**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

###### **FORM10-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 September 30, 2004** |
| ** **                                                 |
| **OR**                                                     |
| ** **                                                 |
| **o**                                                      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

 

**For the transition period from                     to                     **

 

###### **CommissionFile Number: 0-12798**

###### ** **

###### **CHIRONCORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                                        | ** ** | **94-2754624**                       |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     | ** ** | (I.R.S. Employer Identification No.) |
| ** **                                                                          | ** ** | ** **                           |
| **4560 Horton Street, Emeryville, California**                                      | ** ** | **94608**                            |
| (Address of principal executive offices)                                            | ** ** | (Zip code)                           |
|                                                                                | ** ** |                                 |
| **(510) 655-8730**                                                             |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |
| **Not Applicable**                                                                  |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes ý    No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

 

Yes ý    No o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **Title  of Class**           | ** ** | **Outstanding at October 29, 2004** |
|-------------------------------|------------|---------------------------------------------------------|
| Common Stock, $0.01 par value |       | 186,839,927                                             |

 

 

----

 

**EXPLANATORY NOTE**

** **

This Form 10Q/A (the “Report”) is being filed to amend ChironCorporation’s (the “Company”) Quarterly Report on Form 10-Q filed on November2, 2004 (the “Original Report”), as previously amended on December 16, 2004,for the quarterly period ended September 30, 2004 to reflect the restatement ofthe Company’s previously issued financial statements as of and for the threeand nine month periods ended September 30, 2004, and the notes related thereto,as described below, and to make related changes.  The information in this Report as of the dateof the Original Report does not reflect subsequent results, events or developments.  Such subsequent results, events ordevelopments include, among others, the information and events subsequentlydescribed in our Quarterly Reports on Form 10-Q, our Annual Reports on Form10-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 the Securities and ExchangeCommission since the date of the Original Report, which update and supersedeinformation contained in the Original Report and this Report.

 

Chiron has determined that certain sales of a travel vaccine recordedas revenues in the second quarter of 2004 should not have been recorded asrevenue at that time, and that portions of those sales should have beenrecorded as revenues in the third and fourth quarters of 2004 and possibly inlater quarters.  See Note 1 to Chiron’sCondensed Consolidated Financial Statements, included herein, for additionaldiscussion.

 

Chiron has reflected the results of the restatement for the fiscal yearended December 31, 2004 in its Annual Report on Form 10-K for such year, filedwith the SEC on March 16, 2005 and has restated its interim financialstatements in this Report and in an additional Quarterly Report on Form 10-Q/Afor the quarterly period ended June 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 contingentlyconvertible debt instruments (“CoCo’s”) must be included in diluted earningsper share regardless of whether the triggering contingency has been satisfied,if dilutive. Adoption of Issue No. 04-8 would be on a retroactive basisand would require restatement of prior period diluted earnings per share.Chiron adopted 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 millionconvertible debentures due 2033 nor from our $385.0 million convertibledebentures due 2034 for the three and nine months ended September 30, 2004, asdiscussed in Note 2 to Chiron’s Condensed Consolidated Financial Statements.

 

**CHIRON CORPORATION**

 

**TABLE OF CONTENTS**

 
| ** **                                                                                                                  | **Page  No.** |
|-----------------------------------------------------------------------------------------------------------------------------|---------------|
| **PART I. FINANCIAL INFORMATION**                                                                                           | ** **    |
| ** **                                                                                                                  | ** **    |
| **ITEM 1. Financial  Statements (Unaudited)**                                                                               | ** **    |
| ** **                                                                                                                  | ** **    |
| Condensed  Consolidated Balance Sheets at September 30, 2004 and December 31, 2003                                          | 3             |
|                                                                                                                        |          |
| Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2004 and 2003           | 5             |
|                                                                                                                        |          |
| Condensed  Consolidated Statements of Comprehensive Income for the three and nine months  ended September 30, 2004 and 2003 | 6             |
|                                                                                                                        |          |
| Condensed  Consolidated Statements of Cash Flows for the nine months ended September 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**                    | 23            |
| ** **                                                                                                                  |          |
| **ITEM 4. Controls and  Procedures**                                                                                        | 46            |
| ** **                                                                                                                  |          |
| **PART II. OTHER INFORMATION**                                                                                              |          |
| ** **                                                                                                                  | ** **    |
| **ITEM 6. Exhibits**                                                                                                        | 47            |
| ** **                                                                                                                  |          |
| **SIGNATURES**                                                                                                              | 48            |

 

2

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**Item 1.Financial Statements**

 

###### **CHIRONCORPORATION**

###### ** **

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 

**(Unaudited)**

 

**(In thousands, except share data)**
| ** **                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                       |       | **Restated**                 |       |                        |       |
| **ASSETS**                                                       |       |                         |       |                        |       |
| Current assets:                                                  |       |                         |       |                        |       |
| Cash and cash equivalents                                        |       | $                            | 200,983    |                        | $          | 364,270 |   |
| Short-term investments in marketable debt  securities            |       | 343,507                      |       | 174,212                     |       |
| Total cash and short-term investments                            |       | 544,490                      |       | 538,482                     |       |
| Accounts receivable, net of allowances                           |       | 397,802                      |       | 382,933                     |       |
| Current portion of notes receivable                              |       | —                       |       | 1,479                       |       |
| Inventories, net of reserves                                     |       | 218,589                      |       | 199,625                     |       |
| Assets held for sale                                             |       | 2,754                        |       | 2,992                       |       |
| Current net deferred income tax assets                           |       | 60,232                       |       | 50,204                      |       |
| Derivative financial instruments                                 |       | 7,599                        |       | 9,463                       |       |
| Other current assets                                             |       | 65,229                       |       | 72,471                      |       |
| Total current assets                                             |       | 1,296,695                    |       | 1,257,649                   |       |
| Noncurrent investments in marketable debt  securities            |       | 467,813                      |       | 560,292                     |       |
| Property, plant, equipment and leasehold  improvements, at cost: |       |                         |       |                        |       |
| Land and buildings                                               |       | 371,382                      |       | 366,275                     |       |
| Laboratory, production and office equipment                      |       | 644,087                      |       | 615,814                     |       |
| Leasehold improvements                                           |       | 116,602                      |       | 112,200                     |       |
| Construction-in-progress                                         |       | 186,310                      |       | 144,162                     |       |
|                                                             |       | 1,318,381                    |       | 1,238,451                   |       |
| Less accumulated depreciation and  amortization                  |       | (566,988                     | )          | (548,701                    | )          |
| Property, plant, equipment and leasehold  improvements, net      |       | 751,393                      |       | 689,750                     |       |
| Purchased technologies, net                                      |       | 221,122                      |       | 236,707                     |       |
| Goodwill                                                         |       | 820,086                      |       | 787,587                     |       |
| Other intangible assets, net                                     |       | 447,608                      |       | 486,889                     |       |
| Investments in equity securities and  affiliated companies       |       | 113,325                      |       | 121,576                     |       |
| Equity method investments                                        |       | 709                          |       | 953                         |       |
| Noncurrent notes receivable                                      |       | 7,500                        |       | 7,500                       |       |
| Noncurrent derivative financial instruments                      |       | —                       |       | 7,391                       |       |
| Other noncurrent assets                                          |       | 57,080                       |       | 38,875                      |       |
|                                                             |       | $                            | 4,183,331  |                        | $          | 4,195,169 |   |

 

The accompanying Notes to Condensed Consolidated Financial Statementsare integral to this statement.

 

3

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###### **CHIRONCORPORATION**

###### ** **

**CONDENSEDCONSOLIDATED BALANCE SHEETS (Continued)**

 

**(Unaudited)**

 

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

 
| ** **                                                                                                  | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                  |       | **Restated**                 |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                              |       |                         |       |                        |       |
| Current liabilities:                                                                                        |       |                         |       |                        |       |
| Accounts payable                                                                                            |       | $                            | 113,045    |                        | $          | 102,201 |   |
| Accrued compensation and related expenses                                                                   |       | 78,470                       |       | 83,311                      |       |
| Current portion of capital lease                                                                            |       | 944                          |       | 570                         |       |
| Current portion of unearned revenue                                                                         |       | 37,802                       |       | 47,873                      |       |
| Income taxes payable                                                                                        |       | 4,746                        |       | 15,270                      |       |
| Other current liabilities                                                                                   |       | 159,886                      |       | 187,688                     |       |
| Total current liabilities                                                                                   |       | 394,893                      |       | 436,913                     |       |
| Long-term debt                                                                                              |       | 940,295                      |       | 926,709                     |       |
| Capital lease                                                                                               |       | 157,014                      |       | 157,677                     |       |
| Noncurrent derivative financial instruments                                                                 |       | 4,928                        |       | —                      |       |
| Noncurrent net deferred income tax  liabilities                                                             |       | 101,288                      |       | 107,496                     |       |
| Noncurrent unearned revenue                                                                                 |       | 30,525                       |       | 45,564                      |       |
| Other noncurrent liabilities                                                                                |       | 86,462                       |       | 69,448                      |       |
| Minority interest                                                                                           |       | 8,498                        |       | 7,002                       |       |
| Total liabilities                                                                                           |       | 1,723,903                    |       | 1,750,809                   |       |
| Commitments and contingencies                                                                               |       |                         |       |                        |       |
| Stockholders’ equity:                                                                                  |       |                         |       |                        |       |
| Common stock                                                                                                |       | 1,917                        |       | 1,917                       |       |
| Additional paid-in capital                                                                                  |       | 2,527,877                    |       | 2,503,195                   |       |
| Deferred stock compensation                                                                                 |       | (15,572                      | )          | (12,871                     | )          |
| Retained earnings (Accumulated deficit)                                                                     |       | 16,269                       |       | (46,634                     | )          |
| Accumulated other comprehensive income                                                                      |       | 171,460                      |       | 216,302                     |       |
| Treasury stock, at cost (4,999,000 shares  at September 30, 2004 and 4,567,000 shares at December 31, 2003) |       | (242,523                     | )          | (217,549                    | )          |
| Total stockholders’ equity                                                                             |       | 2,459,428                    |       | 2,444,360                   |       |
|                                                                                                        |       | $                            | 4,183,331  |                        | $          | 4,195,169 |   |

 

The accompanying Notes to Condensed Consolidated Financial Statementsare integral to this statement.

 

4

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**CHIRON CORPORATION**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

** **

**(Unaudited)**

 

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

 
| ** **                                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                                  |       | **Restated**                               |       |                                      |       | **Restated** |   |   |   |
| Revenues:                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Product sales, net                                                                    |       | $                                          | 375,549    |                                      | $          | 432,674 |   | $ | 937,836 |   | $ | 897,222 |   |
| Revenues from joint business arrangement                                              |       | 34,017                                     |       | 26,058                                    |       | 92,910 |   | 79,985 |   |
| Collaborative agreement revenues                                                      |       | 4,124                                      |       | 7,816                                     |       | 14,467 |   | 15,554 |   |
| Royalty and license fee revenues                                                      |       | 111,396                                    |       | 66,237                                    |       | 221,384 |   | 186,537 |   |
| Other revenues                                                                        |       | 4,450                                      |       | 7,688                                     |       | 22,363 |   | 32,482 |   |
| Total revenues                                                                        |       | 529,536                                    |       | 540,473                                   |       | 1,288,960 |   | 1,211,780 |   |
| Operating expenses:                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Cost of sales (excludes amortization  expense related to acquired developed products) |       | 238,526                                    |       | 174,380                                   |       | 494,455 |   | 357,389 |   |
| Research and development                                                              |       | 103,000                                    |       | 97,519                                    |       | 301,736 |   | 269,564 |   |
| Selling, general and administrative                                                   |       | 114,531                                    |       | 105,818                                   |       | 326,128 |   | 259,086 |   |
| Amortization expense                                                                  |       | 20,566                                     |       | 19,821                                    |       | 63,077 |   | 35,135 |   |
| Purchased in-process research and  development                                        |       | 9,629                                      |       | 122,700                                   |       | 9,629 |   | 122,700 |   |
| Other operating expenses                                                              |       | 1,280                                      |       | 4,779                                     |       | 8,040 |   | 7,729 |   |
| Total operating expenses                                                              |       | 487,532                                    |       | 525,017                                   |       | 1,203,065 |   | 1,051,603 |   |
| Income from operations                                                                |       | 42,004                                     |       | 15,456                                    |       | 85,895 |   | 160,177 |   |
| Interest expense                                                                      |       | (7,063                                     | )          | (6,222                                    | )          | (19,440 | ) | (12,523 | ) |
| Interest and other income, net                                                        |       | 5,369                                      |       | 5,239                                     |       | 41,252 |   | 31,170 |   |
| Minority interest                                                                     |       | (504                                       | )          | (443                                      | )          | (1,583 | ) | (1,424 | ) |
| Income from continuing operations before  income taxes                                |       | 39,806                                     |       | 14,030                                    |       | 106,124 |   | 177,400 |   |
| Provision for income taxes                                                            |       | 12,359                                     |       | 34,183                                    |       | 28,938 |   | 75,025 |   |
| Income (loss) from continuing operations                                              |       | 27,447                                     |       | (20,153                                   | )          | 77,186 |   | 102,375 |   |
| Gain (loss) from discontinued operations                                              |       | (450                                       | )          | 1,174                                     |       | 24,854 |   | 3,138 |   |
| Net income (loss)                                                                     |       | $                                          | 26,997     |                                      | $          | (18,979 | ) | $ | 102,040 |   | $ | 105,513 |   |
| Basic earnings (loss) per share:                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from continuing operations                                              |       | $                                          | 0.15       |                                      | $          | (0.11 | ) | $ | 0.41 |   | $ | 0.55 |   |
| Net income (loss)                                                                     |       | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.54 |   | $ | 0.57 |   |
|                                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Diluted earnings (loss) per share:                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from continuing operations                                              |       | $                                          | 0.14       |                                      | $          | (0.11 | ) | $ | 0.40 |   | $ | 0.54 |   |
| Net income (loss)                                                                     |       | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.53 |   | $ | 0.55 |   |

 

The accompanying Notes to Condensed Consolidated Financial Statementsare integral to this statement.

 

5

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**CHIRON CORPORATION**

 

###### **CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**

###### ** **

**(Unaudited)**

 

**(In thousands)**

** **
| ** **                                                                                                                                                                                                                                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                                                                                                       | ** ** | **Restated**                               | ** ** | ** **                                | ** ** | **Restated** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                                                                                                                                                                                                                                |       | $                                          | 26,997     |                                      | $          | (18,979 | ) | $ | 102,040 |   | $ | 105,513 |   |
|                                                                                                                                                                                                                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Other comprehensive income (loss):                                                                                                                                                                                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Change in foreign currency translation  adjustment during the period                                                                                                                                                                                                                             |       | 2,960                                      |       | 21,182                                    |       | (34,452 | ) | 66,300 |   |
| Unrealized gains (losses) from investments:                                                                                                                                                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Net unrealized holding gains (losses)  arising during the period, net of tax (provision) benefit of ($5,977) and  ($1,984) for the three months ended September 30, 2004 and 2003,  respectively, and ($3,865) and ($3,268) for the nine months ended September  30, 2004 and 2003, respectively |       | (2,680                                     | )          | 4,200                                     |       | 4,864 |   | 6,840 |   |
| Reclassification adjustment for net gains  included in net income, net of tax (provision) of ($400) for the three months  ended September 30, 2004, and ($9,753) and ($3,626) for the nine months ended  September 30, 2004 and 2003, respectively                                               |       | (625                                       | )          | —                                    |       | (15,254 | ) | (5,744 | ) |
| Net unrealized gains (losses) from  investments                                                                                                                                                                                                                                                  |       | (3,305                                     | )          | 4,200                                     |       | (10,390 | ) | 1,096 |   |
| Other comprehensive income (loss)                                                                                                                                                                                                                                                                |       | (345                                       | )          | 25,382                                    |       | (44,842 | ) | 67,396 |   |
|                                                                                                                                                                                                                                                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Comprehensive income                                                                                                                                                                                                                                                                             |       | $                                          | 26,652     |                                      | $          | 6,403 |   | $ | 57,198 |   | $ | 172,909 | ** ** |

 

The accompanying Notes to Condensed Consolidated Financial Statementsare integral to this statement.

 

6

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**CHIRON CORPORATION**

 

###### **CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

###### ** **

**(Unaudited)**

 

**(In thousands)**

 
| ** **                                                                     | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                     | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                     | ** ** | **Restated**                              | ** ** | ** ** | ** ** |
| Net cash provided by operating activities                                      |       | $                                         | 132,633    |   | $ | 253,933 |   |
| Cash flows from investing activities:                                          |       |                                      |       |   |   |
| Purchases of investments in marketable debt  securities                        |       | (724,616                                  | )          | (622,650 | ) |
| Proceeds from sales of investments in  marketable debt securities              |       | 415,100                                   |       | 748,041 |   |
| Proceeds from maturities of investments in  marketable debt securities         |       | 225,959                                   |       | 364,737 |   |
| Capital expenditures                                                           |       | (134,079                                  | )          | (81,372 | ) |
| Purchases of equity securities and  interests in affiliated companies          |       | (6,216                                    | )          | (4,270 | ) |
| Proceeds from sale of equity securities and  interests in affiliated companies |       | 31,421                                    |       | 12,545 |   |
| Cash paid for acquisitions, net of cash  acquired                              |       | (32,289                                   | )          | (804,728 | ) |
| Other, net                                                                     |       | (3,688                                    | )          | (12,249 | ) |
| Net cash used in investing activities                                          |       | (228,408                                  | )          | (399,946 | ) |
| Cash flows from financing activities:                                          |       |                                      |       |   |   |
| Net repayment of short-term borrowings                                         |       | —                                    |       | (2,344 | ) |
| Repayment of debt and capital leases                                           |       | (380,159                                  | )          | (62,341 | ) |
| Payments to acquire treasury stock                                             |       | (129,665                                  | )          | (132,675 | ) |
| Proceeds from re-issuance of treasury stock                                    |       | 64,178                                    |       | 85,995 |   |
| Proceeds from issuance of debt                                                 |       | 4,996                                     |       | 536 |   |
| Payment of bond issuance costs                                                 |       | (8,285                                    | )          | — |   |
| Proceeds from issuance of convertible  debentures                              |       | 385,000                                   |       | 500,000 |   |
| Proceeds from put options                                                      |       | —                                    |       | 2,144 |   |
| Net cash (used in) provided by financing  activities                           |       | (63,935                                   | )          | 391,315 |   |
| Effect of exchange rate changes on cash and  cash equivalents                  |       | (3,577                                    | )          | 6,655 |   |
| Net (decrease) increase in cash and cash  equivalents                          |       | (163,287                                  | )          | 251,957 |   |
| Cash and cash equivalents at beginning of  the period                          |       | 364,270                                   |       | 247,950 |   |
| Cash and cash equivalents at end of the  period                                |       | $                                         | 200,983    |   | $ | 499,907 |   |

 

The accompanying Notes to Condensed Consolidated Financial Statementsare integral to this statement.

 

7

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**CHIRON CORPORATION**

 

###### **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

###### ** **

**September 30, 2004**

 

**(Unaudited)**

 

**Note 1—Basis of Presentation and Summary of SignificantAccounting Policies**

 

*Basis of Presentation*

 

Theinformation presented in the Condensed Consolidated Financial Statements atSeptember 30, 2004, and for the three and nine months endedSeptember 30, 2004 and 2003, is unaudited but includes adjustments,consisting only of all normal recurring adjustments, which Chiron Corporationbelieves to be necessary for fair presentation of the periods presented.

 

TheCondensed Consolidated Balance Sheet amounts at December 31, 2003, havebeen derived from audited financial statements. Historically, Chiron’soperating results have varied considerably from period to period due to thenature of Chiron’s collaborative, royalty and license arrangements and theseasonality of certain vaccine products. In addition, the mix of products soldand the introduction of new products will affect comparability from quarter toquarter. As a consequence, Chiron’s interim results in any one quarter are notnecessarily indicative of results to be expected for a full year. Thisinformation should be read in conjunction with Chiron’s audited ConsolidatedFinancial Statements as of and for the year ended December 31, 2003, whichare included in the Annual Report on Form 10-K filed by Chiron with theSecurities and Exchange Commission.

 

*Restatementof Financial Statements*

 

Chiron determined that certain sales of a travel vaccine recorded asrevenues in the second quarter of 2004 should not have been recorded as revenueat that time, and that portions of those sales should have been recorded asrevenues in the third and fourth quarters of 2004 and possibly in laterquarters.

