | 3,677              |       | —                 |       |
| Noncurrent net  deferred income tax liabilities                                                                   |       | 90,848             |       | 107,496                |       |
| Noncurrent  unearned revenue                                                                                      |       | 35,330             |       | 45,564                 |       |
| Other noncurrent  liabilities                                                                                     |       | 85,776             |       | 69,448                 |       |
| Minority  interest                                                                                                |       | 7,984              |       | 7,002                  |       |
| Total  liabilities                                                                                                |       | 1,706,815          |       | 1,750,809              |       |
| Commitments and  contingencies                                                                                    |       |               |       |                   |       |
| Stockholders’  equity:                                                                                       |       |               |       |                   |       |
| Common stock                                                                                                      |       | 1,917              |       | 1,917                  |       |
| Additional  paid-in capital                                                                                       |       | 2,527,313          |       | 2,503,195              |       |
| Deferred stock  compensation                                                                                      |       | (18,929            | )          | (12,871                | )          |
| Accumulated  deficit                                                                                              |       | (1,719             | )          | (46,634                | )          |
| Accumulated  other comprehensive income                                                                           |       | 171,805            |       | 216,302                |       |
| Treasury stock,  at cost (4,063,000 shares at June 30, 2004 and 4,567,000 shares at  December 31, 2003) |       | (201,712           | )          | (217,549               | )          |
| Total  stockholders’ equity                                                                                  |       | 2,478,675          |       | 2,444,360              |       |
|                                                                                                              |       | $                  | 4,185,490  |                   | $          | 4,195,169 |   |

 

Theaccompanying Notes to Condensed Consolidated Financial Statements are integralto this statement.

 

4

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**CHIRON CORPORATION**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

 

**(Unaudited)**

 

**(In thousands, except per share data)**

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **Restated**                     | ** ** | ** **                     | ** ** | **Restated** | ** ** | ** ** | ** ** |
| Revenues:                                              |       |                             |       |                           |       |   |   |   |   |
| Product sales,  net                                    |       | $                                | 281,221    |                           | $          | 245,928 |   | $ | 562,287 |   | $ | 464,548 |   |
| Revenues from  joint business arrangement              |       | 28,532                           |       | 27,475                         |       | 58,893 |   | 53,927 |   |
| Collaborative  agreement revenues                      |       | 3,828                            |       | 3,624                          |       | 10,343 |   | 7,738 |   |
| Royalty and  license fee revenues                      |       | 55,196                           |       | 66,876                         |       | 109,988 |   | 120,300 |   |
| Other revenues                                         |       | 10,975                           |       | 6,369                          |       | 17,913 |   | 24,794 |   |
| Total revenues                                         |       | 379,752                          |       | 350,272                        |       | 759,424 |   | 671,307 |   |
| Operating  expenses:                                   |       |                             |       |                           |       |   |   |   |   |
| Cost of sales                                          |       | 129,228                          |       | 97,420                         |       | 255,929 |   | 183,009 |   |
| Research and  development                              |       | 100,326                          |       | 89,915                         |       | 198,736 |   | 172,045 |   |
| Selling, general  and administrative                   |       | 106,857                          |       | 80,226                         |       | 211,597 |   | 153,268 |   |
| Amortization  expense                                  |       | 21,179                           |       | 7,701                          |       | 42,511 |   | 15,314 |   |
| Other operating  expenses                              |       | 4,644                            |       | 1,259                          |       | 6,760 |   | 2,950 |   |
| Total operating  expenses                              |       | 362,234                          |       | 276,521                        |       | 715,533 |   | 526,586 |   |
| Income from  operations                                |       | 17,518                           |       | 73,751                         |       | 43,891 |   | 144,721 |   |
| Interest expense                                       |       | (6,452                           | )          | (2,839                         | )          | (12,377 | ) | (6,301 | ) |
| Interest and  other income, net                        |       | 19,809                           |       | 11,613                         |       | 35,883 |   | 25,931 |   |
| Minority  interest                                     |       | (459                             | )          | (581                           | )          | (1,079 | ) | (981 | ) |
| Income from  continuing operations before income taxes |       | 30,416                           |       | 81,944                         |       | 66,318 |   | 163,370 |   |
| Provision for  income taxes                            |       | 7,604                            |       | 20,485                         |       | 16,579 |   | 40,842 |   |
| Income from  continuing operations                     |       | 22,812                           |       | 61,459                         |       | 49,739 |   | 122,528 |   |
| Gain from  discontinued operations                     |       | 12,459                           |       | 538                            |       | 25,304 |   | 1,964 |   |
| Net income                                             |       | $                                | 35,271     |                           | $          | 61,997 |   | $ | 75,043 |   | $ | 124,492 |   |
| Basic earnings  per share:                             |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                     |       | $                                | 0.12       |                           | $          | 0.33 |   | $ | 0.26 |   | $ | 0.66 |   |
| Net income                                             |       | $                                | 0.19       |                           | $          | 0.33 |   | $ | 0.40 |   | $ | 0.67 |   |
| Diluted earnings  per share:                           |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                     |       | $                                | 0.12       |                           | $          | 0.32 |   | $ | 0.26 |   | $ | 0.65 |   |
| Net income                                             |       | $                                | 0.18       |                           | $          | 0.33 |   | $ | 0.39 |   | $ | 0.66 |   |

 

Theaccompanying Notes to Condensed Consolidated Financial Statements are integralto this statement.

 

5

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** **

**CHIRON CORPORATION**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

 

**(Unaudited)**

 

**(In thousands)**

 
| ** **                                                                                                                                                                                                                                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                  | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                                                                                                  | ** ** | **Restated**                     | ** ** | ** **                     | ** ** | **Restated** | ** ** | ** ** | ** ** |
| Net income                                                                                                                                                                                                                                                                                  |       | $                                | 35,271     |                           | $          | 61,997 |   | $ | 75,043 |   | $ | 124,492 |   |
| Other  comprehensive income (loss):                                                                                                                                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Change in  foreign currency translation adjustment during the period                                                                                                                                                                                                                        |       | (15,784                          | )          | 35,823                         |       | (37,412 | ) | 45,118 |   |
|                                                                                                                                                                                                                                                                                        |       |                             |       |                           |       |   |   |   |   |
| Unrealized gains  (losses) from investments:                                                                                                                                                                                                                                                |       |                             |       |                           |       |   |   |   |   |
| Net unrealized  holding gains (losses) arising during the period, net of tax (provision)  benefit of $4,610 and ($1,541) for the three months ended June 30, 2004  and 2003, respectively, and $2,112 and ($1,284) for the six months ended  June 30, 2004 and 2003, respectively |       | 6,267                            |       | 3,083                          |       | 7,544 |   | 2,640 |   |
| Reclassification  adjustment for net gains included in net income, net of tax provision of  $2,965 and $1,834 for the three months ended June 30, 2004 and 2003,  respectively, and $9,353 and $3,626 for the six months ended June 30, 2004  and 2003, respectively                        |       | (11,361                          | )          | (2,940                         | )          | (14,629 | ) | (5,744 | ) |
| Net unrealized  gains (losses) from investments                                                                                                                                                                                                                                             |       | (5,094                           | )          | 143                            |       | (7,085 | ) | (3,104 | ) |
| Other  comprehensive income (loss)                                                                                                                                                                                                                                                          |       | (20,878                          | )          | 35,966                         |       | (44,497 | ) | 42,014 |   |
| Comprehensive  income                                                                                                                                                                                                                                                                       |       | $                                | 14,393     |                           | $          | 97,963 |   | $ | 30,546 |   | $ | 166,506 |   |

 

Theaccompanying Notes to Condensed Consolidated Financial Statements are integralto this statement.

 

6

----

 

**CHIRON CORPORATION**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

 

**(Unaudited)**

 

**(In thousands)**

 
| ** **                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| ** **                                                                       | ** ** | **Restated**                   | ** ** | ** ** | ** ** |
| Net cash  provided by operating activities                                       |       | $                              | 74,730     |   | $ | 112,706 |   |
| Cash flows from  investing activities:                                           |       |                           |       |   |   |
| Purchases of  investments in marketable debt securities                          |       | (218,815                       | )          | (277,514 | ) |
| Proceeds from  sales and maturities of investments in marketable debt securities |       | 508,121                        |       | 917,794 |   |
| Capital  expenditures                                                            |       | (93,770                        | )          | (52,371 | ) |
| Purchases of  equity securities and interests in affiliated companies            |       | (4,349                         | )          | (36,889 | ) |
| Proceeds from  sale of equity securities and interests in affiliated companies   |       | 16,277                         |       | 7,428 |   |
| Cash paid for  acquisitions, net of cash acquired                                |       | (19,548                        | )          | (1,180 | ) |
| Other, net                                                                       |       | 783                            |       | (777 | ) |
| Net cash  provided by investing activities                                       |       | 188,699                        |       | 556,491 |   |
| Cash flows from  financing activities:                                           |       |                           |       |   |   |
| Net repayment of  short-term borrowings                                          |       | —                         |       | (71 | ) |
| Repayment of  debt and capital leases                                            |       | (380,035                       | )          | (95 | ) |
| Payments to  acquire treasury stock                                              |       | (71,726                        | )          | (68,079 | ) |
| Proceeds from  reissuance of treasury stock                                      |       | 45,001                         |       | 24,526 |   |
| Proceeds from  issuance of debt                                                  |       | 2,317                          |       | — |   |
| Payment of bond  issuance costs                                                  |       | (7,766                         | )          | — |   |
| Proceeds from  issuance of convertible debentures                                |       | 385,000                        |       | — |   |
| Proceeds from  put options                                                       |       | —                         |       | 2,144 |   |
|                                                                             |       |                           |       |   |   |
| Net cash used in  financing activities                                           |       | (27,209                        | )          | (41,575 | ) |
|                                                                             |       |                           |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                    |       | (5,467                         | )          | 471 |   |
|                                                                             |       |                           |       |   |   |
| Net increase in  cash and cash equivalents                                       |       | 230,753                        |       | 628,093 |   |
| Cash and cash  equivalents at beginning of the period                            |       | 364,270                        |       | 247,950 |   |
|                                                                             |       |                           |       |   |   |
| Cash and cash  equivalents at end of the period                                  |       | $                              | 595,023    |   | $ | 876,043 |   |

 

Theaccompanying Notes to Condensed Consolidated Financial Statements are integralto this statement.

 

7

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**CHIRON CORPORATION**

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**June 30, 2004**

 

**(Unaudited)**

 

**Note 1—Basisof Presentation and Summary of Significant Accounting Policies**

 

*Basis ofPresentation*

* *

The information presented inthe Condensed Consolidated Financial Statements at June 30, 2004, and forthe three and six months ended June 30, 2004 and 2003, is unaudited butincludes adjustments, consisting only of all normal recurring adjustments,which Chiron Corporation believes to be necessary for fair presentation of theperiods presented.

 

The Condensed ConsolidatedBalance Sheet amounts at December 31, 2003, have been derived from auditedfinancial statements. Historically, Chiron’s operating results have variedconsiderably from period to period due to the nature of Chiron’s collaborative,royalty and license arrangements and the seasonality of certain vaccineproducts. In addition, the mix of products sold and the introduction of newproducts will affect comparability from quarter to quarter. As a consequence,Chiron’s interim results in any one quarter are not necessarily indicative ofresults to be expected for a full year. This information should be read inconjunction with Chiron’s audited Consolidated Financial Statements as of andfor the year ended December 31, 2003, which are included in the AnnualReport on Form 10-K filed by Chiron with the Securities and ExchangeCommission.

 

*Restatement ofFinancial Statements*

* *

Chiron determined that certain sales of a travelvaccine recorded as revenues in the second quarter of 2004 should not have beenrecorded as revenue at that time, and that portions of those sales should havebeen recorded as revenues in the third and fourth quarters of 2004 and possiblyin later quarters.

 

As a result of the restatement, for the three and sixmonths ended June 30, 2004, product sales were reduced by $13.9 million, costof sales were reduced by $1.5 million and income taxes were reduced by $3.1million. This resulted in a $9.3 million reduction in income from continuingoperations and net income and a $0.05 reduction of diluted income fromcontinuing operations per share ($0.12 per share instead of the $0.17 per shareas previously reported). On the June 30, 2004 consolidated balance sheet,the current portion of unearned revenue was increased by $12.3 million andincome taxes payable was reduced by $3.1 million.

 

*Principlesof Consolidation*

 

The Condensed ConsolidatedFinancial Statements include the accounts of Chiron and its majority-ownedsubsidiaries. For consolidated majority-owned subsidiaries in which Chiron ownsless than 100%, Chiron records minority interest in the Condensed ConsolidatedFinancial Statements to account for the ownership interest of the minorityowner. Investments in limited partnerships and interests in which Chiron has anequity interest of 50% or less are accounted for using either the equity orcost method. All significant intercompany accounts and transactions have beeneliminated in consolidation.

 

On July 8, 2003, Chironacquired PowderJect Pharmaceuticals plc, a company based in Oxford, Englandthat develops and commercializes vaccines. Chiron included PowderJectPharmaceuticals’ operating results in its consolidated operating resultsbeginning July 8, 2003. PowderJect Pharmaceuticals is part of Chiron’svaccines segment.

 

Chiron is a limited partnerin several venture capital funds. Chiron is obligated to pay up to$60.0 million over ten years in equity contributions to these venturecapital funds, of which approximately $36.5 million was paid throughJune 30, 2004. Chiron accounts for these investments under the equitymethod of accounting.

 

*Adoption ofNew Accounting Pronouncements*

 

Financial AccountingStandards Board (or FASB) Interpretation No. 46 (or FIN 46), “Consolidationof Variable Interest Entities, an interpretation of Accounting ResearchBulletin No. 51” as revised, requires a variable interest entity (or VIE)to be consolidated by a company if that company absorbs a majority of the VIEsexpected losses, receives a majority of the entity’s expected residual returns,or both, as a result of ownership, contractual or other financial interest inthe VIE. Prior to the adoption of FIN 46, VIEs were generally consolidated bycompanies owning a majority voting interest in the VIE. The consolidationrequirements of FIN 46 applied immediately to VIEs created afterJanuary 31, 2003, however, the FASB deferred the effective date for VIEscreated before February 1, 2003 to the quarter ended March 31, 2004for calendar year companies. Adoption of the provisions of FIN 46 prior to thedeferred effective date was permitted.

 

We adopted the remainingprovisions of FIN 46 in the first quarter of 2004. The adoption of theseprovisions did not have a material effect on our Condensed ConsolidatedFinancial Statements.

 

8

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*Use ofEstimates and Reclassifications*

 

The preparation of financialstatements requires management to make estimates, assumptions and judgmentsthat affect the reported amounts of assets, liabilities, revenues and expenses,and related disclosures of contingent assets and liabilities. On an on-goingbasis, management evaluates its estimates, including those related toinvestments; 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; andlitigation and other contingencies. Chiron bases its estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from thoseestimates under different assumptions or conditions.

 

Chiron’s blood-testingsegment includes Chiron’s one-half share in the pretax operating earningsgenerated by the joint business contractual arrangement with Ortho-ClinicalDiagnostics, Inc., a Johnson & Johnson company. Chiron accountsseparately for research and development and manufacturing cost reimbursementsand certain product sale revenues received from Ortho-Clinical Diagnostics, butrelating to the joint business contractual arrangement. Chiron’s joint businessarrangement with Ortho-Clinical Diagnostics is a contractual arrangement and isnot a separate and distinct legal entity. Through Chiron’s joint businesscontractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line ofimmunodiagnostic tests to detect hepatitis viruses and retroviruses andprovides supplemental tests and microplate and chemiluminescent instrumentsystems to automate test performance and data collection. Prior to the firstquarter 2003, Chiron had accounted for revenues relating to Ortho-ClinicalDiagnostics’ non-U.S. affiliate sales on a one-quarter lag, with an adjustmentof the estimate to actual in the subsequent quarter. More current informationof Ortho-Clinical Diagnostics’ non-U.S. affiliate sales became available in thefirst quarter 2003, and as a result, Chiron is able to recognize revenuesrelating to Ortho-Clinical Diagnostics’ non-U.S. affiliate sales on a one-monthlag. The effect of this change, net of tax, was an increase to net income by$3.2 million for revenue from the joint business contractual arrangementfor the six months ended June 30, 2003.

 

Chiron currently owns a facility in London, England for internationaloperations. This facility became available for sale in the fourth quarter of2003 and Chiron expects to complete the sale of this facility within one yearof the date it became available for sale. Chiron has committed to a plan tosell this facility and is actively marketing this facility. This facility isclassified as “Assets held for sale” in the Condensed Consolidated Balance Sheetat June 30, 2004.

 

Chiron, prior to filing itsfinancial statements on Form 10-Q, publicly releases an unauditedcondensed balance sheet and statement of operations. Between the date of Chiron’searnings release and the filing of Form 10-Q, reclassifications may berequired. These reclassifications, when made, have no effect on income fromcontinuing operations, net income or earnings per share. There has been no suchreclassification in the second quarter 2004.

 

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

 

*Inventories*

 

Inventories, net of reserves,are stated at the lower of cost or market using the moving weighted-averagecost method. Chiron maintains inventory reserves primarily for product failures,expiration and obsolescence. Inventory that is obsolete (inventory that will nolonger be used in the manufacturing process), expired, or in excess offorecasted usage is written down to its market value, if lower than cost.

 

Inventories, net of reserves,consisted of the following:

 
| ** **      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------|------------|--------------------|------------|-----------------------------|------------|
| Finished goods  |       | $                  | 49,734     |                        | $          | 38,640 |   |
| Work-in-process |       | 169,715            |       | 105,359                     |       |
| Raw materials   |       | 56,125             |       | 55,626                      |       |
|            |       | $                  | 275,574    |                        | $          | 199,625 |   |

 

9

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*IncomeTaxes*

 

The effective tax rate forthe three and six months ended June 30, 2004 and 2003 was 25% of pretaxincome from continuing operations. The effective tax rate may be affected infuture periods by changes in Chiron’s estimates with respect to the deferredtax assets, acquisitions and other items affecting the overall tax rate.

 

*Put Options*

 

Chiron has, in the past, usedwritten put options to reduce the effective costs of repurchasing its commonstock. After expiration of existing put options in the second quarter of 2003,Chiron discontinued the use of put options. Chiron had no put optionsoutstanding at June 30, 2004.

 

*Stock-BasedCompensation*

 

Chiron measures compensationexpense for its stock-based employee compensation plans using the intrinsicvalue method. Compensation expense is based on the difference, if any, betweenthe fair value of Chiron’s common stock and the exercise price of the option orshare right on the measurement date, which is typically the date of grant. Thisamount is recorded as “Deferred stock compensation” in the CondensedConsolidated Balance Sheets and amortized as a charge to operations over thevesting period of the applicable options or share rights. Compensation expenseis included primarily in “Selling, general and administrative” in the CondensedConsolidated Statements of Operations.