 

Asa result of the restatement, in the third quarter of 2004, product sales wereincreased by $5.6 million, cost of sales were increased by $0.9 million andincome taxes were increased by $1.2 million. This resulted in a $3.5 millionincrease in income from continuing operations and net income and a $0.01 increaseof diluted income from continuing operations per share ($0.14 per share insteadof the $0.13 per share as previously reported). On the September 30, 2004consolidated balance sheet, the current portion of unearned revenue increasedby $7.6 million and income taxes payable decreased by $1.9 million.

 

As a result of the restatement, in the second quarter of 2004, productsales were reduced by $13.9 million, cost of sales were reduced by $1.5 millionand income taxes were reduced by $3.1 million. This resulted in a $9.3 millionreduction in income from continuing operations and net income and a $0.05reduction of diluted income from continuing operations per share ($0.12 pershare instead of the $0.17 per share as previously reported).

 

As a result of the restatement, for the nine months ended September 30,2004, product sales were reduced by $8.3 million, cost of sales were reduced by$0.6 million and income taxes were reduced by $1.9 million. This resulted in a$5.8 million reduction in income from continuing operations and net income anda $0.03 reduction of diluted income from continuing operations per share ($0.40per share instead of the $0.43 per share as previously reported).

 

*Principles of Consolidation*

 

TheCondensed Consolidated Financial Statements include the accounts of Chiron andits majority-owned subsidiaries. For consolidated majority-owned subsidiariesin which Chiron owns less than 100%, Chiron records minority interest in theCondensed Consolidated Financial Statements to account for the ownership interestof the minority owner. Investments in limited partnerships and interests inwhich Chiron has an equity interest of 50% or less are accounted for usingeither the equity or cost method. All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

OnJuly 8, 2003, Chiron acquired PowderJect Pharmaceuticals plc, a companybased in Oxford, England that develops and commercializes vaccines. Chironincluded PowderJect Pharmaceuticals’ operating results in its consolidatedoperating results beginning July 8, 2003. PowderJect Pharmaceuticals ispart of Chiron’s vaccines segment.

 

Chironis a limited partner in several venture capital funds. Chiron is obligated topay up to $60.0 million over ten years in equity contributions to theseventure capital funds, of which approximately $38.4 million was paidthrough September 30, 2004. Chiron accounts for these investments underthe equity method of accounting.

 

8

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*New Accounting Pronouncements*

 

InOctober 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 contingent 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, subjectto certain transition provisions. It is effective for all periods ending afterDecember 15, 2004. Accounting pursuant to this Issue would not result inadditional dilution to Chiron’s diluted earnings per share for the three andnine months ended September 30, 2004 from Chiron’s $500.0 millionconvertible debentures due 2033 (“2033 Debentures”) nor from Chiron’s$385.0 million convertible debentures due 2034 (“2034 Debentures”).

 

FinancialAccounting Standards 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 VIE’sexpected 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 by companiesowning a majority voting interest in the VIE. The consolidation requirements ofFIN 46 applied immediately to VIEs created after January 31, 2003;however, the FASB deferred the effective date for VIEs created beforeFebruary 1, 2003 to the quarter ended March 31, 2004 for calendaryear companies. Adoption of the provisions of FIN 46 prior to the deferredeffective date was permitted.

 

Chironadopted the remaining provisions of FIN 46 in the first quarter of 2004. Theadoption of these provisions did not have a material effect on Chiron’scondensed consolidated financial statements.

 

OnMarch 31, 2004, the FASB issued an Exposure Draft (ED), “Share-BasedPayment—An Amendment of FASB Statements No. 123 and 95.” The proposedStatement addresses the accounting for transactions in which an enterprisereceives employee services in exchange for (a) equity instruments of theenterprise or (b) liabilities that are based on the fair value of theenterprise’s equity instruments or that may be settled by the issuance of suchequity instruments. The proposed Statement would eliminate the ability toaccount for share-based compensation transactions using Accounting PrinciplesBoard Opinion No. 25 (APB 25) “Accounting for Stock Issued toEmployees,” and generally would require instead that such transactions beaccounted for using a fair-value based method. As proposed, companies would berequired to recognize an expense for compensation cost related to share-basedpayment arrangements including stock options and employee stock purchase plans.As proposed, the new rules would be applied on a modified prospective basis asdefined in the ED, and would be effective for Chiron beginning July 1,2005. Chiron is currently evaluating option valuation methodologies and assumptionsin light of the evolving accounting standards related to employee stockoptions. Current estimates of option values using the Black-Scholes method maynot be indicative of results from valuation methodologies ultimately adopted inthe final rules.

 

*Use of Estimates and Reclassifications*

 

Thepreparation of financial statements requires management to make estimates,assumptions and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosures of contingentassets and liabilities. On an on-going basis, management evaluates itsestimates, including those related to investments; inventories; derivatives;capital leases; intangible assets; goodwill; purchased in-process research anddevelopment; product discounts, rebates and returns; bad debts; collaborative,royalty and license arrangements; restructuring; pension and otherpost-retirement benefits; income taxes; and litigation and other contingencies.Chiron bases its estimates on historical experience and on various otherassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Actualresults may differ from those estimates under different assumptions orconditions.

 

9

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Chiron’sblood-testing segment includes Chiron’s one-half share in the pretax operatingearnings generated by the joint business contractual arrangement withOrtho-Clinical Diagnostics, Inc., a Johnson & Johnson company.Chiron accounts separately for research and development and manufacturing costreimbursements and certain product sale revenues received from Ortho-ClinicalDiagnostics, but relating to the joint business contractual arrangement. Chiron’sjoint business arrangement with Ortho-Clinical Diagnostics is a contractualarrangement and is not a separate and distinct legal entity. Through Chiron’sjoint business contractual arrangement with Ortho-Clinical Diagnostics, Chironsells a line of immunodiagnostic tests to detect hepatitis viruses andretroviruses and provides supplemental tests and microplate andchemiluminescent instrument systems to automate test performance and datacollection. Prior to the first quarter 2003, Chiron accounted for revenuesrelating to non-U.S. affiliate sales on a one-quarter lag, with an adjustmentof the estimate to actual in the subsequent quarter. More current informationof non-U.S. affiliate sales of Chiron’s joint business contractual arrangementbecame available in the first quarter 2003, and as a result, Chiron is able torecognize revenues relating to non-U.S. affiliate sales on a one-month lag. Theeffect 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 nine months ended September 30, 2003.

 

Chironcurrently owns a facility in London, England for international operations. Thisfacility became available for sale in the fourth quarter of 2003. Chiron hascommitted to a plan to sell this facility and is actively marketing thisfacility. This facility is classified as “Assets held for sale” in theCondensed Consolidated Balance Sheet at September 30, 2004.

 

Chiron,prior to filing its financial statements on Form 10-Q, publicly releasesan unaudited condensed balance sheet and statement of operations. Between thedate of Chiron’s earnings release and the filing of Form 10-Q,reclassifications may be required. These reclassifications, when made, have noeffect on income from continuing operations, net income or earnings per share.There has been no such reclassification in the third quarter of 2004.

 

Certainpreviously reported amounts have been reclassified to conform to the currentyear presentation.

 

*Inventories*

 

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

 

Subsequentto the third quarter of 2004, the UK regulatory body, the Medicines andHealthcare products Regulatory Agency (MHRA), sent Chiron a letter prohibitingChiron from releasing any Fluvirin doses manufactured at Chiron’s Liverpoolfacility since March 2, 2004. In that letter, the MHRA asserted thatChiron’s manufacturing process did not comply with U.K. good manufacturingpractices regulations. In addition to prohibiting release of existing Fluvirindoses, the MHRA letter also suspended Chiron’s license to manufacture furtherinfluenza virus vaccine in its Liverpool facility for three months. Chiron hasnot released any Fluvirin into any territory. Chiron wrote-off the entireinventory of Fluvirin product in the third quarter 2004, resulting in a$91.3 million charge to cost of sales.

 

Inventories,net of reserves consisted of the following:

 

| ** **      | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------------|------------|
| Finished goods  |       | $                            | 55,153     |                        | $          | 38,640 |   |
| Work-in-process |       | 116,596                      |       | 105,359                     |       |
| Raw materials   |       | 46,840                       |       | 55,626                      |       |
|            |       | $                            | 218,589    |                        | $          | 199,625 |   |

 

*Income Taxes*

 

Theeffective tax rate for the three and nine months ended September 30, 2004was 31.0% and 27.3% respectively, of pretax income from continuing operations,including the charge for purchased in-process research and development relatedto the Sagres acquisition. See discussion in “Note 4—Acquisitions”. Theeffective tax rate for the three and nine months ended September 30, 2003was 243.6% and 42.3% respectively, of pretax income from continuing operations,including the charge for purchased in-process research and development relatedto the PowderJect acquisition. The charges for the purchased in-processresearch and development in 2003 and 2004 are not tax deductible. The effectivetax rate for the three and nine months ended September 30, 2004 and 2003was 25% of pretax income from continuing operations, after excluding the impactof the purchased in-process research and development charges. The effective taxrate may be affected in future periods by changes in management’s estimateswith respect to our deferred tax assets and other items affecting the overalltax rate.

 

10

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*Stock-Based Compensation*

 

Chironmeasures compensation expense for its stock-based employee compensation plansusing the intrinsic value method. Compensation expense is based on thedifference, if any, between the fair value of Chiron’s common stock and theexercise price of the option or share right on the measurement date, which istypically the date of grant. This amount is recorded as “Deferred stockcompensation” in the Condensed Consolidated Balance Sheets and amortized as acharge to operations over the vesting period of the applicable options or sharerights. Compensation expense is included primarily in “Selling, general and administrative”in the Condensed Consolidated Statements of Operations.

 

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

* *
| ** **                            | ** **                                                                                                                            | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** **                                                                                                                            | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** **                                                                                                                            | **(in thousands, except per share data)**  | ** ** |
| Net income (loss):                    |                                                                                                                                  |                                       |       |                                      |       |   |   |   |   |
| As reported                           |                                                                                                                                  | $                                          | 26,997     |                                      | $          | (18,979 | ) | $ | 102,040 |   | $ | 105,513 |   |
| Add:                                  | Stock-based employee  compensation expense included in reported net income (loss), net of related  tax effects                        |                                       | 1,118      |                                      | 1,091      |   | 3,807 |   | 3,743 |   |
| Less:                                 | Total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |                                       | 23,778     |                                      | 20,741     |   | 68,055 |   | 58,786 |   |
|                                  | Pro forma                                                                                                                             |                                       | $          | 4,337                                     |       | $ | (38,629 | ) | $ | 37,792 |   | $ | 50,470 |   |
|                                  |                                                                                                                                  |                                       |       |                                      |       |   |   |   |   |
| Basic net income (loss) per  share:   |                                                                                                                                  |                                       |       |                                      |       |   |   |   |   |
|                                  |                                                                                                                                  |                                       |       |                                      |       |   |   |   |   |
| As reported                           |                                                                                                                                  | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.54 |   | $ | 0.57 |   |
| Pro forma                             |                                                                                                                                  | $                                          | 0.02       |                                      | $          | (0.21 | ) | $ | 0.20 |   | $ | 0.27 |   |
| Diluted net income (loss)  per share: |                                                                                                                                  |                                       |       |                                      |       |   |   |   |   |
| As reported                           |                                                                                                                                  | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.53 |   | $ | 0.55 |   |
| Pro forma                             |                                                                                                                                  | $                                          | 0.02       |                                      | $          | (0.21 | ) | $ | 0.20 |   | $ | 0.27 |   |

 

*Comprehensive Income*

 

Forthe three and nine months ended September 30, 2004 and 2003, the foreigncurrency translation component of comprehensive income relates to permanentinvestments in non-U.S. subsidiaries, and accordingly, was not adjusted forincome taxes.

 

*Treasury Stock*

 

Treasurystock is stated at cost. Gains on reissuance of treasury stock are credited to “Additionalpaid-in capital”. 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 “Retained earnings”/ “Accumulateddeficit.” Chiron charged losses of $9.0 million and $39.1 million forthe three and nine months ended September 30, 2004, respectively, and$8.9 million and $40.3 million for the three and nine months endedSeptember 30, 2003, respectively, to “Retained earnings”/ “Accumulateddeficit” in the Condensed Consolidated Balance Sheets.

 

11

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**Note 2—Earnings (Loss) Per Share**

 

Basic earnings per share is based upon the weighted-average number of commonshares 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) the assumedexercise of outstanding stock options, warrants and equivalents, which areincluded under the treasury-stock method; (ii) performance units to theextent 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, if applicable. Due to rounding,quarterly amounts may not sum fully to yearly amounts.

 

Contingently convertible debt instruments (“CoCos”) are included indiluted earnings per share, if dilutive. For the three and nine months endedSeptember 30, 2004, Chiron’s $500.0 million contingently convertible debenturesdue 2033 (“2033 Debentures”) and Chiron’s $385.0 million contingentlyconvertible debentures due 2034 (“2034 Debentures”) were excluded from thecomputations of diluted earnings per share as each of these CoCos were notdilutive.

 

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

 
| ** **                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income (loss) (Numerator):                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from continuing operations                                          |       | $                                          | 27,447     |                                      | $          | (20,153 | ) | $ | 77,186 |   | $ | 102,375 |   |
| Shares (Denominator):                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average common shares outstanding                                        |       | 187,368                                    |       | 186,685                                   |       | 187,751 |   | 186,658 |   |
| Effect of dilutive securities:                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Stock options and equivalents                                                     |       | 2,646                                      |       | —                                    |       | 3,150 |   | 3,828 |   |
| Put options                                                                       |       | —                                     |       | —                                    |       | — |   | 2 |   |
|                                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average common shares outstanding,  plus impact from assumed conversions |       | 190,014                                    |       | 186,685                                   |       | 190,901 |   | 190,488 |   |
| Basic earnings (loss) per share                                                   |       | $                                          | 0.15       |                                      | $          | (0.11 | ) | $ | 0.41 |   | $ | 0.55 |   |
| Diluted earnings (loss) per share                                                 |       | $                                          | 0.14       |                                      | $          | (0.11 | ) | $ | 0.40 |   | $ | 0.54 |   |

 

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

 
| ** **                                                                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Income (loss) (Numerator):                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss)                                                                 |       | $                                          | 26,997     |                                      | $          | (18,979 | ) | $ | 102,040 |   | $ | 105,513 |   |
| Shares (Denominator):                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average common shares outstanding                                        |       | 187,368                                    |       | 186,685                                   |       | 187,751 |   | 186,658 |   |
| Effect of dilutive securities:                                                    |       |                                       |       |                                      |       |   |   |   |   |
| Stock options and equivalents                                                     |       | 2,646                                      |       | —                                    |       | 3,150 |   | 3,828 |   |
| Put options                                                                       |       | —                                     |       | —                                    |       | — |   | 2 |   |
| Weighted-average common shares outstanding,  plus impact from assumed conversions |       | 190,014                                    |       | 186,685                                   |       | 190,901 |   | 190,488 |   |
| Basic earnings (loss) per share                                                   |       | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.54 |   | $ | 0.57 |   |
| Diluted earnings (loss) per share                                                 |       | $                                          | 0.14       |                                      | $          | (0.10 | ) | $ | 0.53 |   | $ | 0.55 |   |

 

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Forthe three and nine months ended September 30, 2004, stock options topurchase 11.7 million and 10.1 million shares with exercise pricesgreater than the average market prices of common stock were excluded from therespective computations of diluted earnings per share as their inclusion wouldbe antidilutive. For the three and nine months ended September 30, 2003,stock options to purchase 4.2 million and 10.7 million shares withexercise prices greater than the average market prices of common stock wereexcluded from the respective computations of diluted earnings (loss) per shareas their inclusion would be antidilutive.

 

The dilutive effect of CoCos must be included in diluted earnings pershare regardless of whether the triggering contingency has been satisfied, ifdilutive. For the three and nine months ended September 30, 2004, 7.3 millionshares of common stock issuable upon conversion of the 2033 Debentures wereexcluded from the computations of diluted earnings per share as their inclusionwould be antidilutive.  If the 2034Debentures are tendered for conversion, the value (“Conversion Value”) of cashand shares of Chiron’s common stock, if any, to be received by a holderconverting $1,000 principal amount of the debentures will be determined bymultiplying the applicable conversion rate by a weighted average price. Chironwill deliver the Conversion Value to debenture holders as follows: (1) anamount in cash (“Principal Return”) equal to the lesser of (a) theaggregate Conversion Value of the debentures to be converted and (b) theaggregate principal amount of the debentures to be converted and (2) ifthe aggregate Conversion Value of the debentures to be converted is greaterthat the Principal Return, an amount in shares (“Net Shares”) equal to theaggregate Conversion Value less the Principal Return (“Net Share Amount”). Thenumber of Net Shares to be paid will be determined by dividing the Net ShareAmount by a weighted average price. If dilutive, common shares to be added tothe diluted shares outstanding would be determined by the net share settlementof the 2034 Debentures. For the three and nine months ended September 30, 2004,the assumed conversion of the 2034 Debentures was not dilutive.

 

Forthe three and nine months ended September 30, 2004, 0.6 million and4.3 million shares of common stock that would be issued upon conversion ofthe Liquid Yield Option Notes (LYONs) were excluded from the computations ofdiluted earnings per share, as their inclusion would be antidilutive. For eachof the three and nine months ended September 30, 2003, 5.2 millionshares of common stock that would be issued upon conversion of the LYONs wereexcluded from the computation of diluted earnings (loss) per share, as their inclusionwould be antidilutive. During the second quarter of 2004, Chiron was requiredto purchase a significant portion of the LYONs as discussed in Note 8 “DebtObligations”.

 

**Note 3—Discontinued Operations**

 

Ina strategic effort to focus on its core businesses of blood-testing, vaccinesand biopharmaceuticals, Chiron completed the sale of Chiron Diagnostics andChiron Vision in 1998 and 1997, respectively.

 

Chironand Bayer Corporation, or Bayer, were involved in a dispute with respect totheir respective rights to certain royalty refunds receivable for which asettlement was reached in 2004. Under this settlement agreement, Chiron made asettlement payment to Bayer in 2004. This settlement includes an agreement thatall outstanding items with Bayer related to the sale of Chiron Diagnostics areresolved and no future indemnity obligations are required. Chiron releasedpreviously established reserves deemed to be excess following this settlement.This settlement resulted in a net gain of $12.8 million, which was includedin “Gain (loss) from discontinued operations” for the nine months endedSeptember 30, 2004. This net gain primarily relates to a tax benefit as aresult of the settlement payment to Bayer.

 

Inthe second quarter 2004, Chiron and the IRS entered into a settlement agreementclosing the open tax years 1996 to 1998. Pursuant to this settlement agreementChiron recognized a tax benefit of approximately $12.5 million, which wasincluded in “Gain (loss) from discontinued operations” for the nine monthsended September 30, 2004.

 

Inthe third quarter 2003, Chiron reversed approximately $1.2 million, net oftax, related to unutilized reserves for Chiron Diagnostics, which was includedin “Gain (loss) from discontinued operations” for the three and nine monthsended September 30, 2003.

 

Inthe first quarter 2003, Chiron and Bayer reached a settlement agreementrelating to certain claims raised by Bayer under the Stock Purchase Agreementdated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics.Under this 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 wasincluded in “Gain (loss) from discontinued operations” for the nine monthsended September 30, 2003.

 

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**Note 4—Acquisitions**

 

**Sagres Discovery**    On July 2, 2004,Chiron acquired Sagres Discovery (Sagres), a privately held companyheadquartered in Davis, California, which focuses on the discovery andvalidation of targets with potential application to the development of cancertherapeutics. Chiron acquired Sagres for a preliminary purchase price of$12.0 million.

 

Sagresis part of Chiron’s biopharmaceuticals segment. Chiron accounted for theacquisition as an asset purchase and included Sagres’s operating results in itsconsolidated operating results beginning on July 2, 2004. The componentsof the preliminary purchase price and allocation thereof based on estimatedfair values are summarized in the following table (in thousands). Thepreliminary purchase price reflects acquisition costs, which includecontractual severance, direct acquisition costs and facility exit costs. Chironis in the process of finalizing certain estimates including those for severanceand facility exit costs for certain research facilities; thus both thepreliminary purchase price and the allocation of the preliminary purchase priceare subject to change.

 

| Consideration and acquisition costs:                     | ** ** | ** ** | ** ** |
|----------------------------------------------------------|------------|------------|------------|
| Cash paid for asset purchase                             |       | $          | 10,057     |   |
| Cash payable for asset purchase                          |       | 837        |       |
| Acquisition costs paid as of September 30,  2004         |       | 1,082      |       |
| Acquisition costs not yet paid as of  September 30, 2004 |       | 47         |       |
| Total preliminary purchase price                         |       | $          | 12,023     |   |

 

| Allocation of preliminary purchase price:      | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------|------------|
| Assets acquired                                |       | $          | 1,698      |   |
| Liabilities assumed                            |       | (724       | )          |
| Deferred tax assets                            |       | 1,420      |       |
| Purchased in-process research and  development |       | 9,629      |       |
| Total preliminary purchase price               |       | $          | 12,023     |   |

 

Chiron allocated the preliminary purchase price based on the fair valueof the assets acquired and liabilities assumed. Chiron allocated a portion ofthe preliminary purchase price to purchased in-process research anddevelopment, which it charged to earnings in the third quarter 2004.

 

Foracquisition costs related to Sagres, Chiron paid $1.1 million for the ninemonths ended September 30, 2004. These payments are reflected in theCondensed Consolidated Statement of Cash Flows as a component of “Cash paid foracquisitions, net of cash acquired” for the nine months endedSeptember 30, 2004.

 

Thedeferred tax assets primarily related to future utilization of net operatingloss carryforwards. Chiron acquired federal and state net operating losscarryforwards of approximately $25.0 million and $20.6 million,respectively and federal and state business credits attributed to Sagres ofapproximately $1.7 million and $1.3 million, respectively. Theavailable utilization of such net operating loss and business tax creditcarryforwards is limited in any one year to approximately $0.2 million perannum over the next twenty years under provisions of the Internal Revenue Code.As such, a significant portion of Sagres’s net operating loss carryforwards isexpected to expire unutilized.

 

**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 purchase price of approximately $940.3 million.

 

Duringthe second quarter 2004, Chiron completed the planned divestiture of certainresearch operations in Madison, Wisconsin and Oxford, England and certainvaccines operations in Sweden. The divestiture of these operations included thedisposition of net assets of $14.7 million (which included$15.5 million of cash), deferred taxes of $9.4 million, and exitliabilities of $21.6 million. The net impact of the divestiture resulted inan increase to goodwill of $2.5 million in the second quarter 2004. Also, duringthe second quarter of 2004, Chiron adjusted the previously recorded obligationrelated to an assumed defined benefit plan, which resulted in an increase togoodwill of $8.1 million.

 

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Duringthe third quarter 2004, Chiron revised estimates of exit costs associated withcertain contractual obligations under supply and research agreements related tothe divested research operations and other direct acquisition costs. Also,during the third quarter 2004, Chiron revised estimates of exit costsassociated with the divestiture of certain research operations in Madison,Wisconsin. The net impact of the revision of these estimates resulted in anincrease to goodwill of $14.0 million, an increase to acquisition costs of$14.5 million and a decrease to current liabilities assumed of$0.5 million. As a result of these adjustments to exit costs, the purchaseprice was revised to $940.3 million.

 

PowderJectPharmaceuticals is part of Chiron’s vaccines segment. Chiron accounted for theacquisition as a business combination and included PowderJect Pharmaceuticals’operating results in its consolidated operating results beginning July 8,2003.

 

Thecomponents of the purchase price, and the allocation thereof based on estimatedfair values are summarized 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 September 30,  2004         |       | 22,340     |          |
| Acquisition costs not yet paid as of  September 30, 2004 |       | 27,827     |          |
| Total purchase price                                     |       | $          |  940,346 |   |

 

| 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                                       |       | 527,492    |       |
| Acquired intangible assets                     |       | 335,500    |       |
| Other assets                                   |       | 4,876      |       |
| Income taxes payable                           |       | (17,741    | )          |
| Current liabilities                            |       | (53,810    | )          |
| Net deferred tax liability                     |       | (69,566    | )          |
| Long-term liabilities                          |       | (82,343    | )          |
| Purchased in-process research and  development |       | 45,300     |       |
| Total purchase price                           |       | $          | 940,346    |   |

 

Chironallocated the purchase price based on the fair value of the assets acquired andliabilities assumed. Chiron allocated a portion of the purchase price topurchased in-process research and development, which it charged to earnings in2003. Purchased in-process research and development represented the valuationof acquired, to-be-completed research projects. Purchased in-process researchand development 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. To assist in determiningthe value of the purchased in-process research and development, a third-partyvaluation was obtained as of the acquisition date.

 

15

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Acquiredintangible assets included the fair value of distribution rights, a contractmanufacturing agreement and developed product technologies. The distributionrights and the contract manufacturing agreement are being amortized on astraight-line basis over 1 to 4 years. The weighted average amortizationperiod for these intangible assets is 2 years. Developed producttechnologies are being amortized using either the estimated sales method over10 years or on a straight-line basis over 1 to 15 years. The weightedaverage amortization period for these intangible assets is 11 years. Theweighted average amortization period for total acquired intangible assets is10 years.

 

Incometaxes payable of $17.7 million relates to current tax liabilitiesassociated with PowderJect Pharmaceuticals at the date of acquisition. The netdeferred tax liability of $69.6 million is comprised of current andnon-current deferred tax assets of $31.1 million primarily related to netoperating losses incurred from April 1, 2003 through the acquisition date,reserves and depreciation timing differences and a non-current deferred taxliability of $100.7 million related to acquired intangibles.

 

Foracquisition costs related to PowderJect Pharmaceuticals, Chiron paid$5.6 million and $5.5 million for the nine months endedSeptember 30, 2004 and September 30, 2003, respectively. For theacquisition of PowderJect Pharmaceuticals, cash paid for common stock andoptions on common stock was $890.2 million for the nine months endedSeptember 30, 2003. These payments are reflected in the CondensedConsolidated Statement of Cash Flows as a component of “Cash paid foracquisitions, net of cash acquired” for the nine months endedSeptember 30, 2004 and 2003, respectively.

 

Chironpaid $1.0 million and $0.2 million related to severance paymentsincluded in acquisition costs for PathoGenesis Corporation and MatrixPharmaceutical, respectively, for the nine months ended September 30,2003. These payments are reflected in the Condensed Consolidated Statement ofCash Flows as a component of “Cash paid for acquisitions, net of cash acquired”for the nine months ended September 30, 2003.

 

**Note 5—Roche Settlement**

 

InOctober 2000, Chiron entered into three license agreements with F. Hoffmann-LaRoche Limited (Roche) and several of its affiliated companies related to thesettlement of certain litigation in the U.S. and certain other countries foruse of Chiron’s hepatitis C virus and HIV nucleic acid testing intellectualproperty. Two agreements relate to *in vitro*diagnostics products. The third agreement relates to blood screening, which wassuperseded in May 2001 by two new agreements, one for hepatitis Cvirus and one for HIV.

 

AnHIV-related patent directed to nucleic acid testing methods for HIV-1 wasissued in the U.S. on March 13, 2003. This patent will expire seventeenyears from the date of issuance. The issuance of the patent triggered amilestone payment to Chiron of $10.0 million from Roche, which wasreceived in April 2003. As permitted under the terms of its licensingagreement, Roche decided to institute arbitration proceedings in regard to theapplication of the U.S. patent. Chiron had deferred recognition of the$10.0 million milestone payment, interest, royalties received androyalties accrued under the patent until the resolution of this dispute. OnSeptember 10, 2004, Chiron reached a settlement agreement with Roche.Under the terms of the settlement agreement, the milestone payment along withany royalties received prior to March 31, 2004 became non-refundable.Accordingly, for the three months ended September 30, 2004, Chiron hasrecognized $10.0 million in license fees and $21.8 million inroyalties up until June 30, 2004, which had previously been deferred, ofwhich $16.3 million has been recognized as revenue in Chiron’s othersegment and $5.5 million has been recognized as revenue in Chiron’s bloodtesting segment. Chiron also recognized $0.8 million in interest on thelicense fee. Also under the settlement agreement, in the first quarter of 2005,Chiron is entitled to receive a lump-sum payment of $78.0 million in lieuof royalties beyond January 1, 2005. Roche may elect under the terms ofthe agreement to obtain a partial refund and revert to paying royalties on thesales of its products in North America. The amount of such potential refundranges between $64.0 million and $0.0 million. The refund availabledecreases in equal quarterly increments over the eight quarters of 2005 and2006. As such, Chiron expects to recognize $64.0 million of the payment asrevenue over those eight quarters. The remaining $14.0 million isnonrefundable and was recognized as revenue for the three months endedSeptember 30, 2004, of which $9.3 million has been recognized asrevenue in Chiron’s other segment and $4.7 million has been recognized asrevenue in Chiron’s blood testing segment.

 

The one time impact on revenues for the three and nine months endedSeptember 30, 2004 from these items from the September 10, 2004settlement with Roche is summarized below (in thousands).

 
| ** **                                      | ** ** | **Other  Segment** | ** ** | **Blood-testing  Segment** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
| Deferred revenues recognized                    |       | $                  | 16,313     |                       | $          | 5,453     |       | $ | 21,766 |   |
| Deferred license fee recognized                 |       | 10,000             |       | —                     |       | 10,000    |       |
| Non-refundable portion of Roche settlement      |       | 9,333              |       | 4,667                      |       | 14,000    |       |
| Total one time royalty and license fee  revenue |       | $                  | 35,646     |                       | $          | 10,120    |       | $ | 45,766 |   |

 

16

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**Note 6—Intangible Assets**

 

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

 
| ** **                                      | ** ** | **September 30, 2004** | ** ** | **December 31, 2003**    | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **Gross  Carrying  Value**  | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** |
| Purchased technologies                          |       | $                           | 332,434    |                          | $          | 111,312 |   | $ | 221,122 |   | $ | 332,543 |   | $ | 95,836 |   | $ | 236,707 |   |
| Patents                                         |       | $                           | 126,847    |                          | $          | 68,620 |   | $ | 58,227 |   | $ | 119,675 |   | $ | 61,747 |   | $ | 57,928 |   |
| Trademarks                                      |       | 60,750                      |       | 22,824                        |       | 37,926 |   | 61,082 |   | 20,507 |   | 40,575 |   |
| Licenses and technology rights                  |       | 48,783                      |       | 34,121                        |       | 14,662 |   | 49,087 |   | 27,818 |   | 21,269 |   |
| Developed product technologies                  |       | 350,828                     |       | 59,642                        |       | 291,186 |   | 347,233 |   | 23,093 |   | 324,140 |   |
| Customer relationships                          |       | 28,334                      |       | 10,896                        |       | 17,438 |   | 28,824 |   | 9,952 |   | 18,872 |   |
| Know how(1)                                     |       | 12,868                      |       | 6,615                         |       | 6,253 |   | 13,090 |   | 6,023 |   | 7,067 |   |
| Databases                                       |       | 7,100                       |       | 1,893                         |       | 5,207 |   | 7,100 |   | 1,538 |   | 5,562 |   |
| Other                                           |       | 34,992                      |       | 18,283                        |       | 16,709 |   | 26,328 |   | 14,852 |   | 11,476 |   |
| Total other intangible assets                   |       | $                           | 670,502    |                          | $          | 222,894 |   | $ | 447,608 |   | $ | 652,419 |   | $ | 165,530 |   | $ | 486,889 |   |
| Total intangible assets subject to amortization |       | $                           | 1,002,936  |                          | $          | 334,206 |   | $ | 668,730 |   | $ | 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 them collectivelyas a separate intangible asset apart from goodwill in accordance with SFAS No.141, “Business Combinations”.

 

Aggregateamortization expense is as follows (in thousands):

 

| For the nine months ended September 30, 2004                                    | ** ** | $      | 71,668  | ** ** |
|---------------------------------------------------------------------------------|------------|--------|---------|------------|
| For the  remaining three months in the year ended December 31, 2004 (estimated) |       | 23,883 |    |
| For the year ended December 31, 2004  (estimated)                               |       | $      | 95,551  |       |
| For the year ended December 31, 2005  (estimated)                               |       | $      | 96,449  |       |
| For the year ended December 31, 2006  (estimated)                               |       | $      | 100,881 |       |
| For the year ended December 31, 2007  (estimated)                               |       | $      | 98,735  |       |
| For the year ended December 31, 2008  (estimated)                               |       | $      | 74,231  |       |
| For the year ended December 31, 2009  (estimated)                               |       | $      | 50,580  |       |

 

Thechanges in the carrying value of goodwill by reporting unit consisted of thefollowing (in thousands):

 
| ** **                         | ** ** | **Biopharmaceuticals** | ** ** | **Vaccines** | ** ** | **Total** | ** ** |
|------------------------------------|------------|------------------------|------------|--------------|------------|-----------|------------|
| Balance as of December 31, 2003    |       | $                      | 187,492    |         | $          | 600,095   |       | $ | 787,587 |   |
| PowderJect adjustment (See Note 4) |       | —                 |       | 24,531       |       | 24,531    |       |
| Effect of exchange rate changes    |       | —                 |       | 7,968        |       | 7,968     |       |
| Balance as of September 30, 2004   |       | $                      | 187,492    |         | $          | 632,594   |       | $ | 820,086 |   |

 

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Chironperformed its annual impairment test for goodwill in the third quarter 2004, asof July 1, 2004. Subsequent to the third quarter 2004, given thedevelopments with respect to Fluvirin discussed in “Note 9—Commitments andContingencies,” Chiron considered the impact of recent Fluvirin developments ongoodwill. Based on this revised analysis, Chiron has no indication of animpairment loss. Chiron will continue to monitor goodwill for any impairmentassociated with future developments related to the Fluvirin matters.

 

**Note 7—Segment Information**

 

Chironis organized based on the products and services that it offers. Under thisorganizational structure, there are three reportable segments:(i) blood-testing, (ii) vaccines and (iii) biopharmaceuticals.The blood-testing segment consists of an alliance with Gen-Probe and Chiron’sone-half share in the pretax operating earnings generated by the joint businesscontractual arrangement with Ortho-Clinical Diagnostics, Inc., aJohnson & Johnson company. Chiron’s alliance with Gen-Probe is focusedon developing and commercializing nucleic acid testing products usingTranscription-Mediated Amplification technology to screen donated blood andplasma products for viral infection. Chiron’s joint business arrangement withOrtho-Clinical Diagnostics is operated under 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. The blood-testingsegment also earns royalties from third parties based on their sales ofimmunodiagnostic and nucleic acid testing probe diagnostic products utilizingChiron’s hepatitis C virus and HIV-related patents, for use in blood screeningand plasma fractionation markets. The vaccines segment consists principally ofadult and pediatric vaccines for viral and bacterial infections. Chiron sellsthese vaccines primarily in the U.S., Germany, Italy, and the United Kingdom,as well as in other international markets. The vaccines segment is alsoinvolved in the development 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. The biopharmaceuticals segment earns royalties on third partysales of several products, including Betaferon® and recombinant insulin andglucagons products and earns license fees for technologies, such as hepatitis Cvirus-related patents, used by third parties to develop therapeutic products.

 

Revenuesand expenses associated with Chiron’s research and development activitiesspecifically benefit each of the reportable segments and as such, have beenincluded in the results of operations of the respective reportable segment.

 

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

 

Theaccounting policies of Chiron’s reportable segments are the same as thosedescribed in Note 1—Basis of Presentation and Summary of SignificantAccounting Policies above and in Chiron’s Annual Report on Form 10-K forthe year ended December 31, 2003. Chiron evaluates the performance of itssegments based on each segment’s income (loss) from continuing operationsexcluding certain special items such as purchased in-process research anddevelopment, which is shown as a reconciling item in the table below.

 

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Thefollowing segment information excludes all significant intersegmenttransactions as these transactions are eliminated for management reportingpurposes (in thousands):

 
| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| *Revenues*                               |       |                                       |       |                                      |       |   |   |   |   |
| Blood-testing:                           |       |                                       |       |                                      |       |   |   |   |   |
| Product sales, net:                      |       |                                       |       |                                      |       |   |   |   |   |
| Procleix® System                    |       | $                                          | 63,629     |                                      | $          | 53,663 |   | $ | 186,104 |   | $ | 141,767 |   |
| Ortho-Clinical Diagnostics               |       | 7,098                                      |       | 6,235                                     |       | 19,940 |   | 19,766 |   |
| Total product sales, net                 |       | 70,727                                     |       | 59,898                                    |       | 206,044 |   | 161,533 |   |
| Revenues from joint business arrangement |       | 34,017                                     |       | 26,058                                    |       | 92,910 |   | 79,985 |   |
| Collaborative agreement revenues         |       | 1,616                                      |       | 2,103                                     |       | 6,005 |   | 6,393 |   |
| Royalty and license fee revenues         |       | 34,115                                     |       | 20,576                                    |       | 66,817 |   | 59,372 |   |
| Other revenues                           |       | 243                                        |       | —                                    |       | 673 |   | — |   |
| Total blood-testing revenues             |       | 140,718                                    |       | 108,635                                   |       | 372,449 |   | 307,283 |   |
|                                     |       |                                       |       |                                      |       |   |   |   |   |
| Vaccines:                                |       |                                       |       |                                      |       |   |   |   |   |
| Product sales, net:                      |       |                                       |       |                                      |       |   |   |   |   |
| Flu vaccines                             |       | 93,486                                     |       | 183,250                                   |       | 109,398 |   | 191,286 |   |
| Meningococcus vaccines                   |       | 8,865                                      |       | 10,642                                    |       | 18,430 |   | 31,876 |   |
| Travel vaccines                          |       | 26,434                                     |       | 11,229                                    |       | 75,705 |   | 59,981 |   |
| Pediatric and other vaccines             |       | 44,491                                     |       | 57,598                                    |       | 143,292 |   | 133,537 |   |
| Total product sales, net                 |       | 173,276                                    |       | 262,719                                   |       | 346,825 |   | 416,680 |   |
| Collaborative agreement revenues         |       | 2,230                                      |       | 4,349                                     |       | 7,410 |   | 4,516 |   |
| Royalty and license fee revenues         |       | 1,213                                      |       | 3,023                                     |       | 3,888 |   | 9,550 |   |
| Other revenues                           |       | 3,006                                      |       | 2,679                                     |       | 12,563 |   | 8,688 |   |
| Total vaccines revenues                  |       | 179,725                                    |       | 272,770                                   |       | 370,686 |   | 439,434 |   |
|                                     |       |                                       |       |                                      |       |   |   |   |   |
| Biopharmaceuticals:                      |       |                                       |       |                                      |       |   |   |   |   |
| Product sales, net                       |       |                                       |       |                                      |       |   |   |   |   |
| Betaseron®                          |       | 35,171                                     |       | 29,010                                    |       | 96,933 |   | 88,788 |   |
| TOBI®                               |       | 55,734                                     |       | 43,022                                    |       | 159,600 |   | 122,740 |   |
| Proleukin®                          |       | 31,739                                     |       | 29,859                                    |       | 98,664 |   | 85,223 |   |
| Other                                    |       | 8,902                                      |       | 8,166                                     |       | 29,770 |   | 22,258 |   |
| Total product sales, net                 |       | 131,546                                    |       | 110,057                                   |       | 384,967 |   | 319,009 |   |
| Collaborative agreement revenues         |       | 278                                        |       | 1,364                                     |       | 1,052 |   | 4,645 |   |
| Royalty and license fee revenues         |       | 15,412                                     |       | 23,523                                    |       | 47,892 |   | 62,098 |   |
| Other revenues                           |       | 1,201                                      |       | 5,009                                     |       | 9,127 |   | 23,794 |   |
| Total biopharmaceuticals revenues        |       | 148,437                                    |       | 139,953                                   |       | 443,038 |   | 409,546 |   |
|                                     |       |                                       |       |                                      |       |   |   |   |   |
| Other:                                   |       |                                       |       |                                      |       |   |   |   |   |
| Royalty and license fee revenues         |       | 60,656                                     |       | 19,115                                    |       | 102,787 |   | 55,517 |   |
| Total revenues                           |       | $                                          | 529,536    |                                      | $          | 540,473 |   | $ | 1,288,960 |   | $ | 1,211,780 |   |

 

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| *Income (loss) from continuing operations*             | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
|--------------------------------------------------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|
| Blood-testing                                          | ** **   | $            | 80,690       |         | $            | 56,994       |         | $            | 203,538      |   | $ | 169,997 | ** ** |
| Vaccines                                               |         | (65,528      | )            | 69,848       |         | (161,880     | )            | 65,340       |         |
| Biopharmaceuticals                                     |         | 1,683        |         | 15,663       |         | 29,709       |         | 48,959       |         |
| Other                                                  |         | 34,788       |         | (4,349       | )            | 24,157       |         | (1,419       | )            |
| Segment income from operations                         |         | 51,633       |         | 138,156      |         | 95,524       |         | 282,877      |         |
| Operating expense reconciling item:                    |         |         |         |         |         |         |         |         |         |
| Purchased in-process research and  development         |         | (9,629       | )            | (122,700     | )            | (9,629       | )            | (122,700     | )            |
| Income from operations                                 |         | 42,004       |         | 15,456       |         | 85,895       |         | 160,177      |         |
| Interest expense                                       |         | (7,063       | )            | (6,222       | )            | (19,440      | )            | (12,523      | )            |
| Interest and other income, net                         |         | 5,369        |         | 5,239        |         | 41,252       |         | 31,170       |         |
| Minority interest                                      |         | (504         | )            | (443         | )            | (1,583       | )            | (1,424       | )            |
| Income from continuing operations before  income taxes |         | $            | 39,806       |         | $            | 14,030       |         | $            | 106,124      |   | $ | 177,400 |   |

 

**Note 8—Debt Obligations**

 

*Convertible Debentures*

 

OnJune 22, 2004, Chiron issued $385.0 million aggregate principalamount of convertible debentures, which mature on June 30, 2034. Theconvertible debentures accrue interest at a rate of 2.75% per year and interestis payable on June 30 and December 30 commencing on December 30,2004. The debentures are senior, unsecured obligations of Chiron and rank equalin right of payment with all of Chiron’s existing and future unsecured andunsubordinated indebtedness.