 

The following tableillustrates the effect on net income and related net income per share, hadcompensation cost for stock-based compensation plans been determined based uponthe fair value method:

 
| ** **                                                                                                                                  | ** ** | **Three Months Ended  June 30,**      | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2004**                                   | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                  |       | **(in  thousands, except per share data)** |       |
| Net income:                                                                                                                                 |       |                                       |       |                                |       |   |   |   |   |
| As reported                                                                                                                                 |       | $                                          | 35,271     |                                | $          | 61,997 |   | $ | 75,043 |   | $ | 124,492 |   |
| Add: Stock-based  employee compensation expense included in reported net income, net of related  tax effects                                |       | 1,349                                      |       | 1,750                               |       | 2,689 |   | 2,651 |   |
| Less: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 22,769                                     |       | 19,933                              |       | 44,277 |   | 38,045 |   |
| Pro forma                                                                                                                                   |       | $                                          | 13,851     |                                | $          | 43,814 |   | $ | 33,455 |   | $ | 89,098 |   |
|                                                                                                                                        |       |                                       |       |                                |       |   |   |   |   |   |   |   |   |
| Basic net income  per share:                                                                                                                |       |                                       |       |                                |       |   |   |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.19       |                                | $          | 0.33 |   | $ | 0.40 |   | $ | 0.67 |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.07       |                                | $          | 0.24 |   | $ | 0.18 |   | $ | 0.48 |   |
| Diluted net  income per share:                                                                                                              |       |                                       |       |                                |       |   |   |   |   |
| As reported                                                                                                                                 |       | $                                          | 0.18       |                                | $          | 0.33 |   | $ | 0.39 |   | $ | 0.66 |   |
| Pro forma                                                                                                                                   |       | $                                          | 0.07       |                                | $          | 0.23 |   | $ | 0.18 |   | $ | 0.47 |   |

* *

*ComprehensiveIncome*

 

For the three and six monthsended June 30, 2004 and 2003, the foreign currency translation componentof comprehensive income relates to permanent investments in non-U.S.subsidiaries, and accordingly, was not adjusted for income taxes.

 

*TreasuryStock*

 

Treasury stock is stated atcost. Gains on reissuance of treasury stock are credited to “Additional paid-incapital.” Losses on reissuance of treasury stock are charged to “Additionalpaid-in capital” to the extent of available net gains on reissuance of treasurystock. Otherwise, losses are charged to “Accumulated deficit.” Chiron chargedlosses of $4.7 million and $30.1 million for the three and six monthsended June 30, 2004, respectively, and $16.3 million and$23.8 million for the three and six months ended June 30, 2003,respectively, to “Accumulated deficit” in the Condensed Consolidated BalanceSheets.

 

10

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**Note 2—EarningsPer Share**

 

Basic earnings per share is based upon the weighted-average number ofcommon shares outstanding. Diluted earnings per share is based upon theweighted-average number of common shares and dilutive potential common sharesoutstanding. Dilutive potential common shares could result from (i) theassumed exercise of outstanding stock options, warrants and equivalents, whichare included under the treasury-stock method; (ii) performance units tothe extent that dilutive shares are assumed issuable; (iii) the assumedexercise of outstanding put options, which are included under the reversetreasury-stock method; and (iv) convertible notes and debentures, whichare included under the if-converted method. Due to rounding, quarterly amountsmay not sum fully to yearly amounts.

 

Contingently convertible debt instruments (“CoCos”)are included in diluted earnings per share, if dilutive. For the three and sixmonths ended June 30, 2004, Chiron’s $500.0 million contingently convertibledebentures due 2033 (“2033 Debentures”) and Chiron’s $385.0 millioncontingently convertible debentures due 2034 (“2034 Debentures”) were excludedfrom the computations of diluted earnings per share as each of these CoCos werenot dilutive.

 

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

 
| ** **                                                                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income  (Numerator):                                                              |       |                                  |       |                                |       |   |   |   |   |
| Income from  continuing operations                                                |       | $                                     | 22,812     |                                | $          | 61,459 |   | $ | 49,739 |   | $ | 122,528 |   |
| Shares  (Denominator):                                                            |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average  common shares outstanding                                       |       | 188,275                               |       | 186,408                             |       | 187,952 |   | 186,584 |   |
| Effect of  dilutive securities:                                                   |       |                                  |       |                                |       |   |   |   |   |
| Stock options  and equivalents                                                    |       | 2,710                                 |       | 3,550                               |       | 3,450 |   | 3,294 |   |
| Put options                                                                       |       | —                                |       | 5                                   |       | — |   | 3 |   |
|                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average  common shares outstanding, plus impact from assumed conversions |       | 190,985                               |       | 189,963                             |       | 191,402 |   | 189,881 |   |
| Basic earnings  per share                                                         |       | $                                     | 0.12       |                                | $          | 0.33 |   | $ | 0.26 |   | $ | 0.66 |   |
|                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Diluted earnings  per share                                                       |       | $                                     | 0.12       |                                | $          | 0.32 |   | $ | 0.26 |   | $ | 0.65 |   |

 

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

 
| ** **                                                                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income  (Numerator):                                                              |       |                                  |       |                                |       |   |   |   |   |
| Net income                                                                        |       | $                                     | 35,271     |                                | $          | 61,997 |   | $ | 75,043 |   | $ | 124,492 |   |
| Shares (Denominator):                                                             |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average  common shares outstanding                                       |       | 188,275                               |       | 186,408                             |       | 187,952 |   | 186,584 |   |
| Effect of  dilutive securities:                                                   |       |                                  |       |                                |       |   |   |   |   |
| Stock options  and equivalents                                                    |       | 2,710                                 |       | 3,550                               |       | 3,450 |   | 3,294 |   |
| Put options                                                                       |       | —                                |       | 5                                   |       | — |   | 3 |   |
| Weighted-average  common shares outstanding, plus impact from assumed conversions |       | 190,985                               |       | 189,963                             |       | 191,402 |   | 189,881 |   |
| Basic earnings  per share                                                         |       | $                                     | 0.19       |                                | $          | 0.33 |   | $ | 0.40 |   | $ | 0.67 |   |
| Diluted earnings  per share                                                       |       | $                                     | 0.18       |                                | $          | 0.33 |   | $ | 0.39 |   | $ | 0.66 |   |

 

 

11

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For the three months endedJune 30, 2004 and 2003, stock options to purchase 11.8 million and16.8 million shares, respectively, and for the six months endedJune 30, 2004 and 2003, stock options to purchase 7.6 million and17.1 million shares, respectively, with exercise prices greater than theaverage market prices of common stock, were excluded from the respectivecomputations of diluted earnings per share as their inclusion would beantidilutive.

 

The dilutive effect of CoCos must be included indiluted earnings per share regardless of whether the triggering contingency hasbeen satisfied, if dilutive. For the three and six months ended June 30, 2004,7.3 million shares of common stock issuable upon conversion of the 2033Debentures were excluded from the computations of diluted earnings per share astheir inclusion would be antidilutive. If the 2034 Debentures are tendered for conversion, the value (“ConversionValue”) of cash and shares of Chiron’s common stock, if any, to be received bya holder converting $1,000 principal amount of the debentures will bedetermined by multiplying the applicable conversion rate by a weighted averageprice. 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 isgreater that the Principal Return, an amount in shares (“Net Shares”) equal tothe aggregate Conversion Value less the Principal Return (“Net Share Amount”).The number of Net Shares to be paid will be determined by dividing the NetShare Amount by a weighted average price. If dilutive, common shares to beadded to the diluted shares outstanding would be determined by the net sharesettlement of the 2034 Debentures. For the three and six months ended June 30,2004, the assumed conversion of the 2034 Debentures was not dilutive.

 

For the three and six monthsended June 30, 2004, 4.1 million and 6.2 million shares ofcommon stock that would be issued upon conversion of the Liquid Yield OptionNotes (LYONs) were excluded from the computations of diluted earnings pershare, as their inclusion would be antidilutive. For each of the three and sixmonths ended June 30, 2003, 5.2 million shares of common stock thatwould be issued upon conversion of the LYONs were excluded from the computationof diluted earnings per share, as their inclusion would be antidilutive. Duringthe second quarter of 2004, Chiron was required to purchase a significantportion of the LYONs as discussed in Note 7 “Debt Obligations”.

 

**Note 3—DiscontinuedOperations**

 

In a strategic effort tofocus on its core businesses of blood-testing, vaccines and biopharmaceuticals,Chiron completed the sale of Chiron Diagnostics and Chiron Vision in 1998 and1997, respectively.

 

In the first quarter 2003,Chiron and Bayer Corporation reached a settlement agreement relating to certainclaims raised by Bayer under the Stock Purchase Agreement datedSeptember 17, 1998, between Chiron and Bayer for Chiron Diagnostics. Underthis settlement agreement, Chiron was required to make a payment to Bayerduring the first quarter 2003. Pursuant to this settlement, Chiron recorded acharge, net of adjustment to its previously provided reserve for indemnityobligations, of $7.6 million, offset by an income tax benefit of$9.0 million, resulting in a net gain of $1.4 million which wasreported as a “Gain from discontinued operations” for the six months endedJune 30, 2003.

 

In the second quarter 2003,we reversed approximately $0.5 million related to unutilized reserves ofChiron Diagnostics and Chiron Vision, which were recorded as a “Gain fromdiscontinued operations” for the three and six months ended June 30, 2003.

 

Chiron and Bayer also wereinvolved in a separate dispute with respect to their respective rights tocertain royalty refunds receivable for which a settlement was reached in 2004.Under this settlement agreement, Chiron made a payment to Bayer in 2004. Thissettlement includes an agreement that all outstanding items with Bayer relatedto the sale of Chiron Diagnostics are resolved and no future indemnityobligations are required. Chiron released previously established reserves inexcess of the required payments for the indemnity obligations in the firstquarter of 2004. This settlement resulted in a benefit of $0.3 million andan income tax benefit of $12.5 million, resulting in a net gain of$12.8 million, which was reported as a “Gain from discontinued operations”for the six months ended June 30, 2004.

 

In the second quarter 2004,Chiron and the IRS entered into a settlement agreement closing the open taxyears 1996 to 1998. Pursuant to this settlement agreement Chiron recognized atax benefit of approximately $12.5 million, which was reported as a “Gainfrom discontinued operations” for the three and six months ended June 30,2004.

 

**Note 4—Acquisitions**

 

**PowderJect Pharmaceuticals plc**    On July 8, 2003,Chiron acquired PowderJect Pharmaceuticals, a company based in Oxford, Englandthat develops and commercializes vaccines. Chiron acquired all of theoutstanding shares of common stock of PowderJect Pharmaceuticals for 550 penceper ordinary share, which, including estimated acquisition costs, resulted in atotal preliminary purchase price of approximately $947.8 million.

 

12

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During the second quarter of2004, Chiron completed the planned divestiture of certain research operationsin Madison, Wisconsin and Oxford, England and certain vaccines operations inSweden. The divestiture of these operations included the disposition of netassets of $14.7 million which included $15.5 million of cash,deferred tax assets of $9.4 million, and exit liabilities of$21.6 million. The net impact of the divestiture resulted in an increaseto goodwill of $2.5 million. Also during second quarter of 2004, Chironadjusted the previously recorded obligation related to an assumed definedbenefit plan, which resulted in an increase to goodwill of $8.1 million.The purchase price includes accruals for estimated exit costs and certain otherdirect acquisition costs. As a result of the adjustment to exit liabilities andestimated direct acquisition costs, the purchase price was revised to$925.8 million. The aggregate purchase price and the allocation of thepurchase price may change upon finalization of these estimates.

 

PowderJect Pharmaceuticals ispart of Chiron’s vaccines segment. PowderJect Pharmaceuticals’ products,including vaccines for influenza, expand Chiron’s portfolio of vaccineproducts. Chiron accounted for the acquisition as a business combination andincluded PowderJect Pharmaceuticals’ operating results in its consolidatedoperating results beginning July 8, 2003.

 

The components of thepurchase price, and the allocation thereof based on estimated fair values aresummarized in the following table (in thousands).

 
| Consideration  and acquisition costs:               |   |    |    |
|-----------------------------------------------------|--------|---------|---------|
| Cash paid for  common stock                         |   | $       | 831,026 |   |
| Cash paid for  options on common stock              |   | 59,153  |    |
| Acquisition  costs paid as of June 30, 2004         |   | 20,739  |    |
| Acquisition  costs not yet paid as of June 30, 2004 |   | 14,883  |    |
| Total purchase  price                               |   | $       | 925,801 |   |
| Allocation of  purchase price:                      |   |    |    |
| Cash and cash  equivalents                          |   | $       | 76,685  |   |
| Short-term  marketable securities                   |   | 8,840   |    |
| Accounts  receivable, net                           |   | 39,600  |    |
| Inventories                                         |   | 64,924  |    |
| Property, plant  and equipment                      |   | 60,589  |    |
| Goodwill                                            |   | 513,520 |    |
| Acquired  intangible assets                         |   | 335,500 |    |
| Other assets                                        |   | 4,876   |    |
| Income taxes  payable                               |   | (17,741 | )       |
| Current  liabilities                                |   | (54,383 | )       |
| Net deferred tax  liability                         |   | (69,566 | )       |
| Long-term  liabilities                              |   | (82,343 | )       |
| Purchased  in-process research and development      |   | 45,300  |    |
| Total purchase  price                               |   | $       | 925,801 |   |
|                                                     |        |         |         |  |  |

 

Chiron allocated the purchaseprice based on the fair value of the assets acquired and liabilities assumed.Chiron allocated a portion of the purchase price to purchased in-processresearch and development, which it charged to earnings in 2003. Purchasedin-process research and development represented the valuation of acquired,to-be-completed research projects. Purchased in-process research anddevelopment was determined using the income approach, which is based on thepremise that the value of a security or asset is the present value of thefuture earning capacity that is available for distribution to the subjectinvestors in the security or asset. In valuing the purchased in-processresearch and development, Chiron used probability-of-success-adjusted cashflows and a 14% discount rate. Cash flows from projects including thoserelating to (i) certain travel vaccines and (ii) vaccines forallergies were assumed to commence between 2004 and 2012. Given the high riskassociated with the development of new drugs, Chiron probability-adjusted therevenue and expense forecasts to reflect the risk of advancement through theregulatory approval process based on the stage of development in the regulatoryprocess. Such a valuation requires significant estimates and assumptions.Chiron believes that the fair value assigned to purchased in-process researchand development is based on reasonable assumptions. However, these assumptionsmay be incomplete or inaccurate, and unanticipated events and circumstances mayoccur. To assist in determining the value of the purchased in-process researchand development, a third-party valuation was obtained as of the acquisitiondate.

 

13

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Acquired intangible assetsincluded the fair value of distribution rights, a contract manufacturingagreement and developed product technologies. The distribution rights and thecontract manufacturing agreement are being amortized on a straight-line basisover 1 to 4 years. The weighted average amortization period for theseintangible assets is 2 years. Developed product technologies are beingamortized using either the estimated sales method over 10 years or on astraight-line basis over 1 to 15 years. The weighted average amortizationperiod for these intangible assets is 11 years. The weighted averageamortization period for total acquired intangible assets is 10 years.

 

Income taxes payable of$17.7 million relates to current tax liabilities associated withPowderJect Pharmaceuticals at the date of acquisition. The net deferred taxliability of $69.6 million is comprised of current and non-currentdeferred tax assets of $31.1 million primarily related to net operatinglosses incurred from April 1, 2003 through the acquisition date, reservesand depreciation timing differences and a non-current deferred tax liability of$100.7 million related to acquired intangibles.

 

For acquisition costs relatedto PowderJect Pharmaceuticals, Chiron paid $4.0 million for the six monthsended June 30, 2004. These payments are reflected in the CondensedConsolidated Statement of Cash Flows as a component of “Cash paid foracquisitions, net of cash acquired” for the six months ended June 30,2004.

 

Chiron paid $1.0 millionand $0.2 million related to severance payments included in acquisitioncosts for PathoGenesis Corporation and Matrix Pharmaceutical, respectively, forthe six months ended June 30, 2003. These payments are reflected in theCondensed Consolidated Statement of Cash Flows as a component of “Cash paid foracquisitions, net of cash acquired” for the six months ended June 30,2003.

 

**Note 5—IntangibleAssets**

 

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

 
| ** **                                       | ** ** | **June 30, 2004**     | ** ** | **December 31, 2003**    | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Value** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Value** | ** ** |
| Purchased  technologies                          |       | $                          | 332,338    |                          | $          | 106,041 |   | $ | 226,297 |   | $ | 332,543 |   | $ | 95,836 |   | $ | 236,707 |   |
| Patents                                          |       | $                          | 123,804    |                          | $          | 66,171 |   | $ | 57,633 |   | $ | 119,675 |   | $ | 61,747 |   | $ | 57,928 |   |
| Trademarks                                       |       | 60,033                     |       | 21,725                        |       | 38,308 |   | 61,082 |   | 20,507 |   | 40,575 |   |
| Licenses and  technology rights                  |       | 48,473                     |       | 32,693                        |       | 15,780 |   | 49,087 |   | 27,818 |   | 21,269 |   |
| Developed  product technologies                  |       | 353,195                    |       | 46,972                        |       | 306,223 |   | 347,233 |   | 23,093 |   | 324,140 |   |
| Customer  relationships                          |       | 27,912                     |       | 10,369                        |       | 17,543 |   | 28,824 |   | 9,952 |   | 18,872 |   |
| Know how (1)                                     |       | 12,676                     |       | 6,289                         |       | 6,387 |   | 13,090 |   | 6,023 |   | 7,067 |   |
| Databases                                        |       | 7,100                      |       | 1,775                         |       | 5,325 |   | 7,100 |   | 1,538 |   | 5,562 |   |
| Other                                            |       | 34,884                     |       | 17,388                        |       | 17,496 |   | 26,328 |   | 14,852 |   | 11,476 |   |
| Total other  intangible assets                   |       | $                          | 668,077    |                          | $          | 203,382 |   | $ | 464,695 |   | $ | 652,419 |   | $ | 165,530 |   | $ | 486,889 |   |
| Total intangible  assets subject to amortization |       | $                          | 1,000,415  |                          | $          | 309,423 |   | $ | 690,992 |   | $ | 984,962 |   | $ | 261,366 |   | $ | 723,596 |   |

 

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

 

14

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Aggregate amortizationexpense is as follows (in thousands):

 
| For the six  months ended June 30, 2004 (reported)                            |   | $      | 47,549 |   |
|-------------------------------------------------------------------------------|--------|--------|--------|--------|
| For the  remaining six months in the year ended December 31, 2004 (estimated) |   | 44,640 |   |
| For the year  ended December 31, 2004 (estimated)                             |   | $      | 92,189 |   |
| For the year  ended December 31, 2005 (estimated)                             |   | $      | 89,732 |   |
| For the year  ended December 31, 2006 (estimated)                             |   | $      | 94,130 |   |
| For the year  ended December 31, 2007 (estimated)                             |   | $      | 91,987 |   |
| For the year  ended December 31, 2008 (estimated)                             |   | $      | 67,474 |   |
| For the year  ended December 31, 2009 (estimated)                             |   | $      | 43,825 |   |

 

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

 
| ** **                                     | ** ** | **Biopharmaceuticals** | ** ** | **Vaccines** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|------------------------|------------|--------------|------------|-----------|------------|
| Balance as of  December 31, 2003               |       | $                      | 187,492    |         | $          | 600,095   |       | $ | 787,587 |   |
| PowderJect  adjustments (See Note 4) |       |                   |       | 10,559       |       | 10,559    |       |
| Effect of exchange  rate changes               |       | —                 |       | 8,613        |       | 8,613     |       |
| Balance as of  June 30, 2004                   |       | $                      | 187,492    |         | $          | 619,267   |       | $ | 806,759 |   |

** **

**Note 6—SegmentInformation**

 

Chiron is organized based onthe products and services that it offers. Under this organizational structure,there are three reportable segments: (i) blood-testing, (ii) vaccinesand (iii) biopharmaceuticals. The blood-testing segment consists of analliance with Gen-Probe Incorporated and Chiron’s one-half share in the pretaxoperating earnings generated by the joint business contractual arrangement withOrtho-Clinical Diagnostics, Inc., a Johnson & Johnson company.Chiron’s alliance with Gen-Probe is focused on developing and commercializingnucleic acid testing products using Transcription-Mediated Amplificationtechnology to screen donated blood and plasma products for viral infection.Chiron’s joint business arrangement with Ortho-Clinical Diagnostics is operatedunder a contractual arrangement and is not a separate and distinct legalentity. Through Chiron’s joint business contractual arrangement withOrtho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests todetect hepatitis viruses and retroviruses and provides supplemental tests andmicroplate and chemiluminescent instrument systems to automate test performanceand data collection. The vaccines segment consists principally of adult andpediatric vaccines for viral and bacterial infections. Chiron sells thesevaccines primarily in the U.S., Germany, Italy, and the United Kingdom, as wellas in other international markets. The vaccines segment is also involved in thedevelopment of novel vaccines and vaccination technology. Thebiopharmaceuticals segment consists of therapeutic products and services, withan emphasis on the treatment of cancer and infectious diseases, using thedevelopment and acquisition of technologies related to therapeutic proteins andsmall molecules.

 

Revenues and expensesassociated with Chiron’s research and development activities specificallybenefit each of the reportable segments and as such, have been included in theresults of operations of the respective reportable segment.

 

Chiron views certain otherrevenues and expenses, particularly certain royalty and license fee revenuesprimarily related to HIV and hepatitis C virus related patents, and unallocatedcorporate expenses, as not belonging to any one reportable segment. As aresult, Chiron has aggregated these items into an “Other” segment.

 

The accounting policies ofChiron’s reportable segments are the same as those described inNote 1—Basis of Presentation and Summary of Significant AccountingPolicies above and in Chiron’s Annual Report on Form 10-K for the yearended December 31, 2003. Chiron evaluates the performance of its segmentsbased on each segment’s income (loss) from continuing operations.

 

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The following segmentinformation excludes all significant intersegment transactions as thesetransactions are eliminated for management reporting purposes (in thousands):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| *Revenues*                                             |       |                                  |       |                                |       |   |   |   |   |
| Blood-testing:                                         |       |                                  |       |                                |       |   |   |   |   |
| Product sales,  net:                                   |       |                                  |       |                                |       |   |   |   |   |
| Procleix® System                                  |       | $                                     | 60,589     |                                | $          | 45,981 |   | $ | 122,475 |   | $ | 88,104 |   |
| Ortho-Clinical  Diagnostics                            |       | 6,608                                 |       | 7,123                               |       | 12,842 |   | 13,531 |   |
| Total product  sales, net                              |       | 67,197                                |       | 53,104                              |       | 135,317 |   | 101,635 |   |
| Revenues from  joint business arrangement              |       | 28,532                                |       | 27,475                              |       | 58,893 |   | 53,927 |   |
| Collaborative  agreement revenues                      |       | 2,325                                 |       | 2,340                               |       | 4,389 |   | 4,289 |   |
| Royalty and  license fee revenues                      |       | 16,267                                |       | 23,160                              |       | 32,701 |   | 38,796 |   |
| Other revenues                                         |       | 235                                   |       | —                              |       | 430 |   | — |   |
| Total  blood-testing revenues                          |       | 114,556                               |       | 106,079                             |       | 231,730 |   | 198,647 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Vaccines:                                              |       |                                  |       |                                |       |   |   |   |   |
| Product sales,  net:                                   |       |                                  |       |                                |       |   |   |   |   |
| Influenza vaccines                                     |       | 8,207                                 |       | 3,783                               |       | 15,912 |   | 8,036 |   |
| Menjugate®                                        |       | 5,016                                 |       | 13,696                              |       | 9,565 |   | 21,234 |   |
| Travel vaccines                                        |       | 26,261                                |       | 23,052                              |       | 49,271 |   | 48,752 |   |
| Pediatric and  other vaccines                          |       | 47,619                                |       | 45,026                              |       | 98,802 |   | 75,939 |   |
| Total product  sales, net                              |       | 87,103                                |       | 85,557                              |       | 173,550 |   | 153,961 |   |
| Collaborative  agreement revenues                      |       | 1,214                                 |       | 166                                 |       | 5,180 |   | 167 |   |
| Royalty and  license fee revenues                      |       | 25                                    |       | 3,343                               |       | 2,675 |   | 6,529 |   |
| Other revenues                                         |       | 5,914                                 |       | 3,218                               |       | 9,556 |   | 6,009 |   |
| Total vaccines  revenues                               |       | 94,256                                |       | 92,284                              |       | 190,961 |   | 166,666 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Biopharmaceuticals:                                    |       |                                  |       |                                |       |   |   |   |   |
| Product sales,  net                                    |       |                                  |       |                                |       |   |   |   |   |
| Betaseron®                                        |       | 31,626                                |       | 30,478                              |       | 61,762 |   | 59,778 |   |
| TOBI®                                             |       | 51,342                                |       | 38,984                              |       | 103,866 |   | 79,718 |   |
| Proleukin®                                        |       | 35,057                                |       | 29,381                              |       | 66,925 |   | 55,364 |   |
| Other                                                  |       | 8,896                                 |       | 8,424                               |       | 20,867 |   | 14,092 |   |
| Total product  sales, net                              |       | 126,921                               |       | 107,267                             |       | 253,420 |   | 208,952 |   |
| Collaborative  agreement revenues                      |       | 289                                   |       | 1,118                               |       | 774 |   | 3,282 |   |
| Royalty and  license fee revenues                      |       | 15,183                                |       | 20,758                              |       | 32,480 |   | 38,574 |   |
| Other revenues                                         |       | 4,826                                 |       | 3,151                               |       | 7,927 |   | 18,785 |   |
| Total  biopharmaceuticals revenues                     |       | 147,219                               |       | 132,294                             |       | 294,601 |   | 269,593 |   |
| Other:                                                 |       |                                  |       |                                |       |   |   |   |   |
| Royalty and  license fee revenues                      |       | 23,721                                |       | 19,615                              |       | 42,132 |   | 36,401 |   |
| Total revenues                                         |       | $                                     | 379,752    |                                | $          | 350,272 |   | $ | 759,424 |   | $ | 671,307 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| *Income  (loss) from continuing operations*            |       |                                  |       |                                |       |   |   |   |   |
| Blood-testing                                          |       | $                                     | 59,208     |                                | $          | 62,441 |   | $ | 122,848 |   | $ | 113,003 |   |
| Vaccines                                               |       | (46,313                               | )          | 794                                 |       | (96,352 | ) | (4,508 | ) |
| Biopharmaceuticals                                     |       | 8,777                                 |       | 8,353                               |       | 28,026 |   | 33,452 |   |
| Other                                                  |       | (4,154                                | )          | 2,163                               |       | (10,631 | ) | 2,774 |   |
| Segment income  from operations                        |       | 17,518                                |       | 73,751                              |       | 43,891 |   | 144,721 |   |
| Interest expense                                       |       | (6,452                                | )          | (2,839                              | )          | (12,377 | ) | (6,301 | ) |
| Interest and  other income, net                        |       | 19,809                                |       | 11,613                              |       | 35,883 |   | 25,931 |   |
| Minority  interest                                     |       | (459                                  | )          | (581                                | )          | (1,079 | ) | (981 | ) |
| Income from continuing  operations before income taxes |       | $                                     | 30,416     |                                | $          | 81,944 |   | $ | 66,318 |   | $ | 163,370 |   |

 

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**Note 7—DebtObligations**

 

*ConvertibleDebentures*

 

On June 22, 2004, Chironissued $385.0 million aggregate principal amount of convertibledebentures, which mature on June 30, 2034. The convertible debenturesaccrue interest at a rate of 2.75% per year and interest is payable onJune 30 and December 30 commencing on December 30, 2004. Thedebentures are senior, unsecured obligations of Chiron and rank equal in rightof payment with all of Chiron’s existing and future unsecured andunsubordinated indebtedness.

 

The holders of the debenturesmay convert their debentures when certain Chiron common stock price targetshave been met at certain times, if the trading price for the debentures fallsbelow certain levels for a specified period of time, if the debentures havebeen called for redemption, if the credit rating assigned to Chiron’s long-termsenior debt is below specified levels, upon the occurrence and continuance ofspecified corporate transactions or in connection with a transaction or eventconstituting a change in control. The initial conversion rate is 14.9254 sharesof Chiron common stock per $1,000 principal amount of debentures. This isequivalent to an initial conversion price of approximately $67.00 per share ofChiron common stock.

 

If the debentures aretendered for conversion, the value (“Conversion Value”) of cash and shares ofChiron’s common stock, if any, to be received by a holder converting $1,000principal amount of the debentures will be determined by multiplying theapplicable conversion rate by a weighted average price. Chiron will deliver theConversion Value to debenture holders as follows: (1) an amount in cash (“PrincipalReturn”) equal to the lesser of (a) the aggregate Conversion Value of thedebentures to be converted and (b) the aggregate principal amount of thedebentures to be converted and (2) if the aggregate Conversion Value ofthe debentures to be converted is greater that the Principal Return, an amountin shares (“Net Shares”) equal to the aggregate Conversion Value less thePrincipal Return (“Net Share Amount”). The number of Net Shares to be paid willbe determined by dividing the Net Share Amount by a weighted average price.

 

If a change in control occurson or prior to July 5, 2010, under certain circumstances, holders of thedebentures will receive a make whole premium on debentures tendered forrepurchase and for debentures converted in connection with a change in control.The amount of the make whole premium will be based on the price paid per shareof Chiron common stock in a transaction constituting a change in control and ispayable in Chiron common stock.

 

The holders of the debenturesmay require Chiron to repurchase for cash all or part of the debentures onJune 30, 2010, June 30, 2014, June 30, 2019, June 30, 2024and June 30, 2029. The repurchase price will be equal to 100% of theprincipal amount of the debentures to be repurchased, plus accrued and unpaidinterest, if any, up to the repurchase date payable in cash.

 

On or after July 5,2010, Chiron may redeem for cash all or part of the debentures at a redemptionprice equal to 100% of principal amount of the debentures to be redeemed, plusaccrued and unpaid interest.

 

Bond issuance costs inconnection with the issuance of the debentures amounted to approximately$8.6 million and are being amortized to interest expense on astraight-line basis, which approximated the effective interest method, over sixyears, which represents the period from the issue date to the earliest putdate. Bond issuance costs are recorded in “Other intangible assets, net” in theCondensed Consolidated Balance Sheets at June 30, 2004.

 

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*LiquidYield Option Notes*

 

In June 2001, Chironissued zero coupon Liquid Yield Option Notes (LYONs) with a face value of$730.0 million and a yield to maturity of 2.0%. The LYONs were carried netof an original issue discount of $328.2 million, which was being accretedto interest expense over the life of the LYONs using the effective interestmethod. No beneficial conversion feature existed at the time of the issuance ofthe LYONs. The LYONs mature on June 12, 2031, at a face value of $1,000per note. The LYONs are uncollateralized and unsubordinated, and rank equal inright of payment to Chiron’s existing and future uncollateralized andunsubordinated indebtedness.

 

On June 12, 2004,certain LYONs holders, at their option, tendered, $649.9 million inaggregate principal amount at maturity for purchase by Chiron. The purchaseprice for the LYONs was $584.31 in cash per $1,000 in principal amount atmaturity. The aggregate purchase price for all the LYONs validly surrenderedfor purchase was $379.7 million. At June 30, 2004, there remainsoutstanding $80.1 million in aggregate principal amount at maturity and anaccreted balance of $46.8 million for the LYONs.

 

At the option of the holder,Chiron may be required to purchase all, or a portion, of the remaining LYONs onthe following dates at the following prices for each note with face value of$1,000:

 
| **Date**      | ** ** | **Price** | ** ** |
|---------------|------------|-----------|------------|
| June 12, 2006 |       | $         | 608.04     |   |
| June 12, 2011 |       | $         | 671.65     |   |
| June 12, 2016 |       | $         | 741.92     |   |
| June 12, 2021 |       | $         | 819.54     |   |
| June 12, 2026 |       | $         | 905.29     |   |

* *

*Other LoansPayable*

 

Chiron has entered intovarious agreements with a governmental body in Italy for which Chiron mayborrow up to 11.0 million Euro ($13.4 million at June 30, 2004)for research purposes. Under these facilities, Chiron has an outstandingbalance of 3.0 million Euro ($3.6 million) as of June 30, 2004with interest rates that range from 2% to 6% and maturities that range from2010 to 2013.

 

**Note 8—Commitmentsand Contingencies**

 

In March 2004, Chironentered into a worldwide, exclusive, multi-product, collaborative arrangementwith XOMA Ltd. for the development and commercialization of antibodyproducts for the treatment of cancer. Under the terms of the arrangement, theparties agreed to jointly research, develop, and commercialize multipleantibody product candidates. Under the arrangement, the parties agreed to sharedevelopment and commercialization expenses, including preclinical and clinicaldevelopment, manufacturing and worldwide marketing costs, as well as revenues,generally on a 70-30 basis, with Chiron’s share being 70% and XOMA’s sharebeing 30%. Chiron agreed to make an initial payment of $10.0 million,which has been paid as of June 30, 2004, and to make a loan facility of upto $50.0 million available to XOMA, starting on January 1, 2005 tofund XOMA’s share of development expenses. The collaboration will initiallyfocus on preclinical, process development and scale up work, with a potentialInvestigative New Drug (IND) filing anticipated early in the collaboration.

 

On June 1, 2004, Chironrenewed its lease for a manufacturing facility in Emeryville, California fromJune 1, 2004 through September 30, 2015 with two 3-year options torenew at the end of the lease term and with a right to cancel the lease as ofMay 31, 2014 without a cancellation fee. Chiron is obligated to pay anaggregate of approximately $17.5 million in lease payments throughMay 31, 2014.

 

Chiron is subject toindemnification provisions under its agreements with other companies in its ordinarycourse of business, typically with business partners, contractors, clinicalsites, insurers and customers. Under these provisions, Chiron generallyindemnifies and holds harmless the indemnified party for losses suffered orincurred by the indemnified party as a result of Chiron’s activities. Theseindemnification provisions generally survive termination of the underlyingagreement. In some cases, the maximum potential amount of future paymentsChiron could be required to make under these indemnification provisions isunlimited. The estimated fair value of the indemnity obligations of theseagreements is minimal. Accordingly, Chiron has no liabilities recorded forthese agreements as of June 30, 2004. Chiron has not incurred materialcosts to defend lawsuits or settle claims related to these indemnificationagreements.

 

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Chiron is party to variousclaims, investigations and legal proceedings arising in the ordinary course ofbusiness. These claims, investigations and legal proceedings relate tointellectual property rights, contractual rights and obligations, employmentmatters, claims of product liability and other issues. While there is noassurance that an adverse determination of any of such matters could not have amaterial adverse impact in any future period, management does not believe,based upon information known to it, that the final resolution of any of thesematters will have a material adverse effect upon Chiron’s consolidatedfinancial position and results of operations or cash flows.

 

Chiron is presently underexamination in several domestic and international tax jurisdictions. Whilethere is no assurance that Chiron will prevail in all tax examinations in theevent the taxing authorities disagree with Chiron’s interpretation of the taxlaw, 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 adverseeffect upon Chiron’s consolidated financial position and results of operationsor cash flows. Adequate provisions have been made for these tax examinations.

 

In the second quarter 2004,Chiron and the IRS entered into a settlement agreement closing the open taxyears 1996 to 1998. Pursuant to this settlement agreement, Chiron recognized atax benefit of approximately $12.5 million, which was reported as a “Gainfrom discontinued operations”, as discussed in Note 3 “DiscontinuedOperations” and a continuing operations tax benefit of $1.1 million forthe three and six months ended June 30, 2004.

 

**Note 9—SubsequentEvents**

 

On July 2, 2004, Chironacquired Sagres Discovery (Sagres), a privately held company headquartered inDavis, California. Sagres focuses on the discovery and validation of targetswith potential application to the development of cancer therapeutics. Sagreswill be part of the Biopharmaceuticals segment. Chiron acquired Sagres for apreliminary purchase price of $11.8 million.

 

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**Item 2. Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

***Overview***

 

*This 10-Q contains forward-looking statements regarding ourexpectations, hopes or intentions regarding the future, including statementsrelating to sales growth, product development initiatives, new productmarketing, acquisitions, competition, in- and out-licensing activities andexpected cost savings that involve risks and uncertainties and are subject tochange. You should read the discussion below in conjunction with Part I,Item 1.,”Financial Statements,” of this 10-Q and Part II, Items 7., 7A.and 8., “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” “Quantitative and Qualitative Disclosures About MarketRisk” and “Financial Statements and Supplementary Data,” respectively, of ourAnnual Report on Form 10-K for the year ended December 31, 2003. Theforward-looking statements contained in this 10-Q reflect our current beliefsand expectations on the date of this 10-Q. Actual results, performance oroutcomes may differ from current expectations. Our actual performance maydiffer from current expectations due to many factors, including the outcome ofclinical trials, regulatory review and approvals, manufacturing capabilities, intellectualproperty protections and defenses, stock-price and interest-rate volatility,and marketing effectiveness. In particular, there can be no assurance that wewill increase sales of existing products, successfully develop and receiveapproval to market new products, or achieve market acceptance for such newproducts. There can be no assurance that our out-licensing activity willgenerate significant revenue, or that our in-licensing activities will fullyprotect us from claims of infringement by third parties. In addition, we mayengage in business opportunities, the successful completion of which is subjectto certain risks, including stockholder and regulatory approvals and theintegration of operations. We have discussed the important factors, which webelieve could cause actual results to differ from what is expressed in theforward-looking statements, under the caption “Factors That May Affect FutureResults” in this 10-Q. Consistent with SEC Regulation FD, we do not undertakean obligation to update the forward-looking information contained in this 10-Q.*

 

As discussed in Note 1 to our Condensed ConsolidatedFinancial Statements, we determined that certain sales of a travel vaccinerecorded as revenues in the second quarter of 2004 should not have beenrecorded as revenue at that time, and that portions of those sales should havebeen recorded as revenues in the third and fourth quarters of 2004 and possiblyin later quarters. As a result, we determined to restate the financialstatements included in our Quarterly Reports on 10-Q for such quarters. Therestatement is reflected in management’s discussion and analysis of financialcondition and results of operations below.

 

We are a globalpharmaceutical company that participates in three healthcare markets:blood-testing, vaccines and biopharmaceuticals. Chiron is focused on developingproducts for cancer, which include immune-based therapies, antibodies and novelsmall molecule anti-cancer agents, and infectious disease, which have a rangeof products spanning all three of our business units. Our revenues consist ofproduct sales, revenues from a joint business contractual arrangement,collaborative agreement revenues, royalty and license fee revenues and otherrevenues, primarily consisting of contract manufacturing and grant revenues.