 

Theholders of the debentures may convert their debentures when certain Chironcommon stock price targets have been met at certain times, if the trading pricefor the debentures falls below certain levels for a specified period of time,if the debentures have been called for redemption, if the credit ratingassigned to Chiron’s long-term senior debt is below specified levels, upon theoccurrence and continuance of specified corporate transactions or in connectionwith a transaction or event constituting a change in control. The initialconversion rate is 14.9254 shares of Chiron common stock per $1,000 principalamount of debentures. This is equivalent to an initial conversion price ofapproximately $67.00 per share of Chiron common stock.

 

Ifthe debentures are tendered for conversion, the value (“Conversion Value”) ofcash and shares of Chiron’s common stock, if any, to be received by a holderconverting $1,000 principal amount of the debentures will be determined bymultiplying the applicable conversion rate by a weighted average price. Chironwill deliver the Conversion Value to debenture holders as follows: (1) anamount in cash (“Principal Return”) equal to the lesser of (a) theaggregate Conversion Value of the debentures to be converted and (b) theaggregate principal amount of the debentures to be converted and (2) ifthe aggregate Conversion Value of the debentures to be converted is greaterthat the Principal Return, an amount in shares (“Net Shares”) equal to theaggregate Conversion Value less the Principal Return (“Net Share Amount”). Thenumber of Net Shares to be paid will be determined by dividing the Net ShareAmount by a weighted average price.

 

Ifa change in control occurs on or prior to July 5, 2010, under certaincircumstances, holders of the debentures will receive a make whole premium ondebentures tendered for repurchase and for debentures converted in connectionwith a change in control. The amount of the make whole premium will be based onthe price paid per share of Chiron common stock in a transaction constituting achange in control and is payable in Chiron common stock.

 

Theholders of the debentures may require Chiron to repurchase for cash all or partof the debentures on June 30, 2010, June 30, 2014, June 30,2019, June 30, 2024 and June 30, 2029. The repurchase price will beequal to 100% of the principal amount of the debentures to be repurchased, plusaccrued and unpaid interest, if any, up to the repurchase date.

 

Onor after July 5, 2010, Chiron may redeem for cash all or part of thedebentures at a redemption price equal to 100% of principal amount of thedebentures to be redeemed, plus accrued and unpaid interest, if any, up to theredemption date.

 

Bondissuance costs in connection with the issuance of the debentures amounted toapproximately $8.6 million and are being amortized to interest expense ona straight-line basis, which approximates the effective interest method, oversix years, 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 September 30, 2004.

 

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*Liquid Yield Option Notes*

 

InJune 2001, Chiron issued zero coupon Liquid Yield Option Notes (LYONs)with a face value of $730.0 million and a yield to maturity of 2.0%. TheLYONs were carried net of an original issue discount of $328.2 million,which was being accreted to interest expense over the life of the LYONs usingthe effective interest method. No beneficial conversion feature existed at thetime of the issuance of the LYONs. The LYONs mature on June 12, 2031, at aface value of $1,000 per note. The LYONs are uncollateralized andunsubordinated, and rank equal in right of payment to Chiron’s existing andfuture uncollateralized and unsubordinated indebtedness.

 

OnJune 12, 2004, certain LYONs holders, at their option, tendered$649.9 million in aggregate principal amount at maturity for purchase byChiron. The purchase price for the LYONs was $584.31 in cash per $1,000 inprincipal amount at maturity. The aggregate purchase price for all the LYONsvalidly surrendered for purchase was $379.7 million. At September 30,2004, there remains outstanding $80.1 million in aggregate principalamount at maturity and an accreted balance of $47.1 million for the LYONs.

 

Atthe option of the holder, Chiron may be required to purchase all, or a portion,of the remaining LYONs on the following dates at the following prices for eachnote 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 Loans Payable*

 

Chironhas entered into various agreements with a governmental body in Italy for whichChiron may borrow up to 8.6 million Euros ($10.6 million atSeptember 30, 2004) for research purposes. Under these facilities, Chironhas an outstanding balance of 5.1 million Euros ($6.4 million) as ofSeptember 30, 2004 with interest rates that range from 2% to 6% andmaturities that range from 2010 to 2013.

 

**Note 9—Commitments and Contingencies**

 

InMarch 2004, Chiron entered into a worldwide, exclusive, multi-product,collaborative arrangement with XOMA Ltd. for the development andcommercialization of antibody products for the treatment of cancer. Under theterms of the arrangement, the parties agreed to jointly research, develop, andcommercialize multiple antibody product candidates. Under the arrangement, theparties agreed to share development and commercialization expenses, includingpreclinical and clinical development, manufacturing and worldwide marketing costs,as well as revenues, generally on a 70-30 basis, with Chiron’s share being 70%and XOMA’s share being 30%. Chiron agreed to make an initial payment of$10.0 million, which has been paid as of September 30, 2004, and tomake a loan facility of up to $50.0 million available to XOMA, starting onJanuary 1, 2005 to fund XOMA’s share of development expenses. Thecollaboration will initially focus on preclinical, process development andscale up work, with a potential Investigative New Drug (IND) filing anticipatedearly in the collaboration.

 

OnJune 1, 2004, Chiron renewed its lease for a manufacturing facility inEmeryville, California from June 1, 2004 through September 30, 2015with two 3-year options to renew at the end of the lease term and with a rightto cancel the lease as of May 31, 2014 without a cancellation fee. Chironis obligated to pay approximately $17.5 million up until May 31,2014.

 

Chironis subject to indemnification provisions under its agreements with othercompanies in its ordinary course of business, typically with business partners,contractors, clinical sites, insurers and customers. Under these provisions,Chiron generally indemnifies and holds harmless the indemnified party forlosses suffered or incurred by the indemnified party as a result of Chiron’sactivities. These indemnification provisions generally survive termination ofthe underlying agreement. In some cases, the maximum potential amount of futurepayments Chiron could be required to make under these indemnification provisionsis unlimited. The estimated fair value of the indemnity obligations of theseagreements is minimal. Accordingly, Chiron has no liabilities recorded forthese agreements as of September 30, 2004. Chiron has not incurredmaterial costs to defend lawsuits or settle claims related to theseindemnification agreements.

 

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Duringthe third quarter of 2004, in conducting final internal release procedures forFluvirin influenza virus vaccine, Chiron’s quality systems identified lots thatdid not meet product sterility specifications. As a result, Chiron determinedat that time to delay releasing any Fluvirin doses pending completion ofinternal investigations. Subsequent to the third quarter, the UK regulatory body,the Medicines and Healthcare products Regulatory Agency (MHRA), sent Chiron aletter prohibiting Chiron from releasing any Fluvirin doses manufactured at itsLiverpool facility since March 2, 2004. In that letter, the MHRA assertedthat Chiron’s manufacturing process did not comply with U.K. good manufacturingpractices regulations. In addition to prohibiting release of existing Fluvirindoses, the MHRA letter also suspended Chiron’s license to manufacture furtherinfluenza virus vaccine in its Liverpool facility for three months. Followingits own investigation, the U.S. Food and Drug Administration, or FDA, announcedthat it would not permit release of any Fluvirin from our Liverpool facilityinto the United States. The MHRA could extend the license suspension or evenmake it permanent. Chiron estimates that Fluvirin production must begin byMarch 2005 in order for Chiron to be able to release the product inSeptember 2005, so any significant extension of the suspension couldresult in Chiron being unable to release Fluvirin for the 2005-2006 season,which would harm its business and results of operations. Chiron cannot predictwith any certainty if or when it will be able to resume production of Fluvirinat its Liverpool facility. In addition, while Chiron is still in the process ofassessing the appropriate corrective steps, its remediation efforts couldentail additional capital and other expenditures, which could be material.Chiron’s inability to supply Fluvirin may also lead to loss of market share. Asa result of the license suspension, competitors have announced plans tointroduce influenza vaccine products in the United States and are seekingexpedited regulatory approval to do so. Even if the license suspension expires,some of Chiron’s customers may choose to purchase flu vaccine from otherproviders as their products become available in the United States. Loss ofmarket share could have a material adverse effect on its business and resultsof operations. Chiron is subject to investigations and litigation in connectionwith the events described above. Chiron has received a grand jury subpoenaissued by the U.S. Attorney’s Office for the Southern District of New Yorkrequesting production of certain documents and materials relating to Chiron’sinfluenza virus vaccine and the suspension by the MHRA of Chiron’s license. TheSecurities and Exchange Commission is also conducting an informal inquiry intowhether Chiron has violated any federal securities laws. Additionalinvestigations regarding these matters may arise, including Congressionalinvestigations. In addition, Chiron and certain of its officers and directorshave also been named as defendants in several putative class action andshareholder derivative lawsuits arising out of these developments.Investigations and litigation could cause Chiron to incur substantial expense,require significant time and attention from Chiron’s management and result incivil and/or criminal penalties against Chiron. The results of any suchinvestigations or proceedings could have a material adverse effect on Chiron’sconsolidated financial position and results of operations or cash flows.

 

Inaddition to the investigations, inquiry and lawsuits related to the recentFluvirin developments, Chiron is party to various claims, investigations andlegal proceedings arising in the ordinary course of business. These claims,investigations and legal proceedings relate to intellectual property rights,contractual rights and obligations, employment matters, claims of product liabilityand other issues. While it is possible that an adverse determination of any ofsuch ordinary course matters could have a material adverse impact in any futureperiod, management does not believe, based upon information known to it, thatthe final resolution of any of these ordinary course matters will have amaterial adverse effect upon Chiron’s consolidated financial position andresults of operations or cash flows.

 

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

 

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

 

***Forward-Looking Statements***

 

*This 10-Q contains forward-looking statementsregarding our expectations, hopes or intentions regarding the future, includingstatements relating to sales growth, product development initiatives, newproduct marketing, acquisitions, competition, in- and out-licensing activitiesand expected 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. Many factors could cause actualresults, performance and outcomes to differ materially from those expressed orimplied by these forward-looking statements. In particular, many factorsrelated to recent developments with respect to our influenza vaccine Fluvirin®could cause actual results, performance or outcomes to differ materially. Theseinclude, among other things, (1) uncertainty with respect to our abilityto deliver Fluvirin in time for the 2005-2006 or future seasons,(2) possible additional adverse developments with respect to Fluvirinresulting from investigations or discussions with or actions taken or requiredby applicable regulatory authorities, such as the U.K. Medicines and Healthcareproducts Regulatory Agency and the U.S. Food and Drug Administration, includingfurther suspension or revocation of our license to manufacture Fluvirin at ourLiverpool facility, (3) possible additional adverse developments resultingfrom discussions with or actions taken or required by other governmentalauthorities and agencies, such as the U.S. Department of Health and HumanServices and the Centers for Disease Control, (4) significant expensesarising out of remediation efforts with respect to our Liverpool facility andin connection with the investigation by the U.S. Attorney’s Office for theSouthern District of New York, the inquiry by the Securities and ExchangeCommission and putative class action and shareholder derivative lawsuitsrelated to the Fluvirin recent developments and (5) additional significantcompetition in the U.S. influenza vaccines market stemming from the recentdevelopments with respect to Fluvirin. Our actual performance may also differfrom current expectations due to the outcome of clinical trials, regulatoryreview and approvals generally, manufacturing capabilities, intellectualproperty protections and defenses, stock-price and interest-rate volatility andmarketing effectiveness. In particular, there can be no assurance that we willincrease sales of existing products, successfully develop and receive approvalto market new products or achieve market acceptance for such new products.There can be no assurance that our out-licensing activity will generatesignificant revenue, or that our in-licensing activities will fully protect usfrom claims of infringement by third parties. In addition, we may engage inbusiness opportunities, the successful completion of which is subject tocertain 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. We do not undertake an obligation to update theforward-looking information contained in this 10-Q.*

 

**Restatement of Financial Statements**

 

As discussed in Note 1 to our Condensed Consolidated FinancialStatements, we determined that certain sales of a travel vaccine recorded asrevenues in the second quarter of 2004 should not have been recorded as revenueat that time, and that portions of those sales should have been recorded asrevenues in the third and fourth quarters of 2004 and possibly in laterquarters. As a result, we determined to restate the financial statementsincluded in our Quarterly Reports on 10-Q for such quarters. The restatement isreflected in management’s discussion and analysis of financial condition andresults of operations below.

 

**Overview**

 

Weare a global pharmaceutical company that participates in three healthcaremarkets: blood-testing, vaccines and biopharmaceuticals. We are focused on developingproducts for cancer, which include immune-based therapies, antibodies and novelsmall molecule anti-cancer agents and infectious disease, which have a range ofproducts 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.

 

Theblood-testing segment consists of an alliance with Gen-Probe and our one-halfshare in the pretax operating earnings generated by the joint businesscontractual arrangement with Ortho-Clinical Diagnostics, Inc., aJohnson & Johnson company. Our alliance with Gen-Probe is focused ondeveloping and commercializing nucleic acid testing products usingtranscription-mediated amplification technology to screen donated blood andplasma products for viral infection. Our joint business arrangement withOrtho-Clinical Diagnostics is operated under a contractual arrangement and isnot a separate and distinct legal entity. Through our joint businesscontractual arrangement with Ortho-Clinical Diagnostics, we sell a line ofimmunodiagnostic tests to detect hepatitis viruses and retroviruses and providesupplemental tests and microplate and chemiluminescent instrument systems toautomate test performance and data collection. The blood-testing segment alsoearns royalties from third parties based on their sales of immunodiagnostic andnucleic acid testing probe diagnostic products utilizing our hepatitis C virusand HIV-related patents, for use in blood screening and plasma fractionationmarkets.

 

Thevaccines segment consists of flu vaccines, including Fluvirin® and other fluvaccines, meningococcal vaccines, travel vaccines, which include rabies andtick-borne encephalitis vaccines, ArilvaxTM and DukoralTM, and pediatric andother vaccines. We sell these vaccines primarily in the U.S., Germany, Italyand the United Kingdom, as well as in other international markets. Our vaccinessegment is also involved in the development of other novel vaccines andvaccination technology. We acquired Fluvirin,

 

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Arilvax and Dukoral as part ofour July 8, 2003 acquisition of PowderJect Pharmaceutical plc, or PowderJect,a company based in Oxford, England. We accounted for that acquisition under thepurchase method of accounting and included PowderJect’s operating results inour consolidated operating results beginning July 8, 2003.

 

Duringthe third quarter 2004, in conducting final internal release procedures for ourFluvirin influenza virus vaccine, our quality systems identified lots that didnot meet product sterility specifications. As a result, we determined at thattime to delay releasing any Fluvirin doses pending completion of internalinvestigations. Subsequent to the third quarter, the U.K. regulatory body, theMedicines and Healthcare products Regulatory Agency, or MHRA, sent us a letterprohibiting us from releasing any Fluvirin doses manufactured at our Liverpoolfacility since March 2, 2004. In that letter, the MHRA asserted that ourmanufacturing process did not comply with U.K. good manufacturing practicesregulations. In addition to prohibiting release of existing Fluvirin doses, theMHRA letter also suspended our license to manufacture further influenza virusvaccine in our Liverpool facility for three months. Following its owninvestigation, the U.S. Food and Drug Administration, or FDA, announced that itwould not permit release of any Fluvirin from our Liverpool facility into theUnited States. Following our announcements of these events, we were served witha grand jury subpoena issued by the U.S. Attorney’s Office for the SouthernDistrict of New York requesting production of certain documents and materialsrelating to our influenza virus vaccine and the suspension by the MHRA of ourlicense. In addition, the Securities and Exchange Commission, or SEC, hasinformed us that it had opened an informal inquiry to determine whether we haveviolated certain provisions of the federal securities laws and requesting thatwe voluntarily provide certain documents and materials, including materialsrelating to Fluvirin and the suspension of our license to manufacture Fluvirin.We and certain of our officers and directors have also been named as defendantsin several putative class action and shareholder derivative lawsuits arisingout of these developments.

 

Theserecent developments with respect to Fluvirin had the following immediate impacton our results of operations for the three and nine months endedSeptember 30, 2004:

 

*•**                                         *we had no sales of Fluvirin during theseperiods (other than, with respect to the nine months ended September 30,$2.4 million in late 2003-2004 season sales), while Fluvirin sales were$103.3 million for the three and nine months ended September 30,2003; and

 

*•**                                         *we wrote-off our entire inventory of Fluvirin,resulting in a $91.3 million charge to cost of sales and a decrease indiluted earnings per share of approximately $0.36 for each of the three andnine months ended September 30, 2004.

 

Inaddition to the above, we do not expect to release any Fluvirin during thefourth quarter of 2004 or for the 2004-2005 flu season and cannot predict withany certainty if or when we will be able to resume production of Fluvirin atour Liverpool facility. We cannot provide any assurances that we will be ableto provide Fluvirin for the 2005-2006 season. As a result, we expect that ourresults of operations for the fourth quarter 2004 will be materially adverselyaffected by these matters and possibly beyond. If we are unable to provideFluvirin for the 2005-2006 season or afterward, we may also have to recognizean impairment charge with respect to the goodwill, certain other intangibleassets and the Liverpool plant resulting from the PowderJect acquisition andthe new flu vaccines manufacturing facility under construction in Liverpool,which could have a material adverse effect on our results of operations. As aresult of these developments, if we are able to resume production anddistribution of Fluvirin from our Liverpool facility, we may experience loss ofmarket share in the U.S. flu vaccine market as competitors seek to introducetheir influenza products into the United States and as governmental authoritiesand agencies face increased pressure to diversify their sources of flu vaccineand find and approve alternative suppliers of flu vaccine, which could furthermaterially adversely affect our results of operations going forward. We alsoexpect to incur expenses in connection with these Fluvirin matters, which couldbe material, including in connection with (1) our remediation efforts atour Liverpool facility; and (2) responding to the U.S. Attorney for theSouthern District of New York, the SEC, the private lawsuits and other claimsand investigations that may arise. For additional information concerning therisks we face as a result of these Fluvirin developments, see “Factors That MayAffect Future Results—The recent developments with respect to Fluvirin willharm our business and results of operations.” For additional information on theU.S. Attorney’s investigation, SEC inquiry and private lawsuits, seePart II, Item 1 of this report on Form 10-Q.

 

Thebiopharmaceuticals segment consists of therapeutic products and services, withan emphasis on the treatment of cancer and infectious diseases. Our in-housecapabilities span three types of therapeutics, including small molecules,therapeutic proteins and monoclonal antibodies. Our products include TOBI®(tobramycin solution for inhalation) for pseudomonal lung infections in cysticfibrosis patients, Proleukin® (aldesleukin) for cancer (metastatic melanoma andrenal cell carcinoma), and Betaseron® (interferon beta-1b) for multiplesclerosis. The biopharmaceuticals segment also includes collaborations withBerlex Laboratories, Inc. and its parent company, Schering AG of Germany,related to Betaseron® interferon beta-1b. The biopharmaceuticals segment earnsroyalties on third party sales of several products, including Betaferon® andrecombinant insulin and glucagons products and earns license fees fortechnologies, such as hepatitis C virus-related patents, used by third partiesto develop therapeutic products.