 

The blood-testing segmentconsists of an alliance with Gen-Probe Incorporated and our one-half share inthe pretax operating earnings generated by the joint business contractualarrangement with Ortho-Clinical Diagnostics, Inc., a Johnson &Johnson company. Our alliance with Gen-Probe is focused on developing andcommercializing nucleic acid testing products using transcription-mediatedamplification technology to screen donated blood and plasma products for viralinfection. Our joint business arrangement with Ortho-Clinical Diagnostics isoperated under a contractual arrangement and is not a separate and distinctlegal entity. Through our joint business contractual arrangement withOrtho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detecthepatitis viruses and retroviruses and provide supplemental tests andmicroplate and chemiluminescent instrument systems to automate test performanceand data collection.

 

The vaccines segment consistsof flu vaccines, including Fluvirin®, a product we obtained as part of ourthird quarter 2003 acquisition of PowderJect Pharmaceuticals (discussed below),a meningococcal vaccine, travel vaccines, which include rabies and tick-borneencephalitis vaccines and two other products we obtained as part of ouracquisition of PowderJect Pharmaceuticals, ArilvaxTM and DukoralTM, and pediatricand other vaccines. We sell these vaccines primarily in the U.S., Germany,Italy and the United Kingdom, as well as in other international markets. Ourvaccines segment is also involved in the development of other novel vaccinesand vaccination technology.

 

The biopharmaceuticalssegment consists of therapeutic products and services, with an emphasis on thetreatment of cancer and infectious diseases. Our in-house capabilities spanthree types of therapeutics, including small molecules, therapeutic proteinsand monoclonal antibodies. Our products include TOBI® (tobramycin solution forinhalation) for pseudomonal lung infections in cystic fibrosis patients,Proleukin® (aldesleukin) for cancer (metastatic melanoma and renal cellcarcinoma), and Betaseron® (interferon beta-1b) for multiple sclerosis. Thebiopharmaceuticals segment also includes collaborations with BerlexLaboratories, Inc. and its parent company, Schering AG of Germany, relatedto Betaseron® interferon beta-1b.

 

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

 

On July 8, 2003, weacquired PowderJect Pharmaceuticals plc, a company based in Oxford, England thatdevelops and commercializes vaccines. We accounted for the acquisition of thisbusiness under the purchase method of accounting and included PowderJectPharmaceuticals’ operating results in our consolidated operating resultsbeginning July 8, 2003. PowderJect Pharmaceuticals is part of our vaccinessegment.

 

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Income from continuingoperations was $22.8 million, or $0.12 per diluted share, and$61.5 million or $0.32 per diluted share, for the three months ended June 30,2004 and 2003, respectively and $49.7 million, or $0.26 per diluted share,and $122.5 million, or $0.65 per diluted share, for the six months ended June 30,2004 and 2003, respectively. These declines were primarily due to (i) theeffect of our acquisition of PowderJect, which includes amortization expensefrom intangible assets associated with the acquisition and (ii) thecontractual decline in the Betaseron® royalty rate. As a result of ouracquisition of PowderJect, which has flu sales primarily in the second half ofthe year, our earnings per share from continuing operations declined $0.12 perdiluted share for the three months ended June 30, 2004 and $0.23 perdiluted share for the six months ended June 30, 2004. Our earnings pershare from continuing operations declined $0.04 per diluted share for the threemonths ended June 30, 2004 and $0.08 per diluted share for the six monthsended June 30, 2004 as a result of the decline in the Betaseron® royaltyrate.

 

Total revenues were$379.8 million and $350.3 million for the three months ended June 30,2004 and 2003, respectively, and $759.4 million and $671.3 millionfor the six months ended June 30, 2004 and 2003, respectively. Productsales were $281.2 million and $245.9 million for the three monthsended June 30, 2004 and 2003, respectively, and $562.3 million and$464.5 million for the six months ended June 30, 2004 and 2003,respectively. Our total revenues were affected by the movement in exchangerates, in particular the movements in the Euro and British Pound against theU.S. dollar. The movement in exchange rates added approximately 2% and 3% toour total revenues for the three and six months ended June 30, 2004,respectively. However, since our Euro and British Pound expenses have alsoincreased due to the movement in exchange rates, our earnings per share fromcontinuing operations declined $0.01 and $0.03 per diluted share for the threeand six months ended June 30, 2004, respectively, due to higher expensescompared to revenues in Euros and British Pounds.

 

For the three months ended June 30,2004, increases in product sales were seen across all three of our businessunits, in particular Procleix® products, TOBI® tobramycin and Proleukin®. Forthe six months ended June 30, 2004, increases in product sales were alsoseen across all three of our business units, in particular Procleix® products,TOBI®, pediatric and other vaccines, and Proleukin®. Revenues from the jointbusiness arrangement, royalty and license fees, collaborative agreementrevenues and other revenues were $98.5 million and $104.3 million forthe three months ended June 30, 2004 and 2003, respectively, and $197.1and $206.8 million for the six months ended June 30, 2004 and 2003,respectively. For the three months ended June 30, 2004 as compared to thethree months ended June 30, 2003, these revenues decreased primarily dueto the decline in the Betaseron® royalty rate and the timing of license feesfrom our intellectual property portfolio. The decrease was offset by increasedprofitability of the joint business arrangement and contract manufacturingactivities. For the six months ended June 30, 2004 compared to the sixmonths ended June 30, 2003, these revenues decreased primarily due to theBiogen and Serono settlements in connection with the McCormick patents owned bySchering’s U.S. subsidiary, Berlex, reported in the six months ended June 30,2003, the decline in the Betaseron® royalty rate and the timing of license feesfrom our intellectual property portfolio. This decrease was offset by increasedprofitability of the joint business arrangement, contract manufacturing activitiesand royalties from our hepatitis C virus and HIV-related patents.

 

Gross margins were 54% and60% for the three months ended June 30, 2004 and 2003, respectively, and54% and 61% for the six months ended June 30, 2004 and 2003, respectively.For the three and six months ended June 30, 2004, gross margins decreaseddue to a decline in the gross margin of the vaccines business, a reduction inthe royalty rate related to Betaseron® and the increased cost of producing theBetaseron® pre-filled diluent syringe.

 

Research and developmentexpenses were $100.3 million and $89.9 million for the three monthsended June 30, 2004 and 2003, respectively, and $198.7 million and$172.0 million for the six months ended June 30, 2004 and 2003,respectively. Research and development expenses for PowderJect Pharmaceuticalswere $0.9 million and $7.7 million for the three and six months endedJune 30, 2004. Research and development expenses associated withPowderJect Pharmaceuticals declined for the three months ended June 30,2004 as we completed the planned divestiture of certain research operations inMadison, Wisconsin and Oxford, England. For the three and six months ended June 30,2004, excluding PowderJect, the main beneficiaries of this increase includetifacogin, our meningococcal vaccines franchise, our flu cell culture program,cyclosporine solution for inhalation, CHIR-258, a growth factor kinaseinhibitor and our first small molecule oncology compound in development, and adry powder formulation of inhaled TOBI®. These increases were partially offsetby decreases due to transfer of responsibility for the SILCAAT trial,discontinuance of development of tezacitabine and PA-2794 and lower costsrelated to the development of new manufacturing processes for Betaseron®.

 

Selling, general andadministrative expenses were $106.9 million and $80.2 million for thethree months ended June 30, 2004 and 2003, respectively, and$211.6 million and $153.3 million for the six months ended June 30,2004 and 2003, respectively. PowderJect Pharmaceuticals, including associatedintegration costs, contributed approximately $8.0 million and$18.6 million for the three and six months ended June 30, 2004. Theremaining increase in selling, general and administrative expenses resultedfrom additional costs associated with increase in sales across our businesses,investment in geographic penetration, defense of our patents and technology,increased headcount and ongoing sales and marketing programs.

 

The effective tax rate forthe three and six months ended June 30, 2004 and 2003 was 25% of pretaxincome from continuing operations.

 

***Critical Accounting Policies and The Use ofEstimates***

 

The preparation of financialstatements requires us to make estimates, assumptions and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosures of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to investments; inventories;derivatives; capital leases; intangible assets; goodwill;

 

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purchasedin-process research and development; product discounts, rebates and returns;bad debts; collaborative, royalty and license arrangements; restructuring; pensionand other post-retirement benefits; income taxes; and litigation and othercontingencies. We base our estimates on historical experience and various otherassumptions that we believe to be reasonable under the circumstances, theresults of which form our basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from those estimates under different assumptions orconditions.

 

Our blood-testing segmentincludes our one-half share in the pretax operating earnings generated by thejoint business contractual arrangement with Ortho-Clinical Diagnostics, Inc.,a Johnson & Johnson company. Our joint business arrangement withOrtho-Clinical Diagnostics is a contractual arrangement and is not a separateand distinct legal entity. Through our joint business contractual arrangementwith Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests todetect hepatitis viruses and retroviruses and provide supplemental tests andmicroplate and chemiluminescent instrument systems to automate test performanceand data collection. Prior to 2003, we had accounted for revenues relating tonon-U.S. affiliate sales on a one-quarter lag, with an adjustment of theestimate to actual in the subsequent quarter. More current information ofnon-U.S. affiliate sales of our joint business contractual arrangement becameavailable for the three months ended March 31, 2003, and as a result, weare able to recognize revenues relating to non-U.S. affiliate sales on aone-month lag. The effect of this change, net of tax, was an increase to netincome by $3.2 million for revenues from the joint business arrangementfor the six months ended June 30, 2003.

 

Our critical accountingpolicies, which incorporate our more significant judgments and estimates usedin the preparation of our Condensed Consolidated Financial Statements are thesame as those described in Part II, Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” in Chiron’s AnnualReport on Form 10-K for the year ended December 31, 2003.

 

**Results ofOperations**

 

***Blood-testing***

 

**Product sales**    Our blood-testing segment recognized productsales of $67.2 million and $53.1 million for the three months ended June 30,2004 and 2003, respectively, and $135.3 million and $101.6 millionfor the six months ended June 30, 2004 and 2003, respectively.

 

*Procleix®*    On February 27, 2002, the U.S. Food andDrug Administration approved the Procleix® HIV-1/HCV Assay. Under acollaboration agreement with Gen-Probe Incorporated, we market and sell theProcleix® HIV-1/HCV Assay and the related instrument system. In additionto selling directly in the U.S., we also sell in various European andAsia/Pacific markets, directly and through distributors. We record revenuebased upon the reported results obtained from the customer from the use ofassays to screen donations or upon sale and delivery of the assays, dependingon the underlying contract. In the case of equipment sales or leases, we recordrevenue upon the sale and transfer of the title of the instrument or ratablyover the life of the lease term, respectively. For the provision of service onthe instruments, we recognize revenue ratably over the life of the serviceagreement.

 

Worldwide product salesrelated to tests, instruments and the provision of services were$60.6 million and $46.0 million for the three months ended June 30,2004 and 2003, respectively, and $122.5 million and $88.1 million forthe six months ended June 30, 2004 and 2003, respectively. The increase inproduct sales for the three and six months ended June 30, 2004 as comparedwith the three and six months ended June 30, 2003 primarily related to (i) theintroduction of the West Nile virus assay on an investigational-use basis inthe U.S. and (ii) market share gains in the U.S. and continued penetrationinto several markets abroad for the Procleix® HIV-1/HCV Assay. In March 2003,the U.S. Food and Drug Administration accepted an investigational new drug(IND) for the West Nile virus assay. The new assay runs on the sameinstrumentation platform as the currently approved Procleix® HIV-1/HCVassay.

 

*Ortho-Clinical Diagnostics*    Under the jointbusiness contractual arrangement with Ortho-Clinical Diagnostics, Inc., wemanufacture bulk reagents and antigens and confirmatory test kits forimmunodiagnostic products. We recognized product sales under this arrangementof $6.6 million and $7.1 million for the three months ended June 30,2004 and 2003, respectively, and $12.8 million and $13.5 million forthe six months ended June 30, 2004 and 2003, respectively. The decrease inproduct sales for the three and six months ended June 30, 2004 as comparedwith the three and six months ended June 30, 2003, primarily related tothe timing of manufacturing services under the arrangement. We also supply bulkantigens for Ortho-Clinical Diagnostics to be included in products to be soldby Bayer under a June 2001 agreement with Ortho-Clinical Diagnostics andBayer Corporation (see also “Royalty and license fee revenues–Bayer” below).

 

We expect competitivepressures related to our blood-testing products to continue, primarily as aresult of the introduction of competing products into the market, as listed in Part I,Item 1. “Business-Competition” of our Annual Report on Form 10-K forthe year ended December 31, 2003.

 

**Revenue from joint business arrangement**    Revenues from ourjoint business contractual arrangement with Ortho-Clinical Diagnostics, Inc.were $28.5 million and $27.5 million for the three months ended June 30,2004 and 2003, respectively, and $58.9 million and $53.9 million forthe six months ended June 30, 2004 and 2003, respectively. The increase inrevenues from our joint business arrangement for the three months ended June 30,2004 as compared with the three months ended June 30, 2003 primarilyresulted from (i) increased profitability of Ortho-Clinical Diagnostics’foreign affiliates and (ii) an increase in royalties. These increases wereoffset by the timing of Ortho-Clinical Diagnostics’ shipments to third partiesand an adjustment of the first quarter 2004 estimate of revenue to actualresults. The increase in revenues from our joint business arrangement for thesix months ended June 30, 2004 as compared with the six months ended June 30,2003 primarily resulted from (i) higher profits from Ortho-

 

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Clinical Diagnostics’ U.S. operations and foreign affiliates and (ii) anincrease in royalties. These increases are offset by a one-time benefit for the three monthsended March 31, 2003 due to a change in estimate from a three-month lag toa one-month lag relating to the Ortho-Clinical Diagnostics, Inc.’snon-U.S. affiliate sales.

 

**Collaborative agreement revenues**    We recognizecollaborative agreement revenues for fees received as we perform researchservices and achieve specified milestones. Under the Ortho-Clinical Diagnostics, Inc.joint business arrangement, we conduct research and development servicesrelated to immunodiagnostic products. Our blood-testing segment recognizedtotal collaborative agreement revenues of $2.3 million and$2.3 million for the three months ended June 30, 2004 and 2003,respectively, and $4.4 million and $4.3 million for the six monthsended June 30, 2004 and 2003, respectively. The majority of collaborativeagreement revenues recognized by our blood-testing segment related toimmunodiagnostic products.

 

Collaborative agreementrevenues tend to fluctuate based on the amount and timing of research servicesperformed, the status of projects under collaboration and the achievement ofmilestones. Due to the nature of our collaborative agreement revenues, resultsin any one period are not necessarily indicative of results to be achieved inthe future. Our ability to generate additional collaborative agreement revenuesmay depend, in part, on our ability to initiate and maintain relationships withpotential and current collaborative partners.

 

**Royalty and license fee revenues**    Our blood-testingsegment earns royalties from third parties based on their sales ofimmunodiagnostic and nucleic acid testing probe diagnostic products utilizingour hepatitis C virus and HIV-related patents, for use in the blood screeningand plasma fractionation markets. Our blood-testing segment also earns licensefees related to our hepatitis C virus and HIV-related patents for technologiesused by third parties to develop products for use in the blood screening andplasma fractionation markets. The blood-testing segment recognized royalty andlicense fee revenues of $16.3 million and $23.2 million for the threemonths ended June 30, 2004 and 2003, respectively, and $32.7 millionand $38.8 million for the six months ended June 30, 2004 and 2003,respectively. The decrease in royalty and license fees for the three monthsended June 30, 2004 as compared to the three months ended June 30,2003 as well as the six months ended June 30, 2004 compared with the sixmonth ended June 30, 2003 primarily related to two license agreements withBaxter A.G. for which we recognized a license fee in the second quarter 2003.

 

*F. Hoffmann-La Roche settlement*    In October 2000,we entered into three license agreements with F. Hoffmann-La Roche Limited andseveral of its affiliated companies related to the settlement of certainlitigation in the U.S. and certain other countries for the use of our hepatitisC virus and HIV intellectual property. Two agreements relate to *in vitro* diagnostic products. See “Other–Royaltyand license fee revenues” below. The third agreement for blood screening wassuperseded in May 2001 by two new agreements, one for each of hepatitis Cvirus and HIV. Revenues under these agreements were $14.6 million and$14.2 million for the three months ended June 30, 2004 and 2003,respectively, and $29.6 million and $28.6 million for the six monthsended June 30, 2004 and 2003, respectively. The increase for the sixmonths ended June 30, 2004 as compared with the six months ended June 30,2003 related to a positive adjustment of the fourth quarter 2003 estimate toactual results. Under these new agreements, royalties continue through thelives of the hepatitis C virus and HIV-related patents covering F. Hoffmann-LaRoche’s nucleic acid testing products. Currently, the applicable issuedhepatitis C virus-related patents begin to expire in 2015 for the U.S. and in2010 for Europe. Currently, the applicable issued HIV-related patent in Europeexpires in 2005. An HIV-related patent was issued in the U.S. on March 13,2003. This patent will expire seventeen years from the date of issuance. Aspermitted under the terms of its licensing agreement, F. Hoffmann-La Rocheinstituted arbitration proceedings in regard to the application of the U.S.patent. We have deferred recognition of $5.5 million and $1.3 millionas of June 30, 2004 and 2003, of royalty revenue, respectively. During anypending arbitration proceedings, F. Hoffmann-La Roche remains obligated to makeall quarterly royalty payments, subject to a right to be reimbursed by us if itis determined in the arbitration that such royalty payments were not due.

 

*Bayer*    InJune 2001, Chiron and Ortho-Clinical Diagnostics, Inc. entered intoan agreement with Bayer Corporation for the clinical diagnostic market. Underthis agreement, Bayer manufactures and sells certain of Ortho-ClinicalDiagnostics’ hepatitis C virus and HIV immunodiagnostic products for use onBayer’s instrument platforms. Bayer paid us a license fee of$45.3 million, which we deferred (due to our continuing manufacturingobligations) and began recognizing as revenue in the third quarter 2001. Wewill recognize the remaining amount ratably through 2010.

 

*Baxter A.G.*    In June 2003, we entered into two licenseagreements with Baxter A.G. related to our hepatitis C virus and HIV technologyfor use in the plasma fractionation market for which we recognized a licensefee in the second quarter 2003.

 

Royalty and license feerevenues may fluctuate based on the nature of the related agreements and thetiming of receipt of license fees. Results in any one period are notnecessarily indicative of results to be achieved in the future. 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. We haveno assurance that we will be able to do so or that future royalty and licensefee revenues will not decline.

 

**Gross profit**    Blood-testing gross profit as a percentage ofnet product sales was 42% and 46% for the three months ended June 30, 2004and 2003, respectively, and 42% and 44% for the six months ended June 30,2004 and 2003, respectively. The blood-testing gross profit margins for thethree months ended June 30, 2003 as well as for the six months ended June 30,2003 were positively impacted by an adjustment to cost of goods sold pursuantto our collaboration agreement with Gen-Probe Incorporated. The blood-testinggross profit margins for the three and six months ended June 30, 2004benefited from an amendment in November 2003 to the worldwide bloodscreening collaboration agreement between Chiron and Gen-Probe Incorporated inorder to adopt permanent, fixed revenue shares for each party. Effective January 1,2004, Gen-Probe’s share was set at 45.75% of net revenues for assays, whichinclude a test for the hepatitis C virus. For commercial assays, which do nottest for hepatitis C virus, such as the West Nile test, the 

 

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agreementremains unchanged with each party retaining 50% of the net revenues afterdeduction of specified expenses.

 

Blood-testing gross profitpercentages may fluctuate in future periods as the blood-testing product andcustomer mix changes.

 

**Research and development**    Our blood-testingsegment recognized research and development expenses of $6.3 million and$5.6 million for the three months ended June 30, 2004 and 2003,respectively, and $11.4 million and $10.8 million for the six monthsended June 30, 2004 and 2003, respectively. The research and developmentspending in 2004 and 2003 related to the continued development of nucleic acidtesting products and activities under the Ortho-Clinical Diagnostics jointbusiness arrangement.

 

Research and developmentexpenses may fluctuate from period to period depending upon the stage ofcertain projects and the level of pre-clinical and clinical trial-relatedactivities.

 

**Selling, general, and administrative**    Our blood-testingsegment recognized selling, general and administrative expenses of$10.3 million and $9.6 million for the three months ended June 30,2004 and 2003, respectively, and $19.6 million and $17.6 million forthe six months ended June 30, 2004 and 2003, respectively. The increasedselling, general and administrative expenses for the three months ended June 30,2004 as compared with the three months ended June 30, 2003, as well as forthe six months ended June 30, 2004 compared with the six months ended June 30,2003, related to increased headcount to support the expansion of our customer basefor the Procleix® HIV-1/HCV Assay in the U.S., Europe and otherinternational markets.

 

We expect continued growth inselling, general and administrative expenses related to nucleic acid testingtechnology and products as our sales opportunities expand in new marketsthrough anticipated additional nucleic acid testing adoption.

 

***Vaccines***

 

**Product sales**    We sell flu, meningococcal, travel, pediatric,and other vaccines in the U.S., Germany, Italy, and the United Kingdom, as wellas in other international markets. Vaccine product sales were$87.1 million and $85.6 million for the three months ended June 30,2004 and 2003, respectively, and $173.6 million and $154.0 millionfor the six months ended June 30, 2004 and 2003, respectively.

 

Sales of our flu vaccineswere $8.2 million and $3.8 million for the three months ended June 30,2004 and 2003, respectively, and $15.9 million and $8.0 million forthe six months ended June 30, 2004 and 2003, respectively. Flu vaccinessales increased for the three months ended June 30, 2004 as compared withthe three month ended June 30, 2003 primarily as a result of sales toSouth Korea. PowderJect Pharmaceuticals flu vaccine sales were$2.4 million for the six months ended June 30, 2004. ExcludingPowderJect Pharmaceuticals, sales of our remaining flu vaccines increased forthe six months ended June 30, 2004 compared with the six months ended June 30,2003 primarily as a result of additional sales to South Korea and Argentina andthe benefit of the movement in the Euro to U.S. Dollar exchange rate.

 

Sales of Menjugate®, ourconjugate vaccine against meningococcal infection caused by the bacterium N.meningitidis serogroup C, were $5.0 million and $13.7 million for thethree months ended June 30, 2004 and 2003, respectively, and$9.6 million and $21.2 million for the six months ended June 30,2004 and 2003, respectively. The decrease in Menjugate® sales for the threemonths ended June 30, 2004 as compared with the three months ended June 30,2003 as well as for the six months ended June 30, 2004 compared with thesix months ended June 30, 2003 was primarily driven by (i) anAustralian tender in the state of New South Wales in the second quarter 2003, (ii) thetiming of outbreaks and vaccination programs in various countries and (iii) increasedcompetition for tender sales.

 

Sales of our travel vaccines,comprised of tick-borne encephalitis and rabies vaccines and two products weobtained as part of our third quarter 2003 acquisition of PowderJectPharmaceuticals, Arilvax, and Dukoral, were $26.3 million and$23.1 million for the three months ended June 30, 2004 and 2003,respectively, and $49.3 million and $48.8 million for the six monthsended June 30, 2004 and 2003, respectively. The increase in travelvaccines for the three months ended June 30, 2004 as compared with thethree months ended June 30, 2003 as well as the six months ended June 30,2004 as compared with the six months ended June 30, 2003 is primarily dueto increased demand for our rabies vaccines in the U.S., primarily due to aproduct recall from a competitor, Europe and Asia and additional sales oftravel vaccine products following our acquisition of PowderJectPharmaceuticals.  For the three and sixmonths ended June 30, 2004 as compared with the three and six months endedJune 30, 2003, the increase was partially offset by lower sales of ourtick-borne encephalitis vaccine for the three and six months ended June 30,2004. Such lower sales of tick-borne encephalitis for the three and six monthsended June 30, 2004 were due to higher sales inthe fourth quarter of 2003, which is typically sold in the first half of theyear.

 

Sales of our pediatric andother vaccines were $47.6 million and $45.0 million for the threemonths ended June 30, 2004 and 2003, respectively, and $98.8 millionand $75.9 million for the six months ended June 30, 2004 and 2003,respectively. The increase in pediatric and other vaccines sales for the threemonths ended June 30, 2004 as compared with the three months ended June 30,2003 was primarily due to increased sales following our acquisition ofPowderJect Pharmaceuticals. The increase in pediatric and other vaccines forthe six months ended June 30, 2004 compared with the six months ended June 30,2003 was primarily due to (i) the timing of tender sales for our poliovaccines and diphtheria, tetanus and pertussis vaccines and (ii) increasedsales following our acquisition of PowderJect Pharmaceuticals, partially offsetby the timing of tender sales of measles, mumps and rubella vaccines.

 

Certain of our vaccineproducts are seasonal, particularly our flu vaccines, which have higher salesprimarily in the second half of the year. In addition, we expect Menjugate®sales to continue to fluctuate as public health authorities consider adoption ofbroad vaccination programs and competitive pressures continue to increase.

 

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We expect competitivepressures related to many of our vaccine products to continue into the future,primarily as a result of the introduction of competing products into themarket, including, but not limited to, new combination vaccines, as listed in Part I,Item 1., “Business–Competition” of our Annual Report on Form 10-Kfor the year ended December 31, 2003.

 

**Collaborative agreement revenues**    We recognizecollaborative agreement revenues for fees received as we perform researchservices and achieve specified milestones. Our vaccines segment recognizedcollaborative agreement revenues of $1.2 million for the three monthsended June 30, 2004 primarily related to increased collaboration agreementrevenues following our acquisition of PowderJect Pharmaceuticals. Our vaccinessegment recognized collaborative agreement revenues of $5.2 million forthe six months ended June 30, 2004 primarily related to an agreement tosupply a vaccine for meningococcal meningitis caused by the bacterium N.meningitidis serogroup B to the Ministry of Health in New Zealand and increasedcollaborative agreement revenues following our acquisition of PowderJectPharmaceuticals.

 

Collaborative agreementrevenues tend to fluctuate based on the amount and timing of research servicesperformed, the status of projects under collaboration and the achievement ofmilestones. Due to the nature of our collaborative agreement revenues, resultsin any one period are not necessarily indicative of results to be achieved inthe future. In addition, the collaboration agreements typically provide forcertain milestone payments and various royalties on future product sales if thecollaborative partners commercialize a product using our technology. Also, ourability to generate additional collaborative agreement revenues may depend, inpart, on our ability to initiate and maintain relationships with potential andcurrent collaborative partners.

 

**Royalty and license fee revenues**    Our vaccines segmentearns royalties on third party sales of, and license fees on, several products.The vaccines segment recognized royalty and license fee revenues of$3.3 million for the three months ended June 30, 2003, and$2.7 million and $6.5 million for the six months ended June 30,2004 and 2003, respectively. Royalty and license fee revenues for the vaccinessegment for the three months ended June 30, 2004 were not material.

 

*GlaxoSmithKline*    An agreement with GlaxoSmithKline plc providesfor royalties on sales of certain vaccine products. Under this agreement, werecognized $1.4 million and $3.4 million of such royalties for thesix months ended June 30, 2004 and 2003, respectively. Under thisagreement, any future royalties have ceased.

 

The balance of royalty andlicense fee revenues recognized in our vaccines segment consisted of variousother arrangements, which individually were not material.

 

Royalty and license feerevenues may fluctuate based on the nature of the related agreements, thetiming of receipt of license fees and the expiration of patents. Results in anyone period are not necessarily indicative of results to be achieved in thefuture. In addition, our ability to generate additional royalty and license feerevenues may depend, in part, on our ability to market and capitalize on ourtechnologies.

 

**Other revenues**    Our vaccines segment recognized other revenuesof $5.9 million and $3.2 million for the three months ended June 30,2004 and 2003, respectively, and $9.6 million and $6.0 million forthe six months ended June 30, 2004 and 2003, respectively.

 

*Grant and contract revenues*    Our vaccines segmentother revenues included grant and contract revenues of $5.1 million and $2.5 millionfor the three months ended June 30, 2004 and 2003, respectively, and$8.0 million and $4.7 million for the six months ended June 30,2004 and 2003, respectively. We have entered into a series of agreements withthe U.S. National Institutes of Health to advance our HIV vaccine program intohuman clinical trials. We recognized grant and contract revenues under thesearrangements of $3.1 million and $2.3 million for the three monthsended June 30, 2004 and 2003, respectively, and $5.5 million and $4.1 millionfor the six months ended June 30, 2004 and 2003, respectively.

 

The balance of other revenuesconsisted of various other agreements, which individually were not material.

 

Other revenues recognized inour vaccines segment may fluctuate due to the nature of the revenues recognizedand the timing of events giving rise to these revenues.

 

**Gross profit**    Vaccines gross profit as a percentage of netproduct sales was 34% and 56% for the three months ended June 30, 2004 and2003, respectively, and 34% and 52% for the six months ended June 30, 2004and 2003, respectively. The decrease in gross profit margins for the threemonths ended June 30, 2004 as compared with the three months ended June 30,2003 was primarily due to additional product reserves in the second quarter2004 as well as reduced sales and margins of the Menjugate® product and reducedsales of our tick-borne encephalitis vaccine. The decrease in gross profitmargins for the six months ended June 30, 2004 as compared with the sixmonths ended June 30, 2003 was primarily due to the addition of PowderJectfacilities, a portion of which traditionally is not in flu production for asignificant part of the first quarter, and additional product reserves in thesecond quarter 2004 as well as reduced sales and margins of the Menjugate®product and reduced sales of our tick-borne encephalitis vaccine.

 

Vaccines gross profitpercentages may fluctuate significantly in future periods due to product andcustomer mix, seasonality and ordering patterns, production yields andcompetitive pressures.

 

**Research and development**    Our vaccines segmentrecognized research and development expenses of $31.9 million and$26.8 million for the three months ended June 30, 2004 and 2003,respectively, and $66.3 million and $47.4 million for the six monthsended June 30, 2004 and 2003, respectively. The increase in research anddevelopment spending for the three months ended June 30, 2004 as comparedwith the three months ended June 20, 2003, as well as for the six monthsended June 30, 2004 compared with the

 

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six monthsended June 30, 2003, resulted mainly from the advancement of severalprograms in our meningococcal franchise and flu cell culture. Also, there was$0.9 million and $7.7 million of incremental research and developmentexpenses for the three and six months ended June 30, 2004, respectively,following our third quarter of 2003 acquisition of PowderJect. Research anddevelopment expenses associated with PowderJect declined for the three monthsended June 30, 2004 as we completed the planned divestiture of certainresearch operations in Madison, Wisconsin and Oxford, England.

 

Research and developmentexpenses may fluctuate from period to period depending upon the stage ofcertain projects and the level of pre-clinical and clinical trial-relatedactivities.

 

**Selling, general, and administrative**    Our vaccines segmentrecognized selling, general and administrative expenses of $35.9 millionand $24.7 million for the three months ended June 30, 2004 and 2003,respectively, and $74.9 million and $46.8 million for the six monthsended June 30, 2004 and 2003, respectively. The increase in selling,general and administrative expenses for the three months ended June 30, 2004as compared with the three months ended June 30, 2003, as well as the sixmonths ended June 30, 2004 compared with the six months ended June 30,2003 primarily related to additional expenses following our third quarter of2003 acquisition of PowderJect. Excluding $8.0 million and$18.6 million of additional selling, general and administrative expenses,including integration costs, associated with PowderJect Pharmaceuticals for thethree and six months ended June 30, 2004, respectively, the remaining increasein selling, general and administrative resulted from ongoing sales andmarketing programs and headcount additions.

 

**Amortization expense**    Our vaccines segment recognized amortizationexpense of $14.9 million and $1.5 million for the three months ended June 30,2004 and 2003, respectively, and $30.0 million and $2.9 million forthe six months ended June 30, 2004 and 2003. The increase in amortizationexpense for the three months ended June 30, 2004 as compared with thethree months ended June 30, 2003, as well as the six months ended June 30,2004 compared with six months ended June 30, 2003 related to theintangibles acquired following our third quarter of 2003 acquisition ofPowderJect.

 

***Biopharmaceuticals***

 

**Product sales**    Biopharmaceutical product sales were$126.9 million and $107.3 million for the three months ended June 30,2004 and 2003, respectively, and $253.4 million and $209.0 millionfor the six months ended June 30, 2004 and 2003, respectively.Biopharmaceutical product sales in 2004 and 2003 consisted principally ofBetaseron®, TOBI® and Proleukin®.

 

*Betaseron® interferon beta-1b*    We manufactureinterferon beta-1b which is marketed by Schering AG and its affiliates,including Berlex Laboratories, Inc. (collectively “Schering”), under thetrade names Betaseron® (in the U.S and other non-European markets) andBetaferon® (in Europe). Boehringer Ingelheim also supplies Betaferon® toSchering for sale in Europe. For product manufactured by us, we recognize aportion of revenue for product sales upon shipment to Schering and theremainder based on a contractual percentage of sales by Schering, both of whichwe record as product sales. For product manufactured by Boehringer Ingelheimand marketed by Schering in Europe under the trade name Betaferon®, we receiveroyalties calculated at the same percentage of sales less the amount paid orincurred by Schering for supply costs, which we record in royalty and licensefee revenues. Starting in the fourth quarter 2003, the amount we record asproduct sales, based on a percentage of sales by Schering, and Betaferon®royalties, declined by five percentage points pursuant to our contractualagreement with Schering. As a result, we estimate that the percentage of salesper unit on which our payments are based will decrease, reducing our per unit revenue by approximately 18% (for sales ofChiron product) and approximately 34% (for royalties from sales of BoehringerIngelheim product) from that received prior to the decline. However, there area number of mitigating considerations, including (i) the transitionalsupply agreement, discussed in “Royalty and license fee revenues–Betaferon®interferon beta-1b” below, (ii) the volume mix of Chiron product andBoehringer Ingelheim product and (iii) the launch of product upgrades withease-of-use features. We believe these considerations will partially offsetthis contractual change. In order to supply Betaferon® to Schering, we continueto make capital improvements to our existing manufacturing facilities to increasecapacity.

 

In October 2003, theU.S. Food and Drug Administration approved a new pre-filled diluent syringe forBetaseron®. The pre-filled diluent syringe was launched in January 2004and enhances the delivery mode and shortens preparation, helping to simplifyinjections of Betaseron®.

 

Betaseron® product sales were$31.6 million and $30.5 million for the three months ended June 30,2004 and 2003, respectively, and $61.8 million and $59.8 million forthe six months ended June 30, 2004 and 2003, respectively. The increase inBetaseron® product sales for the three months ended June 30, 2004 ascompared with the three months ended June 30, 2003 primarily related to (i) increasedsales of clinical materials, (ii) price increases and (iii) increasedpatient demand attributed to key marketing programs. These increases werepartially offset by a decline in the royalty rate by five percentage pointspursuant to our contractual agreement with Schering and by fluctuations inordering patterns.

 

The increase in Betaseron®product sales for the six months ended June 30, 2004 as compared to thesix months ended June 30, 2003 primarily related to (i) priceincreases, (ii) increased patient demand attributed to key marketingprograms, (iii) increased sales of clinical materials and (iv) the benefit of foreign exchange rates. Theseincreases were partially offset by a decline in the royalty rate by fivepercentage points pursuant to our contractual agreement with Schering and byfluctuations in ordering patterns.

 

*TOBI® tobramycin*    We sell TOBI® directly in the U.S. and certaininternational markets. We recognized TOBI® sales of $51.3 million and$39.0 million for the three months ended June 30, 2004 and 2003,respectively, and $103.9 million and

 

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$79.7 millionfor the six months ended June 30, 2004 and 2003, respectively. IncreasedTOBI® sales for the three months ended June 30, 2004 as compared with thethree months ended June 30, 2003, as well as for the six months ended June 30,2004 compared with the six months ended June 30, 2003, primarily relatedto (i) wholesaler ordering patterns, (ii) increased patient demand inthe U.S., (iii) price increases and (iv) the benefit of the movementin the Euro to U.S. Dollar exchange rate.

 

*Proleukin® (aldesleukin)*    Sales were$35.1 million and $29.4 million for the three months ended June 30,2004 and 2003, respectively, and $66.9 million and $55.4 million forthe six months ended June 30, 2004 and 2003, respectively. The increase inProleukin® product sales for the three months ended June 30, 2004 ascompared with the three months ended June 30, 2003, as well as for the sixmonths ended June 30, 2004 as compared with the six months ended June 30,2003 is primarily related to (i) wholesaler ordering patterns, (ii) priceincreases and (iii) the benefit of the movement in the Euro to U.S. Dollarexchange rate.

 

The balance of product salesrecognized in our biopharmaceuticals segment consisted of various otherproducts, which individually were not material.

 

Wholesale ordering patterns,reimbursement and government pressures, competition, foreign currency exchangerates and the level of rebates may influence future biopharmaceutical sales. Weexpect competitive pressures related to many of our biopharmaceutical productsto continue into the future, primarily as a result of the introduction ofcompeting products into the market, as listed in Part I, Item 1., “Business–Competition” of our Annual Report on Form 10-Kfor the year ended December 31, 2003.

 

**Collaborative agreement revenues**    We recognizecollaborative agreement revenues for fees received as we perform researchservices and achieve specified milestones. Our biopharmaceuticals segmentrecognized collaborative agreement revenues of $0.3 million and$1.1 million for the three months ended June 30, 2004 and 2003,respectively, and $0.8 million and $3.3 million for the six monthsended June 30, 2004 and 2003, respectively. The decline for the threemonths ended June 30, 2004 as compared with the three months ended June 30,2003 is due to the near completion of our fourth quarter 2002 collaborationactivities under our collaboration agreement and license agreement withGlaxoSmithKline plc related to certain of our MC-4R compound patents. Thedecline for the six months ended June 30, 2004 as compared with the sixmonths ended June 30, 2003 is due to the near completion of our fourthquarter 2002 collaboration activities under our collaboration agreement andlicense agreement with GlaxoSmithKline plc related to certain of our MC-4Rcompound patents and due to completion in the first quarter 2003 of our 2001collaboration agreement with Taisho Pharmaceuticals Co. Ltd. to targetmacrolide mediated gene discovery.