 

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

 

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##### **SELECTED CONSOLIDATED FINANCIAL DATA**

 
| ** **                                                                      | ** ** | **Three Months Ended**                            | ** ** | **Nine Months Ended**  | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                      | ** ** | **September 30,**                            | ** ** | **September 30,** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** |
| **2004**                                                                        | ** ** | **2003**                                          | ** ** | **2004**               | ** ** | **2003**          |
| ** **                                                                      | ** ** | **($ in 000’s, except per share data)** | ** ** |
| Product sales, net                                                              |       | $                                                 | 375,549    |                   | $          | 432,674           |       | $                | 937,836    |   | $ | 897,222 |   | $ | (57,125 | ) | $ | 40,614 |   | (13.2 | )% | 4.5 | % |
| Royalty and license fee revenues                                                |       | 111,396                                           |       | 66,237                 |       | 221,384           |       | 186,537          |       | 45,159 |   | 34,847 |   | 68.2 | % | 18.7 | % |
| Total revenues                                                                  |       | 529,536                                           |       | 540,473                |       | 1,288,960         |       | 1,211,780        |       | (10,937 | ) | 77,180 |   | (2.0 | )% | 6.4 | % |
| Cost of sales (excludes amortization expense from  acquired developed products) |       | 238,526                                           |       | 174,380                |       | 494,455           |       | 357,389          |       | 64,146 |   | 137,066 |   | 36.8 | % | 38.4 | % |
| Research and development                                                        |       | 103,000                                           |       | 97,519                 |       | 301,736           |       | 269,564          |       | 5,481 |   | 32,172 |   | 5.6 | % | 11.9 | % |
| Selling, general and administrative                                             |       | 114,531                                           |       | 105,818                |       | 326,128           |       | 259,086          |       | 8,713 |   | 67,042 |   | 8.2 | % | 25.9 | % |
| Purchased in-process research and development                                   |       | 9,629                                             |       | 122,700                |       | 9,629             |       | 122,700          |       | (113,071 | ) | (113,071 | ) | (92.2 | )% | (92.2 | )% |
| Income (loss) from continuing operations                                        |       | 27,447                                            |       | (20,153                | )          | 77,186            |       | 102,375          |       | 47,600 |   | (25,189 | ) | 236.2 | % | (24.6 | )% |
| Diluted earnings (loss) per share:                                              |       |                                              |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations                                        |       | $                                                 | 0.14       |                   | $          | (0.11             | )          | $                | 0.40       |   | $ | 0.54 |   | $ | 0.25 |   | $ | (0.14 | ) | 227.3 | % | (25.9 | )% |
|                                                                            |       |                                              |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
| Gross profit margin                                                             |       | 36                                                | %          | 60                     | %          | 47                | %          | 60               | %          |   |   |   |   |   |   |   |   |

 

Income from continuing operations was$27.4 million, or $0.14 per diluted share and loss from continuing operationswas $20.2 million or $0.11 per diluted share for the three months ended September 30,2004 and 2003, respectively. Income from continuing operations was$77.2 million or $0.40 per diluted share and $102.4 million or $0.54per diluted share for the nine months ended September 30, 2004 and 2003,respectively. Total revenues were $529.5 million and $540.5 millionfor the three months ended September 30, 2004 and 2003, respectively, and$1.3 billion and $1.2 billion for the nine months ended September 30,2004 and 2003, respectively. As described above, there were no sales ofFluvirin during the current quarter. Sales of Fluvirin influenza vaccine were$103.3 million for the three months ended September 30, 2003. Inaddition, as described above, our entire Fluvirin product inventory has beenwritten-off in the third quarter 2004, resulting in a $91.3 million chargeto cost of sales. This charge has resulted in an approximate $0.36 decrease indiluted earnings per share for the three and nine months ended September 30,2004, respectively. The loss from continuing operations for the three monthsended September 30, 2003 was driven by a charge for purchased in-processresearch and development from our acquisition of PowderJect of$122.7 million that was expensed for the three months ended September 30,2003. This charge for purchased in-process research and development alsonegatively impacted the nine months ended September 30, 2003. Acontractual decline in the Betaseron® royalty rate, described in more detailbelow, resulted in $11.4 million and $32.7 million declines in totalrevenues for the three and nine months ended September 30, 2004. Our totalrevenues were affected by the movement in exchange rates, in particular themovements in the Euro and British Pound against the U.S. dollar. The movementin exchange rates added approximately 2% and 3% to our total revenues for thethree and nine months ended September 30, 2004, respectively. However,since our Euro and British Pound denominated expenses have also increased dueto the movement in exchange rates, our earnings per share from continuingoperations declined $0.05 and $0.07 per diluted share for the three and ninemonths ended September 30, 2004, respectively, due to higher expensescompared to revenues denominated in Euros and British Pounds.

 

For the three months ended September 30,2004, product sales decreased compared to the three months ended September 30,2003 as there were no Fluvirin influenza vaccine sales for the current quarter.Product sales increased across our other two business units and with respect toour other vaccine products, in particular our other flu vaccines products,TOBI® tobramycin, Procleix® products, travel vaccines and Betaseron®. For thenine months ended September 30, 2004, product sales increased due toincreases in Procleix® products, TOBI®, travel vaccines, Proleukin® andBetaseron®, even though we had no Fluvirin vaccine sales in the currentquarter.

 

For the three and nine months ended September 30,2004, royalty and licenses fees increased significantly due to the F.Hoffmann-La Roche (Roche) settlement regarding our HIV patent in the U.S. inthe three months ended September 30, 2004. The settlement included a$78.0 million lump sum payment, of which $14.0 million was recognizedin the third quarter 2004. In addition, the settlement resulted in$31.8 million of previously deferred royalties and license payments beingrecognized in the three months ended September 30, 2004. The one timeimpact of these items from the Roche settlement was an approximate $0.18increase in diluted earnings per share for the three and nine months ended September 30,2004, respectively. Also, there was an additional

 

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$7.9 millionfor the three and nine months ended September 30, 2004 due to recognitionof a portion of the license fee under our license agreements with the BloodTransfusion Centers of the German Red Cross (German Red Cross) for use of ourHIV-1 and hepatitis C virus (HCV) technology.

 

The declines in gross profit margins for the threeand nine months ended September 30, 2004 as compared with the three andnine months ended September 30, 2003 were primarily due to the write-offof our entire inventory of Fluvirin, resulting in a $91.3 million chargeto cost of sales in the third quarter 2004, as well as the fact that there wereno Fluvirin vaccine sales in the third quarter 2004. The effect of the Fluvirincharge resulted in a 24% and 9% decrease in our gross margin percentage for thethree and nine months ended September 30, 2004.

 

Gross profit margins do not include amortizationexpense from acquired developed products, intangible assets related to businesscombinations.

 

The main components of the increase in research and developmentexpenses for the nine months ended September 30, 2004 as compared to thenine months ended September 30, 2003 include tifacogin, our meningococcalvaccines franchise and our flu cell culture program. These increases werepartially offset by the discontinuance of development of tezacitabine andPA-2794.

 

The increase in selling general and administrativeexpenses for the nine months ended September 30, 2004 as compared to thenine months ended September 30, 2003 mainly reflects the timing of our acquisitionof PowderJect on July 8, 2003. Selling, general and administrativeexpenses for the nine months ended September 30, 2004 include nine monthsof selling, general and administrative expenses from PowderJect while the ninemonths ended September 30, 2003 included three months of such expenses.Selling, general and administrative expenses increased also due to investmentin geographic penetration for our products, marketing programs for our productsand defense of our patents and technology.

 

The effective tax rate for the three and nine monthsended September 30, 2004 was 31.0% and 27.3% respectively, of pretaxincome from continuing operations, including the charge for purchased inprocess research and development related to the Sagres acquisition. Theeffective tax rate for the three and nine months ended September 30, 2003was 243.6% and 42.3% respectively, of pretax income from continuing operationsincluding the charge for purchased in-process research and development relatedto the PowderJect acquisition. The charges for the purchased in-processresearch and development in 2003 and 2004 are not tax deductible. The effectivetax rate for the three and nine months ended September 30, 2004 and 2003was 25% of pretax income from continuing operations, after excluding the impactof the purchased in-process research and development charges. The effective taxrate may be affected in future periods by changes in management’s estimateswith respect to our deferred tax assets and other items affecting the overalltax rate.

 

***Critical Accounting Policies and theUse of Estimates***

 

Our critical accounting policies, which incorporateour more significant judgments and estimates used in the preparation of ourCondensed Consolidated Financial Statements are the same as those described inPart II, Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” in Chiron’s Annual Report onForm 10-K for the year ended December 31, 2003, except for additionaldiscussion in the following two paragraphs.

 

Purchased in-process research and development—Weallocate the purchase price of acquisitions based on the fair value of theassets acquired and liabilities assumed. To assist in determining the value ofthe in-process research and development and certain other intangibles, a thirdparty valuation is typically obtained as of the acquisition date if theacquisition is significant. We generally use the income approach to valuein-process research and development. The income approach 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. We perform a discounted cash flow analysis,utilizing anticipated revenues, expenses and net cash flow forecasts related tothe technology. Given the high risk associated with the development of newdrugs, we probability adjust the revenue and expense forecasts to reflect therisk of advancement through the regulatory approval process based on the stageof development in the regulatory process. Such a valuation requires significantestimates and assumptions. We believe the fair value assigned to the in-processresearch and development is based on reasonable assumptions. However, theseassumptions may be incomplete or inaccurate, and unanticipated events andcircumstances may occur. Additionally, estimates for the purchase priceallocation may change as subsequent information becomes available. On July 2,2004, we acquired Sagres Discovery and accounted for the acquisition as anasset purchase. We allocated the purchase price based on fair value of theassets acquired and liabilities assumed. We allocated $9.6 million of thepurchase price to purchased in-process research and development, which wecharged to operations in the third quarter 2004. We do not anticipate thatthere will be any alternative future use for the purchased in-process researchand development. On July 8, 2003, we acquired PowderJect and accounted forthe acquisition using the purchase method of accounting. We allocated thepurchase price based on fair value of the assets acquired and liabilitiesassumed. We allocated $122.7 million of the purchase price to purchasedin-process research and development, which we charged to operations for thenine months ended September 30, 2003. In the fourth quarter of 2003, uponcompletion of strategic assessments of the value of certain research anddevelopment projects, we revised the allocation of a portion of the purchaseprice resulting in a $77.4 million decrease to purchased in-processresearch and development which we credited to operations and which was offsetagainst goodwill. We do not anticipate that there will be any alternativefuture use for the purchased in-process research and development. In valuingthe purchased in-process research and development, we usedprobability-of-success-adjusted cash flow and a 14% discount rate. Cash flowsfrom projects including those related to (i) certain travel vaccines and (ii) vaccinesfor allergies were assumed to commence between 2004 and 2012.

 

Product returns and rebates—We have extensivehistorical information on returns and rebates for our products. Historical

 

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informationwith respect to actual product returns and rebates is the primary factorassessed in estimating product returns and rebates allowances. In determiningthe allowance for product returns, we primarily use one of the followingmethodologies depending on the product: (i) we match the actual returns tothe actual sale on a product-by-product basis to assess the historical trendfor returns, and based on an analysis of the historical trend, the appropriatereturn percentage for the current period is then applied to current periodsales to arrive at the product returns charge against revenue for the period or(ii) for seasonal products we analyze our actual returns over the previousseasons to arrive at the average actual returns percentage, which is then appliedto the current season’s sales to arrive at the charge against revenue for thecurrent period. In estimating rebates, we use historical trends to analyzerebates against revenue on a product-by-product basis to arrive at an expectedrebate percentage. This expected rebate percentage is applied to current periodsales to arrive at the rebates expense for the period. If actual productreturns and rebates are greater than our estimates, additional product returnand rebates accruals may be required. If actual product returns and rebates areless than our estimates, we may have to reverse certain accruals.

 

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

 

Our blood-testing segment includes in part ourone-half share in the pretax operating earnings generated by the joint businesscontractual arrangement with Ortho-Clinical Diagnostics, Inc., aJohnson & 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 the first quarter of 2003, we accounted forrevenues relating to non-U.S. affiliate sales on a one-quarter lag, with anadjustment of the estimate to actual in the subsequent quarter. More currentinformation of non-U.S. affiliate sales of our joint business contractualarrangement became available for the three months ended March 31, 2003,and as a result, we are able to recognize revenues relating to non-U.S.affiliate sales on a one-month lag. The effect of this change, net of tax, wasan increase to net income by $3.2 million for revenues from the jointbusiness arrangement for the nine months ended September 30, 2003.

 

##### **Results of Operations**

##### ** **

*Blood-testing*

 
|                                    |       | **Three Months Ended**                          |       | **Nine Months Ended**  |       | **$ Change** |       | **% Change**     |       |
|-----------------------------------------|------------|-------------------------------------------------|------------|------------------------|------------|-------------------|------------|------------------|------------|
|                                    |       | **September 30,**                          | ** ** | **September 30,** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** | **Three  Months** | ** ** | **Nine  Months** |   |
| **2004**                                | ** ** | **2003**                                        | ** ** | **2004**               | ** ** | **2003**          |
|                                    |       | **($ in 000’s, except  percentages)** |       |
| Product sales, net:                     |       |                                            |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
|                                    |       |                                            |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
| Procleix®                          |       | $                                               | 63,629     |                   | $          | 53,663            |       | $                | 186,104    |   | $ | 141,767 |   | $ | 9,966 |   | $ | 44,337 |   | 18.6 | % | 31.3 | % |
| Ortho-clinical Diagnostics              |       | 7,098                                           |       | 6,235                  |       | 19,940            |       | 19,766           |       | 863 |   | 174 |   | 13.8 | % | 0.9 | % |
|                                    |       | 70,727                                          |       | 59,898                 |       | 206,044           |       | 161,533          |       | 10,829 |   | 44,511 |   | 18.1 | % | 27.6 | % |
| Revenue from joint business arrangement |       | 34,017                                          |       | 26,058                 |       | 92,910            |       | 79,985           |       | 7,959 |   | 12,925 |   | 30.5 | % | 16.2 | % |
| Collaborative agreement revenues        |       | 1,616                                           |       | 2,103                  |       | 6,005             |       | 6,393            |       | (487 | ) | (388 | ) | (23.2 | )% | (6.1 | )% |
| Royalty and license fee revenues        |       | 34,115                                          |       | 20,576                 |       | 66,817            |       | 59,372           |       | 13,539 |   | 7,445 |   | 65.8 | % | 12.5 | % |
| Other revenues                          |       | 243                                             |       | —                 |       | 673               |       | —           |       | 243 |   | 673 |   | 100.0 | % | 100.0 | % |
| Total blood-testing revenues            |       | $                                               | 140,718    |                   | $          | 108,635           |       | $                | 372,449    |   | $ | 307,283 |   | $ | 32,083 |   | $ | 65,166 |   | 29.5 | % | 21.2 | % |
|                                    |       |                                            |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
| Gross profit margin                     |       | 43                                              | %          | 40                     | %          | 42                | %          | 42               | %          |   |   |   |   |   |   |   |   |
| Research and development                |       | $                                               | 8,387      |                   | $          | 5,947             |       | $                | 19,754     |   | $ | 16,731 |   | $ | 2,440 |   | $ | 3,023 |   | 41.0 | % | 18.1 | % |
| Selling, general and administrative     |       | $                                               | 11,077     |                   | $          | 9,661             |       | $                | 30,657     |   | $ | 27,217 |   | $ | 1,416 |   | $ | 3,440 |   | 14.7 | % | 12.6 | % |

##### ** **

##### **Product sales**

##### ** **

*Procleix®*    On February 27,2002, the U.S. Food and Drug Administration approved the Procleix*®* HIV-1/ HCV Assay. We have marketed theProcleix® HIV-1/HCV Assay in Europe since 1999. On January 15, 2004, theProcleix® UltrioTM HIV-1/HCV/HBV Assay received European CE marking for use onthe semi-automated eSAS system. Under a collaboration agreement

 

27

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withGen-Probe, we market and sell the Procleix*®*HIV-1/ HCV Assay, the Procleix Ultrio Assay and the related instrument system.In addition to selling directly in the U.S., we also sell in various Europeanand Asia / Pacific markets, directly and through distributors. We recordrevenue based upon the reported results obtained from the customer from the useof assays to screen donations or upon sale and delivery of the assays,depending on the underlying contract. In the case of equipment sales or leases,we record revenue upon the sale and transfer of the title of the instrument orratably over the life of the lease term, respectively. For provision of serviceon the instruments, we recognize revenue ratably over the life of the serviceagreement.

 

The increase in product sales for the three monthsended September 30, 2004 as compared with the three months ended September 30,2003 was primarily due to $5.6 million from continued penetration intoseveral markets abroad and $4.3 million from the U.S. market primarily dueto market share gains in the U.S. for the Procleix® HIV-1/ HCV Assay. Theincrease in product sales for the nine months ended September 30, 2004 ascompared with the nine months ended September 30, 2003 was primarily dueto (i) $19.2 million for the introduction of the West Nile virusassay on an investigational-use basis in the U.S. in March 2003,(ii) $15.3 million for the continued penetration into several marketsabroad and (iii) $9.5 million for market share gains in the U.S. forthe Procleix® HIV-1/ HCV Assay.

 

**Revenue from joint businessarrangement**    Theincrease in revenue from joint business arrangement for the three months ended September 30,2004 as compared with the three months ended September 30, 2003 wasprimarily due to $6.8 million for an increase in royalties. The increasein revenue from joint business arrangement for the nine months ended September 30,2004 as compared with the nine months ended September 30, 2003 wasprimarily due to (i) $8.0 million for an increase in royalties and(ii) $7.6 million for higher profits from Ortho-Clinical Diagnostics’U.S. operations and foreign affiliates. These increases were partially offsetby a one-time benefit of $4.3 million for the three months ended March 31,2003 due to a change in estimate from a three-month lag to a one-month lagrelating to non-U.S. affiliate sales.

 

**Collaborative agreement revenues**    Collaborativeagreement revenues tend to fluctuate based on the amount and timing of researchservices performed, the status of projects under collaboration and theachievement of 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. 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 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 increases in royalty and license fee revenuesfor the three and nine months ended September 30, 2004 as compared to thethree and nine months ended September 30, 2003 were primarily due to(i) $10.1 million for the Roche settlement, as described below and(ii) $7.9 million due to recognition of a portion of the license feeunder our license agreements with the German Red Cross for the use of our HIV-1and hepatitis C virus (HCV) technology for use in molecular probe “home brew”blood screening. The increases were partially offset by a $4.0 millionone-time payment relating to back royalties, which was recognized in the threemonths ended September 30, 2003, and was estimated under an agreement withRoche relating to back royalties. In addition, the nine months ended September 30,2003 included a $7.0 million license fee from Baxter A.G. related to ourhepatitis C virus and HIV technology for use in the plasma fractionationmarket.

 

*German Red Cross Settlement*    We have granted anon-exclusive license to the German Red Cross for use of our HIV-1 andhepatitis C virus (HCV) technology for use in molecular probe “home brew” bloodscreening through 2008, for a total license fee payment of $22.8 million.Of this license fee payment, $7.9 million was recognized as royalty andlicense fee revenues in the current quarter, as discussed above, and theremaining balance is expected to be recognized through 2008, as thecancellation privilege in the related agreements expires. In addition, theGerman Red Cross has the option to license our patents beyond 2008 upon paymentof an additional fee. The licensing terms also cover potential pastinfringements.

 

*Roche settlement*    In October 2000,we entered into three license agreements with Roche and several of itsaffiliated companies related to the settlement of certain litigation in theU.S. and certain other countries for the use of our hepatitis C virus and HIVnucleic acid testing 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.

 

An HIV-related patent directed to nucleic acidtesting methods for HIV-1 was issued in the U.S. on March 13, 2003. Thispatent will expire seventeen years from the date of issuance. As permittedunder the terms of its licensing agreement, Roche decided to institute arbitrationproceedings in regard to the application of the U.S. patent. Our blood-testingsegment had deferred recognition of royalties received and royalties accruedunder the patent until the resolution of this dispute. On September 10,2004, we reached a settlement agreement with Roche. Under the terms of thesettlement agreement royalties received prior to March 31, 2004 becamenon-refundable. For discussion regarding the impact of this settlement on ourin vitro diagnostics products, see “Other—Royalty and license fee revenue”below. Accordingly, for the three months ended September 30, 2004, ourblood-testing segment recognized revenue of $5.5 million for royalties upuntil June 30, 2004, which had previously been deferred. Also under thesettlement agreement, in the first quarter of 2005, we are entitled to receivea lump-sum payment of $78.0 million in lieu of royalties beyond January 1,2005. Roche may elect under the terms of the agreement to obtain a partialrefund and revert to paying royalties on the sales of its products in NorthAmerica. The amount of such potential refund ranges between $64.0 millionand $0.0. The amount of the refund

 

28

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availabledecreases in equal quarterly increments over the eight quarters of 2005 and2006. As such, we expect to recognize $64.0 million of the payment asrevenue over those eight quarters. This revenue will be split between ourblood-testing segment and our other segment. The remaining $14.0 millionis nonrefundable and was recognized as revenue for the three months ended September 30,2004, of which, $9.3 million has been recognized as revenue in our othersegment and $4.7 million has been recognized as revenue in ourblood-testing segment.