 

Collaborative agreement revenuestend to fluctuate based on the amount and timing of research servicesperformed, the status of projects under collaboration and our achievement ofperformance milestones. Due to the nature of our collaborative agreementrevenues, results in any one period are not necessarily indicative of resultsto be achieved in the future. In addition, the collaboration agreementstypically provide for certain milestone payments and various royalties onfuture product sales if the collaborative partners commercialize a productusing our technology. Also, our ability to generate additional collaborativeagreement revenues may depend, in part, on our ability to initiate and maintainrelationships with potential and current collaborative partners.

 

**Royalty and license fee revenues**    Our biopharmaceuticalssegment earns royalties on third party sales of several products, includingBetaferon® and recombinant insulin and glucagon products. Ourbiopharmaceuticals segment also earns license fees for technologies, such as hepatitisC virus-related patents, used by third parties to develop therapeutic products.The biopharmaceuticals segment recognized royalty and license fee revenues of$15.2 million and $20.8 million for the three months ended June 30,2004 and 2003, respectively, and $32.5 million and $38.6 million forthe six months ended June 30, 2004 and 2003, respectively.

 

*Betaferon® interferon beta-1b*    We manufactureinterferon beta-1b which is marketed by Schering AG and its affiliates,including Berlex Laboratories, Inc. (collectively “Schering”), under thetrade names Betaseron® (in the U.S and other non-European markets) andBetaferon® (in Europe). Boehringer Ingelheim also supplies Betaferon® toSchering for sale in Europe. For product manufactured by Boehringer Ingelheim,we receive royalties calculated as a percentage of sales less the amount paidor incurred by Schering for supply costs, including Schering’s cost to purchaseproduct from Boehringer Ingelheim.

 

For the three months ended June 30,2004 and 2003, we recognized Betaferon® royalties of $11.6 million and$17.2 million, respectively, and for the six months ended June 30,2004 and 2003, we recognized Betaferon® royalties of $25.4 million and$31.1 million, respectively, under this arrangement. Betaferon® royaltiesdecreased for the three months ended June 30, 2004 as compared with thethree months ended June 30, 2003 as well as for the six months ended June 30,2004 as compared with the six months ended June 30, 2003 primarily due toa decline in the royalty rate by five percentage points, pursuant to ourcontractual agreement with Schering, partially offset by (i) an increasein demand, (ii) the benefit of the movement in the Euro to U.S. Dollarexchange rate and (iii) the benefit of a reduction of the allocated costunder a three-year limited cost sharing arrangement under the transitionalsupply agreement with Schering.

 

We began supplying Betaferon®to Schering in the fourth quarter 2002 for certain additional European markets,which was previously supplied by Boehringer Ingelheim. This resulted in a shiftof revenue recognized under this agreement to product sales, with a decrease inroyalty revenues, beginning in the fourth quarter 2002. In 2003, Scheringextended its supply agreement with Boehringer Ingelheim through 2008. The exactshift of revenue in the future will be contingent on our production capacity,Schering’s minimum purchase commitment under the extended supply agreement withBoehringer Ingelheim and market demand. The shift to product sales is expectedto increase over the next three years. Future Betaferon® royalties will beinfluenced by demand, price changes and foreign currency exchange rates.

 

*Novo Nordisk*    We earn royalty revenues on insulin and glucagonproduct sales by Novo Nordisk AS. We recognized

 

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$0.9 millionand $1.9 million for the three months ended June 30, 2004 and 2003,respectively, and $2.3 million and $3.9 million for the six monthsended June 30, 2004 and 2003, respectively, under this arrangement.Patents related to the production of insulin and glucagon began expiring inlate 2003 and as a result, royalty revenues recognized under this arrangementare declining significantly.

 

The balance of royalty andlicense fee revenues recognized in our biopharmaceuticals segment consisted ofvarious other agreements, which individually were not material.

 

Royalty and license feerevenues may fluctuate based on the nature of the related agreements, thetiming of receipt of license fees and the expiration of patents. Results in anyone period are not necessarily indicative of results to be achieved in thefuture. Also, the license agreements typically provide for certain milestonepayments and various royalties on future product sales if the licenseescommercialize a product using our technology. However, we have no assurancethat the licensees will meet their development objectives or commercialize aproduct using our technology. In addition, our ability to generate additional royaltyand license fee revenues may depend, in part, on our ability to market andcapitalize on our technologies. We have no assurance that we will be able to doso or that future royalty and license fee revenues will not decline.

 

**Other revenues**    Our biopharmaceuticals segment recognized otherrevenues of $4.8 million and $3.2 million for the three months ended June 30,2004 and 2003, respectively, and $7.9 million and $18.8 million forthe six months ended June 30, 2004 and 2003, respectively.

 

*Contract manufacturing revenues*    Our biopharmaceuticalssegment recognized contract manufacturing revenues of $4.7 million and$3.0 million for the three months ended June 30, 2004 and 2003,respectively, and $7.5 million and $3.1 million for the six monthsended June 30, 2004 and 2003, respectively. The fluctuation resulted fromthe level of activity and the timing of contract manufacturing activities.

 

*Biogen and Serono settlements*    A U.S. Court ofAppeals partially reversed a District Court ruling in connection with certainpatents owned by Chiron and licensed exclusively to Schering AG’s U.S.subsidiary, Berlex Laboratories. As a result of the ruling and prior agreementsbetween Biogen and Berlex, Biogen was required to make a settlement payment toSchering. In accordance with an earlier contract between Chiron and Berlex, werecognized approximately $13.0 million during the six months ended June 30,2003, which represented our share of this settlement payment. In addition,there was a similar settlement between Berlex and Serono of which we recognizedapproximately $1.4 million during the six months ended June 30, 2003.

 

The balance of other revenuesrecognized in our biopharmaceuticals segment consisted of various otherarrangements, which individually were not material.

 

Other revenues recognized inour biopharmaceuticals segment may fluctuate due to the nature of the revenuesrecognized and the timing of events giving rise to these revenues. We cannotguarantee that we will be successful in obtaining additional revenues or thatthese revenues will not decline.

 

**Gross profit**    Biopharmaceutical gross profit as a percentageof net product sales was 74% and 71% for the three months ended June 30,2004 and 2003, respectively, and 75% for each of the six months ended June 30,2004 and 2003, respectively. The increase in biopharmaceutical gross profitmargins for the three months ended June 30, 2004 as compared with thethree months ended June 30, 2003 was primarily the result of priceincreases and improved efficiencies in production, partially offset by thecontractual change in the royalty rate related to the sale of Betaseron® andthe increased costs associated with the pre-filled diluent syringe forBetaseron®. Biopharmaceutical gross profit was consistent for the six monthsended June 30, 2004 as compared with the six months ended June 30,2003. Price increases and improved efficiencies in production were offset bythe contractual change in the royalty rate related to the sale of Betaseron®and the increased costs associated with pre-filled diluent syringe forBetaseron®.

 

Biopharmaceutical grossprofit percentages may fluctuate significantly in future periods due toproduction yields, increased cost to produce the Betaseron® pre-filled diluentsyringe, the decline in Betaseron® product sales, based on a percentage ofsales by Schering, by five percentage points pursuant to our contractualagreement with Schering and as the biopharmaceutical product and customer mixchanges.

 

**Research and development**    Our biopharmaceuticalssegment recognized research and development expenses of $61.8 million and$57.4 million for the three months ended June 30, 2004 and 2003,respectively, and $120.4 million and $113.7 million for the sixmonths ended June 30, 2004 and 2003, respectively.

 

The increase in research anddevelopment spending for the three months ended June 30, 2004 as comparedwith the three months ended June 30, 2003, as well as for the six monthsended June 30, 2004 as compared with the six months ended June 30, 2003,primarily related to activities related to the development of (i) tifacogin,as discussed below,(ii) CHIR-258, a growth factor kinase inhibitorand our first small-molecule oncology compound in development, (iii) cyclosporinesolution for inhalation, a therapy under evaluation for the treatment ofrejection and reduction of mortality in lung transplant patients, and (iv) adry powder formulation of inhaler, TOBI®. These increases were partially offsetby (i) the discontinuance of development of tezacitabine in the firstquarter of 2004 based on an analysis of the data from a Phase II trial inpatients with gastroesophageal cancer, (ii) decline in spending due todiscontinuance of development of PA-2794, (iii) decrease in spending ondevelopment of manufacturing processes for Betaseron®, and (iv) decreasein spending on the SILCAAT trial, as described below.

 

In the fourth quarter 2002,we reached an agreement in principle to transfer responsibility for the SILCAAT(referred to also as Proleukin® (aldesleukin) for HIV) trial, a Phase III studyfor recombinant human interleukin-2 (IL-2, aldesleukin), to theNational

 

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Institutes Allergy and Infectious Disease (NIAID) and the University ofMinnesota. Responsibilityfor the SILCAAT study was transferred to NIAID and University of Minnesotaeffective February 14, 2003. Our research and development expenses relatedto the SILCAAT trial are expected to decrease in 2004 as a result of thetransfer. Under the agreement, we are obligated to fund a maximum of$18.0 million over the lifetime of the trial and to supply clinicalmaterials and certain other support services of which $9.0 million hasbeen paid through June 30, 2004.

 

In October 2003, weacquired all of Pfizer, Inc.’s, formerly Pharmacia Corp.’s, interest intifacogin, in return for which Pfizer will receive royalties on future sales oftifacogin. In the second quarter 2004, we began enrolling patients in our PhaseIII trial for tifacogin as a treatment for patients with severecommunity-acquired pneumonia.

 

Research and developmentexpenses may fluctuate from period to period depending upon the stage ofcertain projects and the level of pre-clinical and clinical trial-relatedactivities.

 

**Selling, general, and administrative**    Our biopharmaceuticalssegment recognized selling, general and administrative expenses of$33.2 million and $28.7 million for the three months ended June 30,2004 and 2003, respectively, and $65.2 million and $54.9 million forthe six months ended June 30, 2004 and 2003, respectively. The increase inselling, general and administrative expenses for the three months ended June 30,2004 as compared with the three months ended June 30, 2003, as well as thesix months ended June 30, 2004 compared with six months ended June 30,2003, related to increased expenses for programs and headcount in support ofTOBI® and Proleukin®, and the Euro to U.S. Dollar exchange rate fluctuation,partially offset by lower consulting costs to enhance business processes.

 

**Amortization expense**    Our biopharmaceuticals segment recognizedamortization expense of $6.2 million for each of the three months ended June 30,2004 and 2003, respectively, and $12.5 million and $12.4 million forthe six months ended June 30, 2004 and 2003, respectively.

 

***Other***

 

**Royalty and license fee revenues**    Our other segmentearns royalties on third party sales of, and license fees on, several products.Our other segment recognized royalty and license fee revenues of$23.7 million and $19.6 million for the three months ended June 30,2004 and 2003, respectively, and $42.1 million and $36.4 million forthe six months ended June 30, 2004 and 2003, respectively. The majority ofroyalty and license fee revenues related to the use of our hepatitis C virusand HIV-related patents for diagnostic testing purposes by various thirdparties.

 

*F. Hoffmann-La Roche settlement*    In October 2000,we entered into three license agreements with F. Hoffmann-La Roche Limitedrelated to the settlement of litigation in the U.S. and certain other countriesfor use of our hepatitis C virus and HIV nucleic acid testing intellectualproperty for use in clinical diagnostics.

 

Under the hepatitis C virusagreement, we received $85.0 million, of which we recognized $40.0 millionin the fourth quarter 2000. We deferred the remaining $45.0 million, whichbecomes nonrefundable ratably through 2005. In the first quarter 2001, we beganrecognizing portions of the $45.0 million based upon the greater of (i) thescheduled quarterly minimum non-refundable amount or (ii) the actualearned credits as royalties on future sales related to F. Hoffmann-La Roche’suse of our hepatitis C virus-related patent in its *in vitro* diagnostic products. The agreement also providesfor royalties on future sales related to F. Hoffmann-La Roche’s use of ourhepatitis C virus-related patent in its *invitro* diagnostic products, which commenced in the first quarter2001. Royalty revenues increased for the three months ended June 30, 2004as compared to the three months ended June 30, 2003 as well as for the sixmonths ended June 30, 2004 as compared with the six months ended June 30,2003, primarily as a result of an increase in quarterly minimum amounts werecognize under this agreement, an increase in the positive adjustment ofestimated to actual royalty revenue recorded in the subsequent quarter andincreased product sales recognized by F. Hoffman-La Roche.

 

The HIV agreement alsoprovides for royalties on future sales related to F. Hoffmann-La Roche’s use ofour HIV-related patent in its *in vitro*diagnostic products, which commenced in the first quarter 2001 when theEuropean Patent Office Board of Technical Appeals upheld our HIV-relatedpatent. Royalty revenues recognized under this agreement for the three and sixmonths ended June 30, 2004 were consistent with the three and six monthsended June 30, 2003, respectively.

 

Under these agreements, suchroyalties will continue through the lives of the hepatitis C virus andHIV-related patents covering F. Hoffmann-La Roche’s nucleic acid testingproducts. Currently, the applicable issued hepatitis C virus-related patentsexpire in 2015 for the U.S. and in 2010 for Europe. Currently, the applicableissued HIV-related patent in Europe expires in 2005. An HIV-related patentdirected to nucleic acid testing methods for HIV-1 was issued in the U.S.on March 13, 2003. This patent will expire seventeen years from the dateof issuance. The issuance of the patent triggered a milestone payment to Chironof $10.0 million from F. Hoffmann-La Roche, which was received in April 2003.As permitted under the terms of its licensing agreement, F. Hoffmann-La Rochehas decided to institute arbitration proceedings in regard to the applicationof the U.S. patent. We have deferred recognition of this $10.8 millionmilestone payment and interest as of June 30, 2004 and $16.3 millionand $3.8 million of royalty revenue as of June 30, 2004 and 2003,respectively. During any pending arbitration proceedings, F. Hoffmann-La Rocheremains obligated to make all quarterly royalty payments, subject to a right tobe reimbursed by Chiron if it is determined in the arbitration that suchroyalty payments were not due.

 

*Bayer*    Across-license agreement provides for royalties to us on HIV and hepatitis Cvirus products sold by Bayer, which increased for the three months ended June 30,2004 as compared with the three months ended June 30, 2003, due toincreased donations. The six months ended June 30, 2004 as compared withthe six months ended June 30, 2003 increased primarily due to

 

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(i) additional royalties under the HIV-related patent issued inthe U.S. in March 2003, discussed above, (ii) increased royalty ratesand (iii) increase donations.

 

*Abbott Laboratories*    A cross-license agreement provides for royaltiesto us on HIV and hepatitis C virus products sold by Abbott. We recognizedroyalty and license fee revenues under this agreement in the second quarter2003.

 

The balance of royalty andlicense fee revenues consisted of various other agreements, which individuallywere not material.

 

Royalty and license feerevenues may fluctuate based on the nature of the related agreements, thetiming of receipt of license fees and the expiration of patents. Results in anyone period are not necessarily indicative of results to be achieved in thefuture. In addition, our ability to generate additional royalty and license feerevenues may depend, in part, on our ability to market and capitalize on ourtechnologies.

 

**Selling, general, and administrative**    Our other segmentrecognized selling, general and administrative expenses of $27.4 millionand $17.2 million for the three months ended June 30, 2004 and 2003,respectively, and $52.0 million and $34.0 million for the six monthsended June 30, 2004 and 2003, respectively. The increases in selling,general and administrative for the three and six months ended June 30,2004 as compared with the three and six months ended June 30, 2003 wereprimarily due to higher litigation costs related to the defense of our patentsand technology, higher facility related costs, higher employee related expensesand higher consulting expenses.

 

**Interest expense**    We recognized interest expense of$6.5 million and $2.8 million for the three months ended June 30,2004 and 2003, respectively, and $12.4 million and $6.3 million thesix months ended June 30, 2004 and 2003, respectively. The increase ininterest expense for the three and six months ended June 30, 2004 ascompared with the three and six months ended June 30, 2003 primarilyrelated to interest expense recognized on the $500.0 million convertibledebentures that were issued on July 30, 2003.

 

**Interest and other income, net**    Interest and otherincome, net, primarily consisted of interest income on our cash and investmentbalances and other non-operating gains and losses. We recognized interestincome of $5.8 million and $6.3 million for the three months ended June 30,2004 and 2003, respectively, and $10.9 million and $13.3 million forthe six months ended June 30, 2004 and 2003, respectively. The decreasesin interest income for the three and six months ended June 30, 2004 ascompared with the three and six months ended June 30, 2003 were primarilydue to lower average cash and investment balances following the acquisition ofPowderJect Pharmaceuticals.

 

We recognized gains of$14.3 million and $4.8 million for the three months ended June 30,2004 and 2003, respectively, and $24.0 million and $9.4 million forthe six months ended June 30, 2004 and 2003, respectively, related to thesale of certain equity securities.

 

On December 31, 1998, wecompleted the sale of our 30% interest in General Injectibles &Vaccines, Inc., a distribution business, to Henry Schein, Inc. andreceived payment in full of certain advances we made to General Injectibles &Vaccines. The agreement also provided for us to receive additional payments,calculated as a pre-determined percentage of Henry Schein’s gross profit,through 2003. We received $3.5 million for 2003 and $2.0 million for2002 during the six months ended June 30, 2004 and 2003, respectively.

 

**Income taxes**    The effective tax ratefor the three and six months ended June 30, 2004 and 2003 was 25% ofpretax income from continuing operations. The effective tax rate may beaffected in future periods by changes in management’s estimates with respect toour deferred tax assets and other items affecting the overall tax rate.

 

Management believes theacquisition of PowderJect Pharmaceuticals may cause an increase in the futureeffective tax rate and is in the process of evaluating certain options that maymitigate any potential increase. Specifically, most of PowderJectPharmaceuticals’ profits are earned in the United Kingdom subject to a 30%marginal tax rate.

 

**Discontinued operations**    During the threemonths ended June 30, 2004, Chiron and the IRS entered into a settlementagreement closing the open tax years 1996 to 1998. Pursuant to this settlementagreement we recognized for the three months ended June 30, 2004 a taxbenefit of $12.5 million for discontinued operations.

 

Chiron and Bayer wereinvolved in a dispute with respect to their respective rights to certainroyalty refunds receivable for which a settlement was reached in 2004. Underthis settlement agreement, we made a payment to Bayer in 2004. This settlementincludes an agreement that all outstanding items with Bayer related to the saleof Chiron Diagnostics are resolved and no future indemnity obligations arerequired. We released previously established reserves in excess of the requiredpayments for the indemnity obligations in the first quarter of 2004. Thissettlement resulted in a benefit of $0.3 million and an income tax benefitof $12.5 million, resulting in a net gain of $12.8 million, which wasreported as a “Gain from discontinued operations” for the six months ended June 30,2004.

 

During the three months endedJune 30, 2003, we reversed approximately $0.5 million related tounutilized reserves of Chiron Diagnostics and Chiron Vision, which wererecorded as a “Gain from discontinued operations” for the three months ended June 30,2003.