 

The one time impact on revenues for the three andnine months ended September 30, 2004 from these items from the September 10,2004 settlement with Roche is summarized under “Other—Royalty and license feerevenues” below.

 

Royalty and license fee revenues may fluctuate basedon the nature of the related agreements and the timing of receipt of licensefees. Results in any one period are not necessarily indicative of results to beachieved in the future. 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.

 

**Gross profit margin**    Gross profit marginincreased for the three months ended September 30, 2004 as compared withthe three months ended September 30, 2003 due to a positive impact by anadjustment to cost of goods sold pursuant to our collaboration agreement withGen-Probe. The blood-testing gross profit margin benefited from an amendment inNovember 2003 to the worldwide blood screening collaboration agreementbetween Chiron and Gen-Probe in order to adopt permanent, fixed revenue sharesfor each party. Effective January 1, 2004, Gen-Probe’s share was set at45.75% of net revenues for assays, which include a test for the hepatitis Cvirus. For commercial assays, which do not test for hepatitis C virus, such asthe West Nile test, the agreement remains unchanged with each party retaining50% of the net revenues after deduction of specified expenses.

 

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

 

**Research and development**    The increases inresearch and development expenses for the three and nine months ended September 30,2004 as compared to the three and nine months ended September 30, 2003were primarily due to (i) $1.0 million related to acquisition ofin-process technologies, focused primarily on research into variant Creutzfeldt-Jakobdisease (vCJD) and (ii) the remainder of the increase is driven by thecontinued development of nucleic acid testing products.

 

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

 

**Selling, general, and administrative**    The increases inselling, general and administrative expenses for the three months ended September 30,2004 as compared to the three months ended September 30, 2003 wereprimarily due to (i) $0.6 million from the geographic expansion ofour customer base for the Procleix® HIV-1/HCV Assay particularly in LatinAmerica and Asia markets and (ii) $0.5 million from the support andpre-launch costs associated with TIGRIS, a fully automated testing system. Theincreases in selling, general and administrative expenses for the nine monthsended September 30, 2004 as compared to the nine months ended September 30,2003 were primarily due to (i) $1.6 million from the geographicexpansion of our customer base for the Procleix® HIV-1/HCV Assay particularlyin Latin America and Asia markets and (ii) $0.9 million from thesupport and pre-launch costs associated with TIGRIS, a fully automated testingsystem.

 

We expect continued growth in selling, general andadministrative expenses related to nucleic acid testing technology and productsas our sales opportunities expand in new markets through anticipated additionalnucleic acid testing adoption.

 

***Vaccines***

 
|                                |   | **Three Months Ended**                         |       | **Nine Months Ended**  |       | **$ Change** |       | **% Change**     |    |
|-------------------------------------|--------|------------------------------------------------|------------|------------------------|------------|-------------------|------------|------------------|---------|
|                                |   | **September 30,**                         |       | **September 30,** |       | **Three  Months** |       | **Nine  Months** |    | **Three  Months** |   | **Nine  Months** |   |
|                                |   | **2004**                                       | ** ** | **2003**               | ** ** | **2004**          | ** ** | **2003**         |    |
|                                |   | **($ in 000’s, except percentages)** |       |
| Product sales, net:                 |   |                                           |       |                   |       |              |       |             |    |   |   |   |   |   |   |   |   |
| Flu vaccines:                       |   |                                           |       |                   |       |              |       |             |    |   |   |   |   |   |   |   |   |
| Other Flu vaccines                  |   | $                                              | 93,486     |                   | $          | 79,960            |       | $                | 106,953 |   | $ | 87,996 |   | $ | 13,526 |   | $ | 18,957 |   | 16.9 | % | 21.5 | % |
| Fluvirin                            |   | —                                         |       | 103,290                |       | 2,445             |       | 103,290          |    | (103,290 | ) | (100,845 | ) | (100.0 | )% | (97.6 | )% |
| Flu vaccines                        |   | 93,486                                         |       | 183,250                |       | 109,398           |       | 191,286          |    | (89,764 | ) | (81,888 | ) | (49.0 | )% | (42.8 | )% |
| Meningococcus vaccines              |   | 8,865                                          |       | 10,642                 |       | 18,430            |       | 31,876           |    | (1,777 | ) | (13,446 | ) | (16.7 | )% | (42.2 | )% |
| Travel vaccines                     |   | 26,434                                         |       | 11,229                 |       | 75,705            |       | 59,981           |    | 15,205 |   | 15,724 |   | 135.4 | % | 26.2 | % |
| Pediatric and other vaccines        |   | 44,491                                         |       | 57,598                 |       | 143,292           |       | 133,537          |    | (13,107 | ) | 9,755 |   | (22.8 | )% | 7.3 | % |
|                                |   | 173,276                                        |       | 262,719                |       | 346,825           |       | 416,680          |    | (89,443 | ) | (69,855 | ) | (34.0 | )% | (16.8 | )% |
| Collaborative agreement revenues    |   | 2,230                                          |       | 4,349                  |       | 7,410             |       | 4,516            |    | (2,119 | ) | 2,894 |   | (48.7 | )% | 64.1 | % |
| Royalty and license fee revenues    |   | 1,213                                          |       | 3,023                  |       | 3,888             |       | 9,550            |    | (1,810 | ) | (5,662 | ) | (59.9 | )% | (59.3 | )% |
| Other revenues                      |   | 3,006                                          |       | 2,679                  |       | 12,563            |       | 8,688            |    | 327 |   | 3,875 |   | 12.2 | % | 44.6 | % |
| Total Vaccines revenues             |   | $                                              | 179,725    |                   | $          | 272,770           |       | $                | 370,686 |   | $ | 439,434 |   | $ | (93,045 | ) | $ | (68,748 | ) | (34.1 | )% | (15.6 | )% |
|                                |   |                                           |       |                   |       |              |       |             |    |   |   |   |   |   |   |   |   |
| Gross profit margin                 |   | 11                                             | %          | 58                     | %          | 22                | %          | 56               | %       |   |   |   |   |   |   |   |   |
| Research and development            |   | $                                              | 30,985     |                   | $          | 35,298            |       | $                | 97,313  |   | $ | 82,693 |   | $ | (4,313 | ) | $ | 14,620 |   | (12.2 | )% | 17.7 | % |
| Selling, general and administrative |   | $                                              | 44,806     |                   | $          | 43,419            |       | $                | 119,696 |   | $ | 90,240 |   | $ | 1,387 |   | $ | 29,456 |   | 3.2 | % | 32.6 | % |
| Amortization expense                |   | $                                              | 14,326     |                   | $          | 13,604            |       | $                | 44,352  |   | $ | 16,497 |   | $ | 722 |   | $ | 27,855 |   | 5.3 | % | 168.8 | % |
|                                     |        |                                                |            |                        |            |                   |            |                  |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Product sales**    We sell flu,meningococcal, travel, pediatric, and other vaccines in the U.S., Germany,Italy, and the United Kingdom, as well as in other international markets.

 

*Flu vaccines*    As described aboveunder “Overview,” as a result of recent developments with respect to Fluvirin,we had no Fluvirin sales in the three or nine months ended September 30,2004 (other than, with respect to the nine months ended September 30,$2.4 million in late 2003-2004 season sales). Sales of Fluvirin influenzavaccine were $103.3 million for the three and nine months ended September 30,2003. Sales of our remaining flu vaccines increased in the three and ninemonths ended September 30, 2004 as compared with the three and nine monthsended September 30, 2003 primarily due to approximately $5.1 millionfor the favorable movement in the Euro to U.S. Dollar exchange rate as well asprice increases.

 

*Meningococcus vaccines*    The decrease inmeningococcus vaccines sales for the three months ended September 30, 2004as compared to the three months ended September 30, 2003 was primarily dueto a reduction of $8.0 million in sales of Menjugate® product due to thetiming of outbreaks and vaccination programs in various countries and increasedcompetition for tender sales. This decrease was partially offset by sales in2004 of $6.2 million of MeNZBTM meningococcal B vaccine to the Ministry ofHealth in New Zealand. The decrease in meningococcus vaccines sales for thenine months ended September 30, 2004 as compared to the nine months ended September 30,2003 was primarily due to a reduction of $19.6 million in sales ofMenjugate® product due to the timing of outbreaks and vaccination programs invarious countries and increased competition for tender sales of certainmeningococcus vaccines, which was partially offset by the $6.2 millionMeNZBTM sales in 2004 to the Ministry of Health in New Zealand.

 

*Travel vaccines*    The increase in travelvaccines sales for the three months ended September 30, 2004 as comparedwith the three months ended September 30, 2003 was primarily due to(i) $5.4 million driven by increased demand for our rabies vaccinesin the U.S., primarily due to a product recall from a competitor and(ii) $8.2 million driven by increased sales of our tick-borneencephalitis vaccines, which is typically sold in the first half of the year.The increase in travel vaccines sales for the nine months ended September 30,2004 as compared with the nine months ended September 30, 2003 wasprimarily due to (i) increased demand for our rabies vaccines in the U.S.,primarily due to a product recall from a competitor and increased demand forour rabies vaccines in Europe and Asia, in the amount of $12.9 million and(ii) additional sales of travel vaccine products in the amount of$5.1 million reflecting the fact that the nine months ended September 30,2003 represented only approximately one quarter’s worth of sales of certaintravel vaccines acquired as part of the PowderJect acquisition.  The increase in travel vaccines for the ninemonths ended September 30, 2004 as compared with the nine months ended September 30,2003 were partially offset by $9.3 million in lower sales of our tick-borneencephalitis vaccine.  Such lower salesof tick-borne encephalitis vaccine for the nine months ended September 30,2004 were due to higher sales in the fourth quarter of 2003, which is typicallysold in the first half of the year.

 

*Pediatric and other vaccines*    Sales of our pediatricand other vaccines decreased for the three months ended September 30, 2004as compared with the three months ended September 30, 2003 primarily dueto (i) a reduction of $7.2 million due to the planned divestiture ofcertain vaccines operations in Sweden in the second quarter 2004 acquired viaour acquisition of PowderJect and (ii) a reduction of $2.9 milliondue to the timing of tender sales for our diphtheria, tetanus and pertussisvaccines. Sales of our pediatric and other vaccines increased for the ninemonths ended September 30, 2004 as compared with nine months September 30,2003 primarily due to an additional $12.6 million related to the timing oftender sales for our polio vaccines and diphtheria, tetanus and pertussisvaccines, offset partially by $4.5 million due to the timing of tendersales for our measles, mumps and rubella vaccines.

 

Certain of our vaccine products are seasonal,particularly our flu vaccines, which have higher sales primarily in the secondhalf of the year. Certain of our vaccines require regulatory approval forproduction or sale of the product and sales may fluctuate depending on theseregulatory approvals. Due to the Fluvirin recent developments described above,we expect no sales of Fluvirin influenza vaccine for the 2004-2005 season.There can be no assurance that we will resume manufacturing or sale of Fluvirinfor the 2005-2006 season or future seasons. In addition, we expect Menjugate®sales to continue to fluctuate as public health authorities consider adoptionof broad vaccination programs and competitive pressures continue to increase.

 

We expect competitive pressures related to ourMenjugate® product to continue into the future. In addition, we expectincreased competition for our flu vaccines business in the future.

 

**Collaborative agreement revenues**    We recognizecollaborative agreement revenues for fees received as we perform research servicesand achieve specified milestones. Collaborative agreement revenues for thethree months ended September 30, 2004 as compared with the three monthsended September 30, 2003 decreased primarily due to lower milestonepayments related to an agreement to supply MeNZBTM meningococcal B vaccine tothe Ministry of Health in New Zealand. Collaborative agreement revenues for thenine months ended September 30, 2004 as compared with the nine monthsended September 30, 2003 increased primarily due to(i) $1.5 million due to higher milestone payments related to anagreement to supply MeNZBTM meningococcal B vaccine to the Ministry of Health inNew Zealand and (ii) $1.4 million due to increased collaborativeagreement revenues following our acquisition of PowderJect.

 

30

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Collaborative agreement revenues tend to fluctuatebased on the amount and timing of research services performed, the status ofprojects under collaboration and the achievement of milestones. Due to the natureof our collaborative agreement revenues, results in any one period are notnecessarily indicative of results to be achieved in the future. In addition,the collaboration agreements typically provide for certain milestone paymentsand various royalties on future product sales if the collaborative partnerscommercialize a product using our technology. Also, our ability to generateadditional collaborative agreement revenues may depend, in part, on our abilityto initiate and maintain relationships with potential and current collaborativepartners.

 

**Royalty and license fee revenues**    Our vaccines segmentearns royalties on third party sales of, and license fees on, several products.

 

*GlaxoSmithKline*    An agreement withGlaxoSmithKline plc provides for royalties on sales of certain vaccineproducts. Under this agreement, royalties were $0.8 million and$1.8 million for the three months ended September 30, 2004 and 2003,respectively. Royalties were $2.1 million and $5.2 million for thenine months ended September 30, 2004 and 2003, respectively. Thesedecreases were primarily due to the expiration of various patents under thisagreement.

 

The balance of royalty and license fee revenuesrecognized in our vaccines segment consisted of various other arrangements,which individually were not material.

 

Royalty and license fee revenues may fluctuate basedon the nature of the related agreements, the timing of receipt of license feesand the expiration of patents. Results in any one period are not necessarily indicativeof results to be achieved in the future. In addition, our ability to generateadditional royalty and license fee revenues may depend, in part, on our abilityto market and capitalize on our technologies.

 

**Other revenues**

 

*Grant and contract revenues*    Our vaccines segmentother revenues included grant and contract revenues of $10.2 million and$6.9 million for the nine months ended September 30, 2004 and 2003,respectively. We have entered into a series of agreements with the U.S.National Institutes of Health to advance our HIV vaccine program into humanclinical trials. We recognized grant and contract revenues under thesearrangements of $6.8 million and $6.1 million for the nine monthsended September 30, 2004 and 2003, respectively.

 

The balance of other revenues consisted of variousother agreements, which individually were not material.

 

Other revenues recognized in our vaccines segment mayfluctuate due to the nature of the revenues recognized and the timing of eventsgiving rise to these revenues.

 

**Gross profit margin**    Gross profit margindeclined for the three months ended September 30, 2004 as compared withthe three months ended September 30, 2003 due to (i) the fact thatthere were no sales of Fluvirin in the third quarter of 2004 and (ii) a$91.3 million charge to cost of sales resulting from the write-off of ourentire inventory of Fluvirin. Each of these matters is described in more detailunder “Overview.” Gross profit margin for the three months ended September 30,2004 benefited from higher prices of our other flu vaccines products andincreased sales of our rabies vaccine in the U.S. market. Gross profit margindecreased for the nine months ended September 30, 2004 as compared withthe nine months ended September 30, 2003 primarily due to the Fluvirinmatters described above. Gross profit margin was also negatively impacted byreduced sales and margins of the Menjugate® product and reduced sales of ourtick-borne encephalitis vaccine. These decreases were offset by higher prices ofour other flu vaccines products and increased sales of our rabies vaccine inthe U.S. market.

 

Vaccines gross profit margin does not includeamortization expense from acquired developed products, intangible assetsrelated to business combinations. Such amortization expense is included in thecaption ‘amortization expense’ discussed below.

 

Vaccines gross profit margin may fluctuatesignificantly in future periods due to product and customer mix, seasonalityand ordering patterns, production yields, regulatory approvals and competitivepressures.

 

**Research and development**    The decrease inresearch and development expenses for the three months ended September 30,2004 as compared to the three months ended September 30, 2003 was due tothe planned divestiture of certain research operations, associated with ouracquisition of PowderJect, in Madison, Wisconsin and Oxford, England during thesecond quarter of 2004. Research and development expense associated with theseoperations was approximately $6.3 million for the three months ended September 30,2003. The increase in research and development expenses for the nine monthsended September 30, 2004 as compared to the nine months ended September 30,2003 was primarily due to the advancement of several programs in ourmeningococcal franchise (an additional $6.1 million) and flu cell culture(an additional $5.8 million).

 

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

 

**Selling, general, and administrative**    The increase inselling, general and administrative expenses for the three months ended September 30,2004 as compared with the three months ended September 30, 2003 was due to(i) an additional $2.9 million from ongoing sales and marketingprograms, (ii) $2.9 million for headcount additions,(iii) $1.1 million due to the movement in the Euro and British poundto U.S. Dollar exchange rate and (iv) other increases of$1.8 million, partially offset by a decline in PowderJect integrationcosts of $5.3 million and savings of $2.0 million from the secondquarter 2004 divestiture of certain PowderJect operations. The increase inselling, general and administrative expenses for the nine months ended September 30,2004 as

 

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compared with the nine months ended September 30,2003 was primarily related to additional expenses of $10.1 millionattributable to our third quarter 2003 PowderJect acquisition. The remainingincrease in selling, general and administrative resulted from $5.1millionassociated with ongoing sales and marketing programs, $12.8 million forheadcount additions and other increases of $2.1 million. These increases werepartially offset by savings of $0.6 million from the second quarter 2004divestiture of certain PowderJect operations.

 

**Amortization expense**    The increase inamortization expense for the nine months ended September 30, 2004 ascompared with the nine months ended September 30, 2003 primarily relatedto the intangible assets acquired following our third quarter 2003 PowderJectacquisition.

 

***Biopharmaceuticals***

 
| ** **                          | ** ** | **Three Months Ended**                         | ** ** | **Nine Months Ended**  | ** ** | **$****Change**   | ** ** | **% Change**     | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|------------------------|------------|-------------------|------------|------------------|------------|
| ** **                          | ** ** | **September 30,**                         | ** ** | **September 30,** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** |
| **2004**                            | ** ** | **2003**                                       | ** ** | **2004**               | ** ** | **2003**          |
| ** **                          | ** ** | **($ in 000’s, except percentages)** | ** ** |
| Product sales, net:                 |       |                                           |       |                   |       |              |       |             |       |   |   |   |   |   |   |   |   |
| Betaseron®                     |       | $                                              | 35,171     |                   | $          | 29,010            |       | $                | 96,933     |   | $ | 88,788 |   | $ | 6,161 |   | $ | 8,145 |   | 21.2 | % | 9.2 |   |
| TOBI®                          |       | 55,734                                         |       | 43,022                 |       | 159,600           |       | 122,740          |       | 12,712 |   | 36,860 |   | 29.5 | % | 30.0 |   |
| Proleukin®                     |       | 31,739                                         |       | 29,859                 |       | 98,664            |       | 85,223           |       | 1,880 |   | 13,441 |   | 6.3 | % | 15.8 | % |
| Other                               |       | 8,902                                          |       | 8,166                  |       | 29,770            |       | 22,258           |       | 736 |   | 7,512 |   | 9.0 | % | 33.7 | % |
|                                |       | 131,546                                        |       | 110,057                |       | 384,967           |       | 319,009          |       | 21,489 |   | 65,958 |   | 19.5 | % | 20.7 | % |
| Collaborative agreement revenues    |       | 278                                            |       | 1,364                  |       | 1,052             |       | 4,645            |       | (1,086 | ) | (3,593 | ) | (79.6 | )% | (77.4 | )% |
| Royalty and license fee revenues    |       | 15,412                                         |       | 23,523                 |       | 47,892            |       | 62,098           |       | (8,111 | ) | (14,206 | ) | (34.5 | )% | (22.9 | )% |
| Other revenues                      |       | 1,201                                          |       | 5,009                  |       | 9,127             |       | 23,794           |       | (3,808 | ) | (14,667 | ) | (76.0 | )% | (61.6 | )% |
| Total Biopharmaceutical revenues    |       | $                                              | 148,437    |                   | $          | 139,953           |       | $                | 443,038    |   | $ | 409,546 |   | $ | 8,484 |   | $ | 33,492 |   | 6.1 | % | 8.2 | % |
| Gross profit margin                 |       | 67                                             | %          | 74                     | %          | 72                | %          | 75               | %          |   |   |   |   |   |   |   |   |
| Research and development            |       | $                                              | 63,252     |                   | $          | 56,089            |       | $                | 183,627    |   | $ | 169,827 |   | $ | 7,163 |   | $ | 13,800 |   | 12.8 | % | 8.1 | % |
| Selling, general and administrative |       | $                                              | 33,322     |                   | $          | 29,818            |       | $                | 98,496     |   | $ | 84,723 |   | $ | 3,504 |   | $ | 13,773 |   | 11.8 | % | 16.3 | % |
| Amortization expense                |       | $                                              | 6,240      |                   | $          | 6,217             |       | $                | 18,725     |   | $ | 18,638 |   | $ | 23 |   | $ | 87 |   | 0.4 |   | 0.5 | % |

 

**Product sales**    Biopharmaceuticalproduct sales in 2004 and 2003 consisted principally of Betaseron®, TOBI® andProleukin®.

 

*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 contractual agreementwith Schering. As a result, we estimate that the percentage of sales per uniton which our payments are based will decrease, reducing our per unit revenue byapproximately 18% (for sales of Chiron product) and approximately 34% (forroyalties from sales of Boehringer Ingelheim product) from that received priorto the decline. However, there are a number of mitigating considerations,including (i) the transitional supply agreement, (ii) the volume mixof Chiron product and Boehringer Ingelheim product and (iii) the launch ofproduct upgrades with ease-of-use features. We believe these considerationswill partially offset this contractual change. In order to supply Betaferon® toSchering, we continue to make capital improvements to our existing manufacturingfacilities to increase capacity.

 

In October 2003, the U.S. Food and DrugAdministration approved a new pre-filled diluent syringe for Betaseron®. Thepre-filled diluent syringe was launched in January 2004 and enhances thedelivery mode and shortens preparation, helping to simplify injections ofBetaseron®.

 

The increase in Betaseron® product sales for thethree months ended September 30, 2004 as compared with the three monthsended September 30, 2003 primarily related to an additional(i) $9.5 million from inventory ordering patterns and(ii) $1.8 million from patient demand attributed to key marketingprograms. These increases were partially offset by a $6.3 millionreduction due to a decline in the royalty rate by five percentage pointspursuant to our contractual agreement with Schering. The increase in Betaseron®product sales for the nine months ended September 30, 2004 as compared tothe nine months ended September 30, 2003 primarily related to anadditional (i) $7.5 million from inventory ordering patterns,(ii) $6.4 million from price increases, (iii) $6.3 millionfrom increased patient demand attributed to key marketing programs,(iv) $2.7 million from increased sales of clinical materials and

 

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(iv) $2.3 millionfrom the benefit of foreign exchange rates. These increases were partiallyoffset by a $17.1 million reduction due to a decline in the royalty rateby five percentage points pursuant to our contractual agreement with Schering.

 

*TOBI® tobramycin*    We sell TOBI® directlyin the U.S. and certain international markets. The increase in sales for thethree months ended September 30, 2004 as compared to the three monthsended September 30, 2003 was primarily due to an additional(i) $4.7 million due to increased patient demand in the U.S.,(ii) $4.3 million due to wholesaler ordering patterns,(iii) $2.1 million due to price increases and(iv) $1.3 million due to the benefit of the movement in the Euro toU.S. Dollar exchange rate. The increase in sales for the nine months ended September 30,2004 as compared to the nine months ended September 30, 2003 was primarilydue to an additional (i) $11.9 million due to wholesaler orderingpatterns, (ii) $8.8 million due to increased patient demand in theU.S, (iii) $6.4 million due to price increases and(iv) $4.9 million due to favorable movement in the Euro to U.S.Dollar exchange rate.

 

*Proleukin® (aldesleukin)*    The increase in salesfor Proleukin (aldesleukin) for the three months ended September 30, 2004as compared with the three months ended September 30, 2003 was primarilydue to price increases. The increase in sales for Proleukin (aldesleukin) forthe nine months ended September 30, 2004 as compared with the nine monthsended September 30, 2003 was primarily due to an additional(i) $6.3 million due to wholesaler ordering patterns,(ii) $3.7 million from price increases and(iii) $2.3 million due to favorable movement in the Euro to U.S.Dollar exchange rate, partially offset by a $1.2 million reduction due toa decline in patient demand.

 

The balance of product sales recognized in ourbiopharmaceuticals segment consisted of various other products, whichindividually were not material.

 

Wholesale ordering patterns, reimbursement andgovernment pressures, competition, foreign currency exchange rates and thelevel of rebates may influence future biopharmaceutical sales.

 

**Collaborative agreement revenues**    We recognizecollaborative agreement revenues for fees received as we perform research servicesand achieve specified milestones.

 

Collaborative agreement revenues tend to fluctuatebased on the amount and timing of research services performed, the status ofprojects under collaboration and our achievement of performance milestones. Dueto the nature of our collaborative agreement revenues, results in any oneperiod are not necessarily indicative of results to be achieved in the future.In addition, the collaboration agreements typically provide for certainmilestone 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 biopharmaceuticalssegment earns royalties on third party sales of several products, includingBetaferon® and recombinant insulin and glucagon products. Our biopharmaceuticalssegment also earns license fees for technologies, such as hepatitis Cvirus-related patents, used by third parties to develop therapeutic products.

 

*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.

 

The decrease in Betaferon® royalties for the threemonths ended September 30, 2004 as compared with the three months ended September 30,2003 was primarily due to the reduction in the royalty rate of five percentagepoints ($5.1 million), pursuant to our contractual agreement withSchering, partially offset by (i) $1.6 million due to an increase indemand and (ii) $1.0 million due to favorable movement in the Euro toU.S. Dollar exchange rate.

 

The decrease for the nine months ended September 30,2004 as compared with the nine months ended September 30, 2003 wasprimarily due to the reduction in the royalty rate of five percentage points($15.5 million), pursuant to our contractual agreement with Schering,partially offset by (i) $4.5 million due to an increase in demand and(ii) $3.9 million due to favorable movement in the Euro to U.S.Dollar exchange rate.

 

We began supplying Betaferon®, which was previouslysupplied by Boehringer Ingelheim, to Schering in the fourth quarter 2002 forcertain additional European markets. This resulted in a shift of revenuerecognized under this agreement to product sales, with a decrease in royaltyrevenues, beginning in the fourth quarter 2002. In 2003, Schering extended itssupply agreement with Boehringer Ingelheim through 2008. The magnitude of theshift 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 royaltyrevenues on insulin and glucagon product sales by Novo Nordisk AS. Royaltieswere $1.0 million for the three months ended September 30, 2004 ascompared with $2.3 million for the three months ended September 30,2003 and $3.4 million for the nine months ended September 30, 2004 ascompared with $6.2 million for the nine months ended September 30,2003. The decreases were due to the expiration of patents beginning in late2003 related to the production of insulin and glucagons.

 

The balance of royalty and license fee revenuesrecognized in our biopharmaceuticals segment consisted of various other

 

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agreements,which individually were not material.

 

Royalty and license fee revenues may fluctuate basedon the nature of the related agreements, the timing of receipt of license feesand the expiration of patents. Results in any one period are not necessarilyindicative of results to be achieved in the future. Also, the licenseagreements typically provide for certain milestone payments and variousroyalties on future product sales if the licensees commercialize a productusing our technology. However, we have no assurance that the licensees willmeet their development objectives or commercialize a product using ourtechnology. In addition, our ability to generate additional royalty and licensefee revenues may depend, in part, on our ability to market and capitalize onour technologies.

 

**Other revenues**

 

*Contract manufacturing revenues*    Our biopharmaceuticalssegment recognized contract manufacturing revenues of $1.1 million and $4.7 millionfor the three months ended September 30, 2004 and 2003, respectively, and$8.6 million and $7.8 million for the nine months ended September 30,2004 and 2003, respectively. The fluctuation resulted from the level ofactivity and the timing of contract manufacturing activities.

 

*Biogen and Serono settlements*    As a result of afavorable federal court decision and prior agreements between Chiron and AG’sU.S. subsidiary, Berlex Laboratories, and Berlex and Biogen, Biogen wasrequired to make a settlement payment to Schering. In accordance with anearlier contract between Chiron and Berlex, we recognized approximately$13.0 million as revenue during the nine months ended September 30,2003, which represented our share of this settlement payment. In addition,there was a similar settlement between Berlex and Serono, S.A. of which werecognized approximately $1.4 million during the nine months ended September 30,2003.

 

The balance of other revenues recognized in ourbiopharmaceuticals segment consisted of various other arrangements, whichindividually were not material.

 

Other revenues recognized in our biopharmaceuticalssegment may fluctuate due to the nature of the revenues recognized and thetiming of events giving rise to these revenues. We cannot guarantee that wewill be successful in obtaining additional revenues or that these revenues willnot decline.

 

**Gross profit margin**    The decreases in grossprofit margin for the three and nine months ended September 30, 2004 ascompared to the three and nine months ended September 30, 2003 wereprimarily due to the contractual change in the royalty rate related to the saleof Betaseron® and the increased costs associated with the pre-filled diluentsyringe for Betaseron®.

 

Biopharmaceutical gross profit margin does notinclude amortization expense from acquired developed products, intangibleassets related to business combinations. Such amortization expense is includedin the caption “amortization expense’.

 

Biopharmaceutical gross profit margin may fluctuatesignificantly in future periods due to production yields, increased cost toproduce the Betaseron® pre-filled diluent syringe, the decline in Betaseron®product sales, based on a percentage of sales by Schering, which decreased byfive percentage points pursuant to our contractual agreement with Schering andas the biopharmaceutical product and customer mix changes.

 

**Research and development**    The increase inresearch and development costs for the three months ended September 30,2004 as compared with the three months ended September 30, 2003 wasprimarily the result of activities related to the development of tifacogin, asdiscussed below.

 

The increase in research and development costs forthe nine months ended September 30, 2004 as compared with the nine monthsended September 30, 2003 was primarily the result of activities related tothe development of tifacogin, as discussed below, (an additional$28.1 million). These increases were partially offset by (i) areduction of $9.0 million due to the discontinuance of development oftezacitabine in the first quarter of 2004 based on an analysis of the data froma Phase II trial in patients with gastroesophageal cancer and a decline of$8.4 million in spending due to discontinuance of development of PA-2794.

 

In the fourth quarter 2002, we reached an agreementin principle to transfer responsibility for the SILCAAT trial, a Phase IIIstudy for recombinant human interleukin-2 (IL-2, aldesleukin), to the NationalInstitutes Allergy and Infectious Disease (NIAID) and the University ofMinnesota. Responsibility for the SILCAAT study was transferred to NIAID andUniversity of Minnesota effective February 14, 2003. Our research anddevelopment expenses related to the SILCAAT trial have decreased for the threeand nine months ended September 30, 2004 as a result of the transfer.Under the agreement, we are obligated to fund a maximum of $18.0 millionover the lifetime of the trial and to supply clinical materials and certainother support services of which $12.0 million has been paid through September 30,2004.

 

In October 2003, we acquired all ofPfizer, Inc.’s, formerly Pharmacia Corporation’s, interest in tifacogin,in return for which Pfizer will receive royalties on future sales of tifacogin.In the second quarter 2004, we began enrolling patients in our Phase III trialfor tifacogin as a treatment for patients with severe community-acquiredpneumonia.

 

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

 

**Selling, general, and administrative**    The increase inselling, general and administrative expenses for the three months ended September 30,2004 as compared with the three months ended September 30, 2003 wasprimarily due to $1.5 million for programs and headcount in support ofTOBI® and $ 1.0 million for the Euro to U.S. Dollar exchange ratefluctuation. The increase for

 

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thenine months ended September 30, 2004 as compared with the nine monthsended September 30, 2003 was primarily due to (i) $3.3 millionfor the Euro to U.S. Dollar exchange rate fluctuation,(ii) $2.3 million for increased expenses for programs and headcountin support of TOBI and (iii) $2.3 million for expenses to enhancebusiness processes.

 

***Other***

 
| ** **                          | ** ** | **Three Months Ended**                         | ** ** | **Nine Months Ended**  | ** ** | **$****Change**   | ** ** | **% Change**     | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|------------------------|------------|-------------------|------------|------------------|------------|
| ** **                          | ** ** | **September 30,**                         | ** ** | **September 30,** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** | **Three  Months** | ** ** | **Nine  Months** | ** ** |
| **2004**                            | ** ** | **2003**                                       | ** ** | **2004**               | ** ** | **2003**          | ** ** |
| ** **                          | ** ** | **($ in 000’s, except percentages)** | ** ** |
| Royalty and license fee revenues    |       | $                                              | 60,656     |                   | $          | 19,115            |       | $                | 102,787    |   | $ | 55,517 |   | $ | 41,541 |   | $ | 47,270 |   | 217.3 | % | 85.1 | % |
| Selling, general and administrative |       | 25,326                                         |       | 22,920                 |       | 77,279            |       | 56,906           |       | 2,406 |   | 20,373 |   | 10.5 | % | 35.8 | % |
| Interest expense                    |       | 7,063                                          |       | 6,222                  |       | 19,440            |       | 12,523           |       | 841 |   | 6,917 |   | 13.5 | % | 55.2 | % |
| Interest and other income, net      |       | 5,369                                          |       | 5,239                  |       | 41,252            |       | 31,170           |       | 130 |   | 10,082 |   | 2.5 | % | 32.3 | % |
|                                     |            |                                                |            |                        |            |                   |            |                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Royalty and license fee revenues**    Our other segment earnsroyalties on third party sales of, and license fees on, several products. Themajority of royalty and license fee revenues related to the use of ourhepatitis C virus and HIV-related patents for diagnostic testing purposes byvarious third parties.

 

*Roche settlement*    In October 2000,we entered into three license agreements with Roche and several of itsaffiliated companies related to the settlement of certain litigation in theU.S. and certain other countries for use of our hepatitis C virus and HIV nucleicacid testing intellectual property. Two agreements relate to *in vitro* diagnostics products. The thirdagreement relates to blood screening. See “Blood Testing—Royalty and licensefee revenues” above for more information on these agreements.

 

Under the hepatitis C virus agreement, we received$85.0 million, of which we recognized $40.0 million in the fourthquarter 2000. We deferred the remaining $45.0 million, which becomesnonrefundable ratably through 2005. In the first quarter 2001, we began recognizingportions 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 Roche’s use of ourhepatitis C virus-related patent in its *invitro* diagnostic products. The agreement also provides for royaltieson future sales related to Roche’s use of our hepatitis C virus-related patentin its *in vitro* diagnosticproducts, which commenced in the first quarter 2001. Royalty revenues increasedfor the nine months ended September 30, 2004 as compared with the ninemonths ended September 30, 2003, by $4.6 million and 13.3%.

 

The HIV agreement also provides for royalties onfuture sales related to Roche’s use of our HIV-related patent in its *in vitro* diagnostic products, whichcommenced in the first quarter 2001 when the European Patent Office Board ofTechnical Appeals upheld our HIV-related patent. Royalty revenues recognizedunder this agreement increased by $37.4 million for the three months endedSeptember 30, 2004 as compared with the three months ended September 30,2003, and $37.8 million for the nine months ended September 30, 2004as compared with the nine months ended September 30, 2003. These increasesare mainly due to a settlement agreement with Roche, described in more detailbelow, in which we recognized revenues for a license fee, deferred royaltiesand a portion of a nonrefundable royalty payment.

 

An HIV-related patent directed to nucleic acidtesting methods for HIV-1 was issued in the U.S. on March 13, 2003. Thispatent will expire seventeen years from the date of issuance. The issuance ofthe patent triggered a milestone payment to us of $10.0 million fromRoche, which was received in April 2003. As permitted under the terms of itslicensing agreement, Roche decided to institute arbitration proceedings inregard to the application of the U.S. patent. We had deferred recognition ofthe $10.0 million milestone payment, interest, royalties received androyalties accrued under the patent until the resolution of this dispute. On September 10,2004, we reached a settlement agreement with Roche. Under the terms of thesettlement agreement, the milestone payment along with any royalties receivedprior to March 31, 2004 became non-refundable. Accordingly, for the threemonths ended September 30, 2004, we have recognized $10.0 million inlicense fees and $21.8 million in royalties up until June 30, 2004,which had previously been deferred, of which $16.3 million has beenrecognized as revenue in our other segment and $5.5 million has beenrecognized as revenue in our blood testing segment. We also recognized$0.8 million in interest on the license fee. Also under the settlementagreement, in the first quarter of 2005, we are entitled to receive a lump-sumpayment of $78.0 million in lieu of royalties beyond January 1, 2005.Roche may elect under the terms of the agreement to obtain a partial refund andrevert to paying royalties on the sales of its products in North America. Theamount of such potential refund ranges between $64.0 million and$0.0 million. The amount of the refund available decreases in equalquarterly increments over the eight quarters of 2005 and 2006. As such, Chironexpects to recognize $64.0 million of the payment as revenue over thoseeight quarters. The remaining $14.0 million is nonrefundable and wasrecognized as revenue for the three months ended September 30, 2004, ofwhich, $9.3 million has been recognized as revenue in our other segmentand $4.7 million has been recognized as revenue in our blood testingsegment.

 

The one time impact on revenues for the three andnine months ended September 30, 2004 from these items from the September 10,2004 settlement with Roche is summarized below (in thousands).

 

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| ** **                                      | ** ** | **Other  Segment** | ** ** | **Blood-testing  Segment** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
| Deferred  revenues recognized                   |       | $                  | 16,313     |                       | $          | 5,453     |       | $ | 21,766 |   |
| Deferred  license fee recognized                |       | 10,000             |       | —                     |       | 10,000    |       |
| Non-refundable  portion of Roche settlement     |       | 9,333              |       | 4,667                      |       | 14,000    |       |
| Total one  time royalty and license fee revenue |       | $                  | 35,646     |                       | $          | 10,120    |       | $ | 45,766 |   |

 

Currently, the applicable issued hepatitis Cvirus-related patents expire in 2015 for the U.S. and in 2010 for Europe.Currently, the applicable issued HIV-related patent in Europe expires in 2005.

 

*Roche PCR agreement*    For the three and ninemonths ended September 30, 2004, we recognized a $3.0 millionsettlement with Roche regarding a July 1991 agreement between Roche andCetus Corporation (a company acquired by us) under which we received royaltieson sales of polymerase chain reaction products and services sold by Roche andits licensees. Roche’s royalty obligations, with certain limited exceptions forfuture products, expired in the fourth quarter of 2000.

 

*Bayer*    A cross-licenseagreement provides for royalties to us on HIV and hepatitis C virus productssold by Bayer Corporation. Royalties were consistent for the three months endedSeptember 30, 2004 as compared with the three months ended September 30,2003. Royalties increased $1.2 million for the nine months ended September 30,2004 as compared with the nine months ended September 30, 2003.

 

The balance of royalty and license fee revenuesconsisted of various other agreements, which individually were not material.

 

Royalty and license fee revenues may fluctuate basedon the nature of the related agreements, the timing of receipt of license feesand the expiration of patents. Results in any one period are not necessarilyindicative of results to be achieved in the future. In addition, our ability togenerate additional royalty and license fee revenues may depend, in part, onour ability to market and capitalize on our technologies.

 

**Selling, general, and administrative**    The increase inselling, general and administrative expenses for the three months ended September 30,2004 as compared with the three months ended September 30, 2003 wasprimarily due to an increase in litigation costs of $4.1 million relatedto the defense of our patents and technology and an increase in informationsystems costs of $1.8 million, offset by a $3.5 million reduction inemployee related expenses. The increase in selling, general and administrativeexpenses for the nine months ended September 30, 2004 as compared with thenine months ended September 30, 2003 was primarily due to an increase inlitigation costs of $8.4 million related to the defense of our patents andtechnology, an increase in facility related costs of $7.1 million, anincrease in information systems costs of $3.5 million, and an increase incorporate governance costs of $1.7 million, partially offset by loweremployee related expenses of $1.8 million.

 

**Interest expense**    The increase ininterest expense for the nine months ended September 30, 2004 as comparedto the nine months ended September 30, 2003 primarily related to theeffect of nine months versus two months of interest expense recognized on the$500.0 million convertible debentures that were issued on July 30,2003. The interest expense on the LYONs decreased significantly when themajority of the LYONs were put to us in June 2004. However, interestexpense increased due to interest on the $385.0 million convertibledebentures that were issued on June 22, 2004.

 

**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 $6.6 million and $5.4 million for the three months ended September 30,2004 and 2003, respectively, and $17.5 million and $18.7 million forthe nine months ended September 30, 2004 and 2003, respectively. Interestincome varied due to the fluctuating cash balances from the acquisition ofPowderJect and the retirement and issuance of long-term debt.

 

We recognized gains of $1.0 million and$0.0 million for the three months ended September 30, 2004 and 2003,respectively, and $25.0 million and $9.4 million for the nine monthsended September 30, 2004 and 2003, respectively, related to the sale ofcertain equity securities.

 

On December 31, 1998, we completed the sale ofour 30% interest in General Injectibles & Vaccines, Inc., adistribution business, to Henry Schein, Inc. and received payment in fullof certain advances we made to General Injectibles & Vaccines. Theagreement also provided for us to receive additional payments, calculated as apre-determined percentage of Henry Schein’s gross profit, through 2003. Wereceived $3.5 million for 2003 and $2.0 million for 2002 during the ninemonths ended September 30, 2004 and 2003, respectively.

 

There were no losses attributable to impairment ofequity securities for the three and nine months ended September 30, 2003.For the three and nine months ended September 30, 2004, we recognizedlosses attributable to the impairment of certain equity securities of$1.4 million.