 

During the three months endedMarch 31, 2003, Chiron and Bayer Corporation reached a settlementagreement relating to certain claims raised by Bayer under the Stock PurchaseAgreement dated September 17, 1998, between Chiron and Bayer for Chiron

 

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Diagnostics.Under this settlement agreement, we were required to make a payment to Bayerduring the first quarter 2003. Pursuant to this settlement, we recorded acharge, net of adjustment to our previously provided reserve for indemnityobligations, of $7.6 million, offset by an income tax benefit of$9.0 million, resulting in a net gain of $1.4 million, which wasreported as a “Gain from discontinued operations” for the six months ended June 30,2003.

 

**Liquidityand Capital Resources**

 

Our capital requirements havegenerally been funded by cash flow from operations, borrowings from commercialbanks and issuance of debt securities and common stock. Our cash, cashequivalents and investments in marketable debt securities, which totaled$1,034.0 million at June 30, 2004, are invested in a diversifiedportfolio of financial instruments, including money market funds andinstruments, corporate notes and bonds, government or government agencysecurities and other debt securities issued by financial institutions and otherissuers with strong credit ratings. By policy, the amount of credit exposure toany one institution is limited. Investments are generally not collateralizedand primarily mature within three years.

 

On June 12, 2004,certain Liquid Yield Option Notes (LYONs) holders, at their option, tendered$649.9 million in aggregate principal amount at maturity of LYONs, whichwere purchased by us. The purchase price for the LYONs was $584.31 in cash per$1,000 in principal amount at maturity. The aggregate purchase price for allthe LYONs validly surrendered for purchase was $379.7 million. At June 30,2004, there remains $80.1 million in aggregate principal amount atmaturity and an accreted balance of $46.8 million for the LYONs.

 

On June 22, 2004, weissued $385.0 million aggregate principal amount of convertibledebentures, which mature on June 30, 2034. The convertible debenturesaccrue interest at a rate of 2.75% per year and interest is payable on June 30and December 30 commencing December 30, 2004. The debentures aresenior, unsecured obligations and rank equal in right of payment with all ofour existing and future unsecured and unsubordinated indebtedness.

 

We believe that our cash,cash equivalents and marketable debt securities, together with funds providedby operations and leasing arrangements, will be sufficient to meet ourforeseeable operating cash requirements including any cash utilized under ourstock repurchase program and our contractual obligations. In addition, webelieve we could access additional funds from the debt and capital markets.

 

**Sources and uses of cash**    We had cash and cashequivalents of $595.0 million and $876.0 million at June 30,2004 and 2003, respectively.

 

*Operating activities*    For the six monthsended June 30, 2004, net cash provided by operating activities was$74.7 million as compared with $112.7 million for the six monthsended June 30, 2003. The decrease in cash provided by operating activitiesprimarily was due to lower income from continuing operations beforedepreciation and amortization and non-cash charges mainly from higher costs inour vaccines segment related to the effect of our acquisition of PowderJect.This was partially offset by higher royalty payments received under the Rocheroyalty arrangements for the six months ended June 30, 2004. In addition,the cash provided by operations for the six months ended June 30, 2003 wasnegatively impacted by tax payments and a payment to Bayer Corporation as aresult of a settlement agreement relating to certain claims raised by Bayer inconnection with the Stock Purchase Agreement dated September 17, 1998 andpositively impacted by $14.4 million of cash received as a result of theBiogen and Serono settlements in connection with the McCormick patents duringthe six months ended June 30, 2003.

 

*Investing activities*    For the six monthsended June 30, 2004, net cash provided by investing activities consistedof proceeds from sales and maturities of investments in marketable debtsecurities of $508.1 million, proceeds from the sale of equity securitiesand interests in affiliated companies of $16.3 million and other proceedsof $0.8 million. Cash provided by investing activities was offset bypurchases of investments in marketable debt securities of $218.8 million,capital expenditures of $93.8 million, cash paid for acquisitions, net ofcash acquired of $19.5 million, which consists of $15.5 million ofcash delivered on the divestiture of certain research operations in Madison,Wisconsin and Oxford, England and certain vaccines operations in Sweden and$4.0 million for previously accrued costs in connection with theacquisition of PowderJect, purchases of equity securities and interests inaffiliated companies of $4.3 million.

 

In 2003, our Board ofDirectors approved $50.7 million in expenditures for a 25-year leasefor buildings and $42.2 million for capital improvements, both of whichare part of a $97.0 million project for a new flu vaccines manufacturingfacility in Liverpool, England. The new manufacturing facility will replaceexisting flu vaccines manufacturing facilities in Liverpool, England. In December 2003,we entered into a 25-year lease for these buildings. As of June 30,2004, we have incurred $6.3 million for these capital improvements.

 

For the six months ended June 30,2003, net cash provided by investing activities consisted of proceeds fromsales and maturities of investments in marketable debt securities of$917.8 million and proceeds from the sale of equity securities andinterests in affiliated companies of $7.4 million. Cash provided byinvesting activities was offset by purchases of investments in marketable debtsecurities of $277.5 million, capital expenditures of $52.4 million,purchases of equity securities and interests in affiliated companies of$36.9 million, cash paid for acquisitions, net of cash acquired of $1.2 millionand other uses of cash of $0.8 million.

 

*Financing activities*    For the six monthsended June 30, 2004, net cash used in financingactivities consisted of $380.0 million for the repayment of debt andcapital leases, $71.7 million for the acquisition of treasury stock and$7.8 million for the payment of debt issuance costs. Cash used infinancing activities was offset by $385.0 million of proceeds fromissuance of convertible debentures, $45.0 million of proceeds from thereissuance of treasury stock and $2.3 million of proceeds from theissuance of debt.

 

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Our Board of Directors hasauthorized the repurchase of our common stock on the open market. In December 5,2003, the Board of Directors granted authority to buy 5.0 million sharesand authorized the repurchases through December 31, 2004. From January 1,2004 through June 30, 2004, 1.5 million shares were repurchased.

 

For the six months ended June 30,2003, net cash used in financing activities consisted of $68.1 million forthe acquisition of treasury stock, $0.1 million for the net repayment ofshort-term borrowings and $0.1 million for the repayment of debt. Cashused in financing activities was offset by $24.5 million of proceeds fromthe reissuance of treasury stock (related to stock option exercises), and$2.1 million of proceeds from put options.

 

From time to time, weevaluate a number of business development opportunities. To the extent that weare successful in reaching agreements with third parties, these transactionsmay involve selling a significant portion of our current investment portfolio,incurring additional debt or issuing additional Chiron shares.

 

**Borrowing arrangements**    Under a revolving,committed, uncollateralized credit agreement with a major financialinstitution, we can borrow up to $100.0 million in the U.S. This creditfacility is guaranteed by Novartis AG under a November 1994 InvestmentAgreement, provides various interest rate options and matures in February 2006.There were no borrowings outstanding under this credit facility at June 30,2004 and December 31, 2003. In December 1999, Chiron and Novartisamended the November 1994 Investment Agreement to reduce the maximumamount of our obligations that Novartis would guarantee from $725.0 millionto $702.5 million.

 

As of June 30, 2004,Novartis had also guaranteed $173.3 million of Chiron’s lease commitmentsfor a six-year lease to rent a research facility in Emeryville, California.

 

**Factors ThatMay Affect Future Results**

 

As a global pharmaceuticalcompany, we are engaged in a rapidly evolving and often unpredictable business.The forward-looking statements contained in this 10-Q and in otherperiodic reports, press releases and other statements issued by us from time totime reflect our current beliefs and expectations concerning objectives, plans,strategies, future performance and other future events. The followingdiscussion highlights some of the factors, many of which are beyond ourcontrol, which could cause actual results to differ.

 

*If ourfocus on the research and development of emerging technologies does not resultin the creation of commercial products, our business could be harmed.*

 

We focus our research anddevelopment activities on areas in which we have particular strengths and ontechnologies that appear promising. These technologies often are on the cuttingedge of modern science. As a result, the outcome of any research or developmentprogram is highly uncertain. Only a very small fraction of these programsultimately result in commercial products or even product candidates. Productcandidates that initially appear promising often fail to yield successfulproducts. In many cases, preclinical or clinical studies will show that aproduct candidate is not efficacious (that is, it lacks the intendedtherapeutic or prophylactic effect), or that it raises safety concerns or hasother side effects, which outweigh the intended benefit. Success in preclinicalor early clinical trials (which generally focus on safety issues) may nottranslate into success in large-scale clinical trials (which are designed toshow efficacy), often for reasons that are not fully understood. Further,success in clinical trials will likely lead to increased investment, adverselyaffecting short-term profitability, to bring such products to market. And evenafter a product is approved and launched, general usage or post-marketingstudies may identify safety or other previously unknown problems with theproduct which may result in regulatory approvals being suspended, limited tonarrow indications or revoked, or which may otherwise prevent successfulcommercialization.

 

*Conflictswith or decisions by third parties we collaborate with could harm our business.*

 

An important part of ourbusiness strategy depends upon collaborations with third parties, includingresearch collaborations and joint efforts to develop and commercialize newproducts. As circumstances change, Chiron and our strategic partners maydevelop conflicting priorities or other conflicts of interest. We mayexperience significant delays and incur significant expenses in resolving theseconflicts and may not be able to resolve these matters on acceptable terms.Even without conflicts of interest, we may disagree with our strategic partnersas to how best to realize the value associated with a current product or aproduct in development. In some cases, the strategic partner may haveresponsibility for formulating and implementing key strategic or operationalplans. In addition, merger and acquisition activity within the pharmaceuticaland biotechnology industries may affect our strategic partners, causing them toreprioritize their efforts related to the research collaborations and otherjoint efforts with us. Decisions by corporate partners on key clinical,regulatory, marketing (including pricing), inventory management and otherissues may prevent successful commercialization of the product or otherwiseimpact our profitability.

 

*If we failto obtain or maintain the regulatory approvals we need to market our products,our business will suffer.*

 

We must obtain and maintainregulatory approval in order to market most of our products. Generally, theseapprovals are on a product-by-product and country-by-country basis. In the caseof therapeutic products, a separate approval is required for each therapeuticindication. Product candidates that appear promising based on early, and evenlarge-scale, clinical trials may not receive regulatory approval. The resultsof clinical trials often are susceptible to varying interpretations that maydelay, limit or prevent approval or result in the need for post-marketingstudies. In addition, regulations may be amended from time to time. Revised

 

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regulationsmay require us to reformulate products on a country or regional basis, obtainadditional regulatory approvals, or accept additional risks that our productswill not maintain market acceptance or be eligible for third party insurancecoverage. Increased regulatory scrutiny and restrictions regarding marketingpractices for products that are subject to government reimbursement may impactthe sales of such products. There is no guarantee that we will be able tosatisfy these new regulatory requirements and may suffer a loss of revenue as aresult.

 

*Ourproducts are complex and difficult to manufacture on a large-scale basis, whichcould cause us to delay product launches, experience shortages of products orprevent us from offering products on a volume basis.*

 

Most of our products arebiologics. Manufacturing biologic products is complex. Unlike chemicalpharmaceuticals, a biologic product generally cannot be sufficientlycharacterized (in terms of its physical and chemical properties) to rely onassaying of the finished product alone to ensure that the product will performin the intended manner. Accordingly, it is essential to be able to bothvalidate and control the manufacturing process, that is, to show that theprocess works and that the product is made strictly and consistently incompliance with that process. Slight deviations anywhere in the manufacturingprocess, including quality control, labeling and packaging, may result inunacceptable changes in the products that may result in lot failures or productrecalls, or liability to a third party to the extent we are contractmanufacturing products in our facilities for such third party. Manufacturingprocesses which are used to produce the smaller quantities of material neededfor research and development purposes may not be successfully scaled up toallow production of commercial quantities at reasonable cost or at all. All ofthese difficulties are compounded when dealing with novel biologic productsthat require novel manufacturing processes. Additionally, manufacturing issubject to extensive government regulation. Even minor changes in themanufacturing process require regulatory approval, which, in turn, may requirefurther clinical studies. For some of our products, we rely on others to supplyraw materials and to manufacture those products according to regulatoryrequirements.

 

In addition, any prolongedinterruption in our operations or those of our partners could result in ourinability to satisfy the product demands of our customers. A number of factorscould cause interruptions, including equipment malfunctions or failures,interruptions due to labor action, damage to a facility due to naturaldisasters, such as an earthquake, suspension of power supplied to thesefacilities arising out of regional power shortages or terrorist activities andarmed conflict, including as a result of the disruption of operations of oursubsidiaries and our customers, suppliers, distributors, couriers,collaborative partners, licensees and clinical trial sites.

 

*Our mishandlingof hazardous materials could result in substantial costs and harm to ourbusiness.*

 

In connection with ourresearch and manufacturing activities, we utilize some hazardous materials. Webelieve we take great care to ensure we have appropriate procedures and permitsin place for storing and handling such hazardous materials. We could be subjectto loss of our permits, government fines or penalties and/or other adversegovernmental action if such hazardous materials are stored, handled or releasedinto the environment in violation of law or any permit. A substantial fine orpenalty, the payment of significant environmental remediation costs or the lossof a permit or other authorization to operate or engage in our ordinary courseof business could result in material, unanticipated expenses and the possibleinability to satisfy customer demand.

 

*If any ofour third party suppliers or manufacturers cannot adequately meet our needs,our business could be harmed.*

 

We use raw materials andother supplies that generally are available from multiple commercial sources.Certain manufacturing processes, however, use materials that are available fromsole sources, or that are in short supply, or are difficult for the supplier toproduce and certify in accordance with our specifications. From time to time,concerns are raised with respect to potential contamination of biologicalmaterials that are supplied to us. These concerns can further tighten marketconditions for materials that may be in short supply or available from limitedsources. Moreover, regulatory approvals to market our products may beconditioned upon obtaining certain materials from specified sources. Ourability to substitute material from an alternate source may be delayed pendingregulatory approval of such alternate source. Although we work to mitigate therisks associated with relying on sole suppliers, there is a possibility thatmaterial shortages could impact production.

 

We purchase bulk powderedtobramycin, the primary basic raw material in TOBI® tobramycin, from two of theprincipal worldwide suppliers of the drug. We anticipate that either one ofthese suppliers alone will be able to supply sufficient quantities to meetcurrent needs; however, there can be no assurance that these suppliers will beable to meet future demand in a timely and cost-effective manner. As a result,our operations could be adversely affected by an interruption or reduction inthe supply of bulk-powdered tobramycin.

 

We have entered intocontracts with third parties for the production and packaging of TOBI®. Overtime, we can use alternative production and packaging sources. However, if thecontracted third parties become unable to produce or package sufficientquantities of TOBI® due to work stoppages or other factors, our operationscould be disrupted until alternative sources are secured.

 

We have entered intocontracts with third parties for the packaging of the pre-filled diluentsyringe for Betaseron®. Over time, we can use alternative packaging sources.However, if the contracted third parties become unable to produce or packagesufficient quantities of the pre-filled diluent syringe for Betaseron® due towork stoppages or other factors, our operations could be disrupted untilalternative sources are secured.

 

In connection with theproduction of our flu vaccine products, we must purchase large quantities ofchicken eggs. Currently, for Fluvirin® vaccine, we purchase those eggs andincubation services from a single supplier in the United Kingdom and, pursuantto the contract with that supplier, we are required tomake specified minimum purchases from that supplier through 2007. If oursupplier

 

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were to failto supply eggs in sufficient quantities or quality, including as a result ofany health or other issues related to the chickens, our business would bematerially adversely affected.

 

We are a key provider for theblood screening field of nucleic acid testing and immunodiagnostics. In nucleicacid testing, we rely on our collaborative partner, Gen-Probe, to manufacturethe West Nile virus assay, currently in use on an investigational-use basis inthe U.S. and the Procleix® HIV-1/HCV Assay. We currently source therelated instrument system from third party suppliers. Currently, Gen-Probe isthe only manufacturer of nucleic acid testing products usingTranscription-Mediated Amplification technology. In immunodiagnostics, underthe Ortho-Clinical Diagnostics, Inc. contract, we manufacture bulkreagents and antigens and confirmatory test kits sold in the clinicaldiagnostics and blood screening fields. While we and our partners work tomitigate the risks associated with being a key provider, there can be noassurance that our partner, Gen-Probe, will be able to provide sufficientquantities of the Procleix® HIV-1/HCV Assay or that we will be able tomanufacture sufficient bulk reagents and antigens and confirmatory test kitsfor immunodiagnostic products. Our difficulties or delays or those of ourpartners’ could cause a public health concern for the blood supply, as well asincrease costs and cause loss of revenue or market share.

 

*If wecannot obtain necessary licenses to third party patents for the manufacture orsale of our products, we may have to withdraw from the market or delay theintroduction of the affected product.*

 

Third parties, includingcompetitors, have patents and patent applications in the U.S. and othersignificant markets that may be useful or necessary for the manufacture, use orsale of certain products and products in development by our strategic partnersand us. It is likely that third parties will obtain these patents in thefuture. Certain of these patents may be broad enough to prevent or delay us andour strategic partners from manufacturing or marketing products important toour current and future business. We cannot accurately predict the scope,validity and enforceability of these patents, if granted, the extent to whichwe may wish or need to obtain licenses to these patents, and the cost and availabilityof these licenses. If we do not or cannot obtain these licenses, products maybe withdrawn from the market or delays could be encountered in marketintroduction while an attempt is made to design around these patents, or wecould find that the development, manufacture or sale of such products isforeclosed. We could also incur substantial costs in licensing or challengingthe validity and scope of these patents.

 

*Becausemost of our products are based on technologies that are unfamiliar to the healthcarecommunity, they may not be accepted by healthcare providers and patients, whichcould harm our business.*

 

We may experiencedifficulties in launching new products, many of which are novel products basedon technologies that are unfamiliar to the healthcare community. We have noassurance that healthcare providers and patients will accept such products. Inaddition, government agencies, as well as private organizations involved inhealthcare, from time to time publish guidelines or recommendations tohealthcare providers and patients. Such guidelines or recommendations can bevery influential and may adversely affect the usage of our products directly(for example, by recommending a decreased dosage of our product in conjunctionwith a concomitant therapy or a government entity withdrawing itsrecommendation to screen blood donations for certain viruses) or indirectly(for example, by recommending a competitive product over our product).

 

*If we areunable to avoid significant exposure to product liability claims, our businesscould be harmed.*

 

We are exposed to productliability and other claims in the event that the use of our products is allegedto have resulted in adverse effects. While we will continue to takeprecautions, we may not avoid significant product liability exposure. Althoughwe maintain product liability insurance, there is no guarantee that thiscoverage will be sufficient. It is not feasible to obtain adequate insurancecoverage for certain products and we are self-insured in relation to theseproducts. If we are sued for any injury caused by our products, we could suffera significant financial loss.

 

As we are a key provider forthe blood screening field of nucleic acid testing and immunodiagnostics, we mayhave product liability in addition to contract exposure, in the event that ourdifficulties or delays or those of our partners could cause a public healthconcern for the blood supply.

 

*If we areunable to successfully compete in the highly competitive healthcare industry,our business could be harmed.*

 

We operate in a highlycompetitive environment, and the competition is expected to increase.Competitors include large pharmaceutical, chemical and blood testing companies,compounding pharmacies, and biotechnology companies. Some of these competitors,particularly large pharmaceutical and blood testing companies, have greaterresources than us. Accordingly, even if we are successful in launching aproduct, we may find that a competitive product dominates the market for anynumber of reasons, including:

 

•*              *The possibility that the competitor may havelaunched its product first;

 

•*              *The competitor may have greater access tocertain raw materials;

 

•*              *The competitor may have more efficientmanufacturing processes;

 

•*              *The competitor may adapt more quickly totechnological change;

 

•*              *The competitor may have greater marketingcapabilities;

 

•*              *The competitive product may have therapeuticor other advantages; or

 

•*              *New competitors may enter into markets wherewe currently have significant competitive advantage.