 

**Income taxes**    The effective tax ratefor the three and nine months ended September 30, 2004 was 31.0% and 27.3%respectively, of pretax income from continuing operations, including the chargefor purchased in-process research and development related to the Sagresacquisition. The effective tax rate for the three and nine months ended September 30,2003 was 243.6% and 42.3% respectively, of pretax income from continuing operations,including the charge for purchased in-process research and development relatedto the PowderJect acquisition. The charges for the purchased in-processresearch and development in 2003 and

 

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2004are not tax deductible. The effective tax rate for the three and nine monthsended September 30, 2004 and 2003 was 25% of pretax income from continuingoperations, after excluding the impact of the purchased in-process research anddevelopment charges. The effective tax rate may be affected in future periodsby changes in management’s estimates with respect to our deferred tax assetsand other items affecting the overall tax rate.

 

Management believes the acquisition of PowderJect maycause an increase in the future effective tax rate and is in the process ofevaluating certain options that may mitigate any potential increase.Specifically, most of PowderJect’s profits are earned in the United Kingdomsubject to a 30% marginal tax rate.

 

**Discontinued operations**    In a strategic effortto focus on our core businesses of blood-testing, vaccines andbiopharmaceuticals, we completed the sale of Chiron Diagnostics and ChironVision in 1998 and 1997, respectively.

 

Chiron and Bayer Corporation, or Bayer, were involvedin a dispute with respect to their respective rights to certain royalty refundsreceivable for which a settlement was reached in 2004. Under this settlementagreement, we made a settlement 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 deemed to be excessfollowing this settlement. This settlement resulted in a net gain of$12.8 million, which was included in “Gain (loss) from discontinuedoperations” for the nine months ended September 30, 2004. This net gainprimarily relates to a tax benefit as a result of the settlement payment toBayer.

 

In the second quarter 2004, Chiron and the IRSentered into a settlement agreement closing the open tax years 1996 to 1998.Pursuant to this settlement agreement we recognized a tax benefit ofapproximately $12.5 million, which was included in “Gain (loss) from discontinuedoperations” for the nine months ended September 30, 2004.

 

In the third quarter 2003, we reversed approximately$1.2 million, net of tax, related to unutilized reserves for ChironDiagnostics, which was included in “Gain (loss) from discontinued operations”for the three and nine months ended September 30, 2003.

 

In the first quarter 2003, Chiron and Bayer reached asettlement agreement relating to certain claims raised by Bayer under the StockPurchase Agreement dated September 17, 1998, between Chiron and Bayer forChiron Diagnostics. Under this settlement agreement, we were required to make apayment to Bayer during the first quarter 2003. Pursuant to this settlement, werecorded a charge, net of adjustment to our previously provided reserve forindemnity obligations, of $7.6 million, offset by an income tax benefit of$9.0 million, resulting in a net gain of $1.4 million which wasincluded in “Gain (loss) from discontinued operations” for the nine monthsended September 30, 2003.

 

**New Accounting Pronouncements**

 

In October 2004, the Emerging Issues Task Force(EITF) reached a consensus on EITF Issue No. 04-8 “The Effect ofContingently Convertible Instruments on Diluted Earnings per Share,” that thedilutive effect of contingent convertible debt instruments (“CoCo’s”) must beincluded in diluted earnings per share regardless of whether the triggeringcontingency has been satisfied, if dilutive. Adoption of Issue No. 04-8would be on a retroactive basis and would require restatement of prior period dilutedearnings per share, subject to certain transition provisions. It is effectivefor all periods ending after December 15, 2004. Accounting pursuant tothis Issue would not result in additional dilution to our diluted earnings pershare for the three and nine months ended September 30, 2004 from our$500.0 million convertible debentures due 2033 (“2033 Debentures”) norfrom our $385.0 million convertible debentures due 2034 (“2034 Debentures”).

 

Financial Accounting Standards Board (or FASB)Interpretation No. 46 (or FIN 46), “Consolidation of Variable InterestEntities, an interpretation of Accounting Research Bulletin No. 51” asrevised, requires a variable interest entity (or VIE) to be consolidated by acompany if that company absorbs a majority of the VIE’s expected losses,receives a majority of the entity’s expected residual returns, or both, as aresult of ownership, contractual or other financial interest in the VIE. Priorto the adoption of FIN 46, VIEs were generally consolidated by companies owninga majority voting interest in the VIE. The consolidation requirements of FIN 46applied immediately to VIEs created after January 31, 2003; however, theFASB deferred the effective date for VIEs created before February 1, 2003to the quarter ended March 31, 2004 for calendar year companies. Adoptionof the provisions of FIN 46 prior to the deferred effective date was permitted.

 

We adopted the remaining provisions of FIN 46 in thefirst quarter of 2004. The adoption of these provisions did not have a materialeffect on our condensed consolidated financial statements.

 

On March 31, 2004, the FASB issued an ExposureDraft (ED), “Share-Based Payment—An Amendment of FASB Statements No. 123and 95.” The proposed Statement addresses the accounting for transactions inwhich an enterprise receives employee services in exchange for (a) equityinstruments of the enterprise or (b) liabilities that are based on thefair value of the enterprise’s equity instruments or that may be settled by theissuance of such equity instruments. The proposed Statement would eliminate theability to account for share-based compensation transactions using APB 25, andgenerally would require instead that such transactions be accounted for using afair-value based method. As proposed, companies would be required to recognizean expense for compensation cost related to share-based payment arrangementsincluding stock options and employee stock purchase plans. As proposed, the newrules would be applied on a modified prospective basis as defined in the ED,and would be effective for us beginning July 1, 2005. We are currentlyevaluating option valuation methodologies and assumptions in light of theevolving accounting standards related to employee stock options. Currentestimates of option values using the Black-Scholes method may not

 

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beindicative of results from valuation methodologies ultimately adopted in thefinal rules.

 

**Liquidity and Capital Resources**

 

Our capital requirements have generally been fundedby cash flow from operations, borrowings from commercial banks and issuance ofconvertible debt securities and common stock. Our cash, cash equivalents andinvestments in marketable debt securities, which totaled $1,012.3 millionat September 30, 2004, are invested in a diversified portfolio offinancial instruments, including money market funds and instruments, corporatenotes and bonds, government or government agency securities and other debtsecurities issued by financial institutions and other issuers with strongcredit ratings. By policy, the amount of credit exposure to any one institutionis limited. Investments are generally not collateralized and primarily maturewithin three years.

 

Subsequent to the third quarter of 2004, the UKregulatory body, the Medicines and Healthcare products Regulatory Agency, orMHRA, sent us a letter prohibiting us from releasing any Fluvirin dosesmanufactured at our Liverpool facility since March 2, 2004. In thatletter, the MHRA asserted that our manufacturing process did not comply withU.K. good manufacturing practices (GMP) regulations. In addition to prohibitingrelease of existing Fluvirin doses, the MHRA letter also suspended our licenseto manufacture influenza virus vaccine in our Liverpool facility for threemonths. Following the MHRA’s decision, the FDA conducted its own inspection ofour Liverpool facility and provided a written report citing FDA observationsconcerning GMP compliance and other matters relating to the manufacturing of Fluvirin.The FDA also announced that it would not permit release of any Fluvirin fromour Liverpool facility into the United States. We cannot predict if or when wewill be able to resume production of Fluvirin at our Liverpool facility. Anysignificant extension of the suspension could result in our being unable torelease Fluvirin for the 2005-2006 season, which would diminish or eliminateany cash flows we receive from the sale of Fluvirin. Sales of Fluvirininfluenza vaccine were $219.2 million in 2003. In addition, while we arestill in the process of assessing the appropriate corrective steps for ourLiverpool plant, our remediation efforts could entail cash payments foradditional capital and other expenditures, which could be material. If we suffera permanent loss of Fluvirin influenza vaccine sales, it would have a materialadverse effect on our cash flow.

 

We are subject to investigations and litigation inconnection with this matter. We have received a grand jury subpoena issued bythe U.S. Attorney’s Office for the Southern District of New York requestingproduction of certain documents and materials relating to our influenza virusvaccine and the suspension by the MHRA of our license. The Securities andExchange Commission is also conducting an informal inquiry into whether we haveviolated any federal securities laws. Additional investigations regarding thesematters may arise, including Congressional investigations. We and certain ofour officers and directors have also been named as defendants in severalputative class action and shareholder derivative lawsuits arising out of thesedevelopments. We are in the process of addressing these investigations andlitigation, which may entail substantial expense, and the results of whichcould have a material adverse effect on our consolidated financial position andresults of operations or cash flows. It is not known when or on what basisthese matters will be concluded.

 

For additional information concerning the risks weface as a result of these Fluvirin developments, see “Factors That May AffectFuture Results—The recent developments with respect to Fluvirin will harm ourbusiness and results of operations.” For additional information on the U.S.Attorney’s investigation, SEC inquiry and private lawsuits, see Part II,Item 1 of this report on Form 10-Q.

 

On June 12, 2004, certain holders of our LiquidYield Option Notes (LYONs), at their option, tendered LYONs with$649.9 million in aggregate principal amount at maturity, which we wererequired to purchase. The purchase price for the tendered LYONs was $584.31 incash per $1,000 in principal amount at maturity. The aggregate purchase pricefor all the LYONs validly surrendered for purchase was $379.7 million. At September 30,2004, there remains $80.1 million outstanding in aggregate principalamount at maturity with a current accreted balance of $47.1 million.

 

On June 22, 2004, we issued $385.0 millionaggregate principal amount of new convertible debentures, which mature on June 30,2034. The convertible debentures accrue interest at a rate of 2.75% per yearwith interest payable each June 30 and December 30 commencing December 30,2004. The debentures are senior, unsecured obligations and rank equal in rightof payment with all of our existing and future unsecured and unsubordinatedindebtedness.

 

We believe that our cash, cash equivalents andmarketable debt securities, together with funds provided by operations andborrowing and leasing arrangements, will be sufficient to meet our foreseeableoperating cash requirements including any cash needed for remediation effortsfor our Liverpool plant, cash utilized for our stock repurchase program and ourcurrent contractual obligations. In addition, we believe we could accessadditional funds from the debt and capital markets should the need arise. Asnoted above, if we suffer a permanent loss of Fluvirin influenza vaccine sales,it would have a material adverse effect on our cash flow.

 

**Sources and uses of cash**    We had cash and cashequivalents of $201.0 million and $499.9 million at September 30,2004 and 2003, respectively.

 

*Operating activities*    For the nine monthsended September 30, 2004, net cash provided by operating activities was$132.6 million as compared with $253.9 million for the nine months endedSeptember 30, 2003. The decrease in cash provided by operating activitieswas primarily due to lower income from continuing operations beforedepreciation, amortization and other non-cash charges as a result of thesuspension of our license to manufacture Fluvirin® influenza virus vaccine inour Liverpool facility which prevented the release of any of the product duringthe 2004-2005 influenza season. Cash provided by operating activities alsodecreased due to (i) lower royalty payments received under the Rocheroyalty arrangements for the nine months ended September 30, 2004 asopposed to the nine months ended September 30, 2003, (ii) increasedresearch and development costs and increased selling,

 

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generaland administrative expenses for the nine months ended September 30, 2004and (iii) $14.4 million of cash received as a result of the Biogenand Serono settlements in connection with the McCormick patents in the ninemonths ended September 30, 2003. These decreases were offset by lower taxpayments for the nine months ended September 30, 2004 as compared to thenine months ended September 30, 2003 and a payment to Bayer Corporationduring the nine months ended September 30, 2003 from a settlement agreementrelating to certain claims raised by Bayer in connection with the StockPurchase Agreement dated September 17, 1998.

 

*Investing activities*    For the nine monthsended September 30, 2004, net cash used in investing activities consistedof purchases of investments in marketable debt securities of$724.6 million, capital expenditures of $134.1 million, cash paid foracquisitions net of cash acquired of $32.3 million, purchases of equitysecurities and interests in affiliated companies of $6.2 million and otheruses of cash of $3.7 million. Included in net cash paid for acquisitionswas $5.6 million for previously accrued costs in connection with theacquisition of PowderJect, $15.5 million of cash delivered on thedivestiture of certain operations in Wisconsin, the U.K., and Sweden and$11.2 million of cash paid for the acquisition of Sagres. Cash used ininvesting activities was offset by proceeds from sales of investments inmarketable debt securities of $415.1 million, proceeds from maturities ofinvestments in marketable debt securities of $226.0 million and proceedsfrom the sale of equity securities and interests in affiliated companies of$31.4 million.

 

In 2003, our Board of Directors approved$50.7 million in expenditures for a 25-year building lease and$42.2 million for capital improvements, both of which are part of a$97.0 million project for expansion and replacement of our flu vaccinesmanufacturing facility in Liverpool, England. The new manufacturing facilitywill replace a portion of the existing flu vaccines manufacturing facilities inLiverpool, England and is anticipated to be available in late 2007 for themanufacture of flu vaccines, subject to regulatory approval. In December 2003,we entered into a 25-year lease for the building; as of September 30,2004, we have incurred $6.8 million for the capital improvements portionof the project. Management does not currently expect the recent Fluvirindevelopments to impact the timing of this project.

 

For the nine months ended September 30, 2003,net cash used in investing activities consisted of cash paid for acquisitions,net of cash acquired of $804.7 million, purchases of investments inmarketable debt securities of $622.7 million, capital expenditures of$81.4 million, purchases of equity securities and interests in affiliatedcompanies of $4.3 million and other uses of cash of $12.2 million.For the nine months ended September 30, 2003, cash paid for acquisitions,net of cash acquired, primarily consisted of cash paid to acquire PowderJectPharmaceuticals, net of cash acquired, of $803.5 million. Cash used ininvesting activities was offset by proceeds from sales of investments inmarketable debt securities of $748.0 million, proceeds from the maturitiesof investments in marketable debt securities of $364.7 million andproceeds from the sale of equity securities and interests in affiliatedcompanies of $12.5 million.

 

*Financing activities*    For the nine monthsended September 30, 2004, net cash used in financing activities consistedof $380.2 million for the repayment of debt and capital leases,$129.7 million for the acquisition of treasury stock and $8.3 millionfor the payment of debt issuance costs. Cash used in financing activities wasoffset by $385.0 million of proceeds from issuance of convertibledebentures, $64.2 million of proceeds from the reissuance of treasurystock and $5.0 million of proceeds from the issuance debt.

 

Our Board of Directors has authorized the repurchaseof our common stock on the open market. On December 5, 2003, the Board ofDirectors granted authority to buy 5.0 million shares and authorized therepurchases through December 31, 2004. From January 1, 2004 through September 30,2004, 2.9 million shares were repurchased.

 

For the nine months ended September 30, 2003,net cash provided by financing activities consisted of $500.0 million ofproceeds from the issuance of convertible debentures, $86.0 million ofproceeds from the reissuance of treasury stock (related to stock optionexercises), $2.1 million of proceeds from selling put options and$0.5 million of proceeds from the issuance of debt. Cash provided byfinancing activities was offset by $132.7 million for the acquisition oftreasury stock, $62.3 million for the repayment of debt and capital leaseand $2.3 million for the repayment of short-term borrowings.

 

From time to time, we evaluate a number of businessdevelopment opportunities. To the extent that we are successful in reachingagreements with third parties, these transactions may involve selling a significantportion of our current investment portfolio, incurring additional debt orissuing 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 September 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 million to $702.5 million. The Novartis loan guarantee willexpire on December 31, 2007 unless certain debt ratings are triggeredwhich would extend the guarantee on a declining basis ratably over thesubsequent three year period.

 

As of September 30, 2004, Novartis had alsoguaranteed $173.3 million of Chiron’s lease commitments for a six-yearlease to rent a research facility in Emeryville, California.

 

**Factors That May Affect Future Results**

 

As a global pharmaceutical company, we are engaged ina rapidly evolving and often unpredictable business. The forward-lookingstatements contained in this 10-Q and in other periodic reports, press releasesand other statements issued by us from time to

 

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timereflect 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.

 

*The recent developments with respect to Fluvirin willharm our business and results of operations.*

 

During the third quarter of 2004, in conducting finalinternal release procedures for our Fluvirin influenza virus vaccine, ourquality systems identified lots that did not meet product sterilityspecifications. As a result, we determined at the time to delay releasing anyFluvirin doses pending completion of internal investigations. Subsequent to thethird quarter, the U.K. regulatory body, the Medicines and Healthcare productsRegulatory Agency, or MHRA, sent us a letter prohibiting us from releasing anyFluvirin doses manufactured at our Liverpool facility since March 2, 2004.In that letter, the MHRA asserted that our manufacturing process did not complywith U.K. good manufacturing practices regulations. Following the MHRA’sdecision, the Food and Drug Administration, or FDA, conducted its owninspection of our Liverpool facility and provided a written report, known as an“FDA Form 483” or simply a “483” citing FDA observations concerning GMPcompliance and other matters relating to the manufacture of Fluvirin. If thenature of any noted issues requires it or if Chiron fails to respond adequatelyto the Form 483 observations, the FDA may modify our license in an adversemanner, issue a warning letter against us and impose fines, require temporaryor permanent cessation of future manufacturing or selling of Fluvirin or takeother action that could reduce our ability to produce or market Fluvirin. TheFDA also announced that it would not permit release of any Fluvirin from ourLiverpool facility into the United States. We do not expect to release anyFluvirin product during the 2004-2005 influenza season.

 

In addition to prohibiting release of existingFluvirin doses, the MHRA letter suspended our license to manufacture influenzavirus vaccine in our Liverpool facility for three months. The MHRA could extendthe license suspension or even make it permanent. We estimate that Fluvirinproduction must begin by March 2005 in order for us to be able to releasethe product in September 2005, so any significant extension of thesuspension could result in our being unable to release Fluvirin for the2005-2006 season, which would harm our business and results of operations. Wecannot predict with any certainty if or when we will be able to resumeproduction of Fluvirin at our Liverpool facility. In addition, while we arestill in the process of assessing the appropriate corrective steps, ourremediation efforts could entail additional capital and other expenditures,which could be material. There can be no assurances that we will be able tomake changes to adequately address the issues identified by the FDA and MHRA,or that these regulatory agencies will be satisfied with our remediation efforts.If the license suspension is extended beyond three months, certain assetsrelated to Fluvirin, such as goodwill, certain other intangible assets, theexisting Liverpool plant and the new flu vaccines manufacturing facility underconstruction in Liverpool, with a total carrying value of $913.6 millionat September 30, 2004, could be impaired. This could result in ourrecording impairment losses that could have a material adverse effect on ourresults of operations. In addition, if we suffer a permanent loss of Fluvirininfluenza vaccine sales, it would have a material adverse effect on our cashflow.

 

Our inability to supply Fluvirin may also lead toloss of market share. As a result of the license suspension, competitors haveannounced plans to introduce influenza vaccine products in the United Statesand are seeking expedited regulatory approval to do so. Even if the licensesuspension expires, some of our customers may choose to purchase flu vaccinefrom other providers as their products become available in the United States.Loss of market share could have a material adverse effect on our business andresults of operations.

 

We are subject to investigations and litigation inconnection with the events described above. We have received a grand jury subpoenaissued by the U.S. Attorney’s Office for the Southern District of New Yorkrequesting production of certain documents and materials relating to ourinfluenza virus vaccine and the suspension by the MHRA of our license. TheSecurities and Exchange Commission is also conducting an informal inquiry intowhether Chiron has violated any federal securities laws. Additionalinvestigations regarding these matters may arise, including Congressionalinvestigations. In addition, we and certain of our officers and directors havealso been named as defendants in several putative class action and shareholderderivative lawsuits relating to these developments. Investigations andlitigation could cause us to incur substantial expense, require significanttime and attention from our management and result in civil and/or criminalpenalties against Chiron. The results of any such investigations or proceedingscould have a material adverse effect on our business and results of operations.

 

*If our focus on the research and development ofemerging technologies does not result in the creation of commercial products,our business could be harmed.*

 

We focus our research and development activities onareas in which we have particular strengths and on technologies that appearpromising. These technologies often are on the cutting edge of modern science.As a result, the outcome of any research or development program is highlyuncertain. Only a very small fraction of these programs ultimately result incommercial products or even product candidates. Product candidates thatinitially appear promising often fail to yield successful products. In manycases, preclinical or clinical studies will show that a product candidate isnot efficacious (that is, it lacks the intended therapeutic or prophylacticeffect), or that it raises safety concerns or has other side effects, whichoutweigh the intended benefit. Success in preclinical or early clinical trials(which generally focus on safety issues) may not translate into success inlarge-scale clinical trials (which are designed to show efficacy), often forreasons that are not fully understood. Further, success in clinical trials willlikely lead to increased investment, adversely affecting short-termprofitability, to bring such products to market. And