 

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The technologies applied byour competitors and us are rapidly evolving, and new developments frequentlyresult in price competition and product obsolescence. In addition, we may beimpacted by competition from generic forms of our products or substituteproducts.

 

*Our patentsmay not prevent competition or generate revenues.*

 

We seek to obtain patents onmany of our inventions. Without the protection of patents, competitors may beable to use our inventions to manufacture and market competing products withoutbeing required to undertake the lengthy and expensive development efforts madeby us and without having to pay royalties or otherwise compensate us for theuse of the invention. We have no assurance that patents and patent applicationsowned or licensed to us will provide substantial protection. Important legalquestions remain to be resolved as to the extent and scope of available patentprotection for biotechnology products and processes in the U.S. and otherimportant markets. We do not know how many of our pending patent applicationswill be granted, or the effective coverage of those that are granted. In theU.S. and other important markets, the issuance of a patent is neither conclusiveas to its validity nor the enforceable scope of its claims. We have engaged insignificant litigation to determine the scope and validity of certain of ourpatents and expect to continue to do so. An adverse outcome of litigation couldresult in the reduction or loss of royalty revenues. Engaging in patentlitigation against one party may place significant royalty revenues received orto be received from other parties at risk. Even if we are successful inobtaining and defending patents, there can be no assurance that these patentswill provide substantial protection. The length of time necessary to resolvepatent litigation successfully may allow infringes to gain significant marketadvantage. Third parties may be able to design around the patents and developcompetitive products that do not use the inventions covered by our patents.Many countries, including certain countries in Europe, have compulsorylicensing laws under which a patent owner may be compelled to grant licenses tothird parties (for example, the third party’s product is needed to meet athreat to public health or safety in that country, or the patent owner hasfailed to “work” the invention in that country, or the third party has patentedimprovements). In addition, most countries limit the enforceability of patentsagainst government agencies or government contractors. In these countries, thepatent owner may be limited to monetary relief and may be unable to enjoininfringement, which could materially diminish the value of the patent. Inaddition, royalty revenues may decline as patents expire.

 

*Sales ofour products may be adversely affected by the availability and amount ofreimbursement to the user of our products from third parties, such as thegovernment and insurance companies.*

 

In the U.S. and othersignificant markets, sales of our products may be affected by the availabilityof reimbursement from the government or other third parties, such as insurancecompanies. It is difficult to predict the reimbursement status of newly approved,novel biotechnology products, and current reimbursement policies for existingproducts may change. In certain foreign markets, governments have issuedregulations relating to the pricing and profitability of pharmaceuticalcompanies. There have been proposals in the U.S. (at both the federal and statelevel) to implement such controls. If the United States Congress enactslegislative proposals addressing parallel importation currently beingdeliberated, revenues from certain products may be affected by this change inU.S. policy. The growth of managed care in the U.S. also has placed pressure onthe pricing of healthcare products. These pressures can be expected tocontinue.

 

*If ourefforts to integrate acquired or licensed businesses or technologies into ourbusiness are not successful, our business could be harmed.*

 

As part of our businessstrategy, we expect to continue to grow our business through in-licensing,collaborations or acquisitions of products or companies. The failure toadequately address the financial, operational or legal risks raised by such transactions, could harm our business. Financial aspectsrelated to these transactions may alter our financial position, reportedoperating results or stock price, and include:

 

*•**             *Use of cash resources;

 

*•**             *Potentially dilutive issuances of equitysecurities;

 

*•**             *The incurrence of debt and contingentliabilities, impairment losses or restructuring charges;

 

*•**             *Large write-offs and difficulties inassessment of the relative percentages of in-process research and developmentexpense that can be immediately written off as compared to the amount whichmust be amortized over the appropriate life of the asset; and

 

*•**             *Amortization expenses related to otherintangible assets.

 

Operational risks that couldharm our existing operations or prevent realization of anticipated benefitsfrom such transactions include:

 

*•**             *Challenges associated with managing anincreasingly diversified business;

 

*•**             *Difficulties in assimilating the operations,products, technology, information systems or personnel of the acquired company;

 

*•**             *Diversion of management’s attention from otherbusiness concerns;

 

*•**             *Inability to maintain uniform standards,controls, procedures and policies;

 

*•**             *The assumption of known and unknownliabilities of the acquired company, including intellectual property claims; 

 

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and

 

*•**             *Subsequent loss of key personnel.

 

Legal risks may includerequirements to obtain the consent of our stockholders or a third party, or theapproval of various regulatory authorities.

 

If such efforts to integrateacquired or licensed businesses or technologies into our business are notsuccessful, our business could be harmed.

 

*If wecannot initiate and maintain revenue-generating relationships with thirdparties, we may not be able to grow our revenues in the near to medium term.*

 

Many products in our currentpipeline are in relatively early stages of research or development. Our abilityto grow earnings in the near- to medium-term may depend, in part, on ourability to initiate and maintain other revenue generating relationships withthird parties, such as licenses to certain of our technologies, and on ourability to identify and successfully acquire rights to later-stage products fromthird parties. We may fail to establish such other sources of revenue.

 

*Fluctuationsin interest rates and foreign currency exchange rates could harm our business.*

 

We have significant cashbalances and investments. Our financial results, therefore, are sensitive tointerest rate fluctuations. In addition, we sell products in many countriesthroughout the world, and our financial results could be significantly affectedby fluctuations in foreign currency exchange rates or by weak economicconditions in foreign markets.

 

*Our levelof debt could limit cash flow available for our operations and could adverselyaffect our ability to service our debt or obtain additional financing, ifnecessary.*

 

As of June 30, 2004, ourtotal debt was $938.0 million. Our level of debt could restrict ouroperations and make it more difficult for us to satisfy our obligations underthe 2033 and the 2034 convertible debentures (“the debentures”). Among otherthings, our level of debt may:

 

*•**             *Limit our ability to obtain additional financingfor working capital, capital expenditures, strategic acquisitions and generalcorporate purposes;

 

*•**             *Require us to dedicate all or a substantialportion of our cash flow to service our debt, which will reduce funds availablefor other business purposes, such as capital expenditures or acquisitions;

 

*•**             *Limit our flexibility in planning for orreacting to changes in the markets in which we compete;

 

*•**             *Place us at a competitive disadvantagerelative to our competitors with less leverage;

 

*•**             *Render us more vulnerable to general adverseeconomic and industry conditions; and

 

*•**             *Make it more difficult for us to satisfy ourfinancial obligations, including those relating to the debentures and our otherdebt obligations.

 

We and our subsidiaries maystill be able to incur substantially more debt. The terms of our creditfacility, the indentures governing the debentures and the agreements governingour other debt permit additional borrowings. Our incurrence of additional debtcould further exacerbate the risks described above.

 

Our ability to satisfy ourobligations under the debentures and our debt agreements will depend on ourfuture operating performance, which will be subject, in part, to factors beyondour control, including general economic and business conditions. If we areunable to generate sufficient cash flow to service our debt, we may be requiredto refinance all or a portion of our debt, including the debentures, obtainadditional financing, sell some of our assets or operations, reduce or delay capitalexpenditures, or revise or delay our strategic plans. If we are required totake any of these actions, it could have a material adverse effect on ourbusiness, financial condition and results of operations. In addition, we cannotassure you that we would be able to take any of these actions, that theseactions would enable us to continue to satisfy our capital requirements or thatthese actions would be permitted under the terms of our various debtinstruments, including the indentures governing the debentures.

 

*Ourrelationship with Novartis AG could limit our ability to enter intotransactions, pursue opportunities in conflict with Novartis and cause theprice of our common stock to decline.*

 

We have an alliance withNovartis AG, a life sciences company headquartered in Basel, Switzerland. Undera series of agreements between Chiron and Novartis, and as a result ofsubsequent stock issuances by Chiron, Novartis’ ownership interest in Chironwas approximately 42% as of June 30, 2004. The governance agreementbetween Chiron and Novartis contains provisions that require the approval ofNovartis before we enter into certain corporate transactions. Thesetransactions generally include significant debt or equity issuances, debt orequity repurchases, most mergers and acquisitions, thepayment of cash dividends, amendments to Chiron’s certificate of incorporationor by-laws, and other transactions that would adversely impact the rights ofNovartis, or discriminate against Novartis, as a Chiron stockholder. In addition,a majority of the independent directors must approve any material transactionsbetween Chiron and Novartis. These provisions may limit our ability to enterinto transactions with third parties otherwise viewed as beneficial to Chiron.All of our shares owned by Novartis are eligible for sale in the public marketsubject to compliance with the applicable securities laws. We have agreed that,upon Novartis’ request, we will file one or more registration statements under

 

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theSecurities Act in order to permit Novartis to offer and sell shares of ourcommon stock. Sales of a substantial number of shares of our common stock byNovartis in the public market could adversely affect the market price of our commonstock.

 

*Volatilityof our stock price could negatively impact our profitability.*

 

The price of our stock, likethat of other pharmaceutical companies, is subject to significant volatility.Any number of events, both internal and external to us, may affect our stockprice. These include, without limitation:

 

*•**             *Fluctuations in earnings from period toperiod;

 

*•**             *Results of clinical trials conducted by us orby our competitors;

 

*•**             *Announcements by us or our competitorsregarding product development efforts, including the status of regulatoryapproval applications;

 

*•**             *The outcome of legal proceedings, includingclaims filed by us against third parties to enforce our patents and claimsfiled by third parties against us relating to patents held by the third parties;

 

*•**             *The launch of competing products;

 

*•**             *The resolution of (or failure to resolve)disputes with strategic partners;

 

*•**             *Corporate restructuring by us;

 

*•**             *The sale of a substantial number of sharesheld by our existing stockholders;

 

*•**             *Licensing activities by us; and

 

*•**             *The acquisition or sale by us of products,products in development or businesses.

 

In connection with ourresearch and development collaborations, from time to time we may invest inequity securities of our strategic partners. The price of these securities alsois subject to significant volatility and may be affected by, among otherthings, the types of events that affect our stock. Changes in the market priceof these securities may impact our profitability.

 

*We aresubject to taxation in a number of jurisdictions and changes to the corporatetax rate and laws of any of these jurisdictions could increase the amount ofcorporate taxes we have to pay.*

 

We pay taxes principally inthe U.S., Germany, Italy, The Netherlands and, withthe acquisition of PowderJect, the United Kingdom. All of these jurisdictionshave in the past and may in the future make changes to their corporate taxrates and other tax laws, which could increase our future tax provision. Wehave negotiated a number of rulings regarding income and other taxes that aresubject to periodic review and renewal. If such rulings are not renewed or aresubstantially modified, income taxes payable in particular jurisdictions couldincrease. While we believe that all material tax liabilities are reflectedproperly in our balance sheet, we are presently under audit in severaljurisdictions and may be subject to further audits in the future, and we haveno assurance that we will prevail in all cases in the event the taxingauthorities disagree with our interpretations of the tax law. In addition, wehave assumed liabilities for all income taxes incurred prior to the sales ofour former subsidiaries, Chiron Vision (subject to certain limitations) andChiron Diagnostics. Future levels of research and development spending, capitalinvestment and export sales will impact our entitlement to related tax creditsand benefits which have the effect of lowering our effective tax rate.

 

*Volatilityof earnings could negatively impact our business.*

 

Our operating results mayvary considerably from quarter to quarter. Any number of factors may affect ourquarterly operating results. These factors include, but are not limited to thefollowing:

 

*•**             *Inventory management practices, includingwholesale ordering patterns;

 

*•**             *The level of pre-clinical and clinicaltrial-related activities;

 

*•**             *Seasonality of certain vaccine products;

 

*•**             *The tender driven nature of certain vaccineproducts;

 

*•**             *The nature of our collaborative, royalty andlicense arrangements and other revenue sources;

 

*•**             *Foreign currency exchange rate fluctuations;and

 

*•**             *The level of product reserves due to variousissues, including seasonality patterns, excess and obsolete inventory, andproduction yields.

 

Our results in any onequarter are not necessarily indicative of results to be expected for a fullyear.

 

*Revisionsto accounting standards, financial reporting and corporate governancerequirements and tax laws could result in changes to our standard practices andcould require a significant expenditure of time, attention and resources,especially by senior management.*

 

We must follow accountingstandards, financial reporting and corporate governance requirements and taxlaws set by the

 

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governingbodies and lawmakers in the U.S. and other countries where we do business. Fromtime to time, these governing bodies and lawmakers implement new and revised rules andlaws. These new and revised accounting standards, financial reporting andcorporate governance requirements and tax laws may require changes to ourfinancial statements, the composition of our board of directors, thecomposition, the responsibility and manner of operation of various board-levelcommittees, the information filed by us with the governing bodies andenforcement of tax laws against us. Implementing changes required by such newstandards, requirements or laws likely will require a significant expenditureof time, attention and resources, especially by our senior management. It isimpossible to predict the impact, if any, on Chiron of future changes toaccounting standards, financial reporting and corporate governance requirementsand tax laws. In addition, it is possible that the application of certaincurrent accounting standards may change due to environmental factors, which maynecessitate a change in our standard practice related to these accountingstandards.

 

**Item 4.****Controls and Procedures**

 

*(a)         ***Evaluation of disclosurecontrols and procedures** Asof the end of the period covered by our Annual Report on Form 10-Kfor the year ended December 31, 2004, Chiron carried out an evaluationunder the supervision and with the participation of Chiron’s management,including Chiron’s CEO and CFO, of the effectiveness of the design and operationof Chiron’s disclosure controls and procedures. Based on that evaluation,Chiron’s management, including the CEO and CFO, concluded that as of June 30,2004, Chiron’s disclosure controls and procedures were ineffective to ensurethat information required to be disclosed by the Company in reports that itfiles or submits under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in SEC rules and forms.   The following paragraphs discuss the reasonsand matters on which this conclusion was based.

 

Themanagement of Chiron Corporation is responsible for establishing andmaintaining adequate internal control over financial reporting. Chiron’sinternal control system was designed to provide reasonable assurance to theCompany’s management and board of directors regarding the preparation and fairpresentation of published financial statements.

 

The management of Chiron assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2004. In making its assessment of internal control over financial reportingmanagement used the criteria issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO) in*Internal Control—Integrated Framework.*

 

Inperforming the assessment management has identified three material weaknessesin internal control over financial reporting as of December 31, 2004.

 

Thefirst material weakness pertains to both the design and operating effectivenessof controls relating to revenue recognition at our vaccines subsidiary inGermany. Specifically, controls pertaining to the communication and evaluationof any special terms and other actions of the sales organization that mayaffect revenue recognition were not effective. As a result, on March 8,2005, the Audit Committee of the Board of Directors, following discussion withand upon the recommendation of management and following discussion with Chiron’sindependent auditors, concluded that the previously issued financial statementsfor the second and third quarters of 2004 should be restated to correct certainerrors contained therein and should not be relied upon. The identified errorsaffected product revenue, cost of goods sold, accounts receivable, and unearnedrevenue for the Company’s vaccines segment. In addition to the restatement ofthe financial statements for the second and third quarters of 2004, adjustmentswere recorded in the consolidated financial statements for year ended December 31,2004 to correct the identified errors.

 

The second material weakness pertains to both thedesign and operating effectiveness of controls relating to the annual incometax provision. Specifically, there were errors in the annual tax provision forthe year ended December 31, 2004 as a result of ineffective controlsrelating to the design and use of analytical tools to analyze and calculate thetax provision, the reconciliation of certain tax accounts, and the review ofthose reconciliations. These errors affected income tax expense and income taxasset and liability accounts. Adjustments were recorded in the consolidatedfinancial statements for year ended December 31, 2004 to correct theidentified errors.

 

The third material weakness pertains to both thedesign and operating effectiveness of controls relating to the timelydetermination of the appropriate accrual for legal services. Specifically,procedures to estimate the accrual for unbilled services and controls over thetimely recording of invoices payable were not effective. Errors resulting fromthese deficiencies affected operating expenses, intangible assets and accruedliabilities. Adjustments were recorded in the consolidated financial statementsfor year ended December 31, 2004 to correct the identified errors.

 

Management has concluded that each of the abovecontrol deficiencies represents a material weakness in internal control overfinancial reporting. A material weakness is a control deficiency, orcombination of control deficiencies, that results in a more than remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. As a result of the materialweaknesses described above, management believes that, as of December 31,2004, the Company’s system of internal control over financial reporting was noteffective based on the criteria in*InternalControl—Integrated Framework*.

 

*(b)         ***Remediation steps to addressmaterial weakness**  We have an ongoingprocess of analyzing and attempting to improve our internal controls, includingthose related to the matters identified above. With regard to the revenuerecognition material weakness, the Company is taking steps designed to provideits sales force with the necessary training with respect to applicableaccounting principles so that the sales force understands the impact of itsactivities on the Company’s financial reporting. In addition, we intend to takesteps to implement processes to provide that changes to our standard terms ofsale will need specified levels of approval prior to being made, such asapproval from finance and legal departments or personnel. Additionally, theCompany is in the process of establishing a remediation plan to address theineffective controls related to the annual tax provision process. Theremediation plan is expected to

 

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include consideration andidentification of additional controls and reconciliations and the considerationand implementation of different analytical tools in order to enhance the analysisand calculation of the tax provision. With regard to the legal services accrualmaterial weakness, we are taking steps to increase awareness and understandingof the accruals process by providing training to the legal department andredesigning the processes related to estimating the accrual and the timelyrecording of legal invoices, and we are also working to improve communicationbetween the finance and legal departments.

 

*(c)          ***Changes in internal controls** There have been no significant changes in Chiron’sinternal controls over financial reporting that have materially affected, orare reasonably likely to materially affect internal controls over financialreporting during the fiscal quarter ended June 30, 2004. Refer to Item 4(b) fora discussion of remediation activities in connection with the material weaknessesin internal control over financial reporting referred to above.

 

**Item 6.****Exhibits**

 

*(a)**                              *Exhibits

 
| **Exhibit  Number** | ** ** | **Exhibit**                                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certification of the Chief  Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated  under the Securities Exchange Act of 1934, as amended. |
| 31.2                |       | Certification of the Chief  Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated  under the Securities Exchange Act of 1934, as amended. |
| 32.1                |       | Certification of the Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.         |
| 32.2                |       | Certification of the Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.         |

 

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**CHIRON CORPORATION**

**June 30, 2004**

**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, Chiron has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|                     | CHIRON CORPORATION |
|--------------------------|--------------------|
| DATE: April 6, 2005 |               |   |
|                     |               |   |
|                     | By:                | /s/  HOWARD H.  PIEN |   |
|                     |               | Howard H. Pien |
|                     |               | *Chief  Executive Officer* |
|                     |               |   |
|                     |               |   |
| DATE: April 6, 2005 |               |   |
|                     | By:                | /s/  DAVID V.  SMITH |   |
|                     |               | David V. Smith |
|                     |               | *Vice  President and Chief Financial Officer* |
|                     |               | * * |

 

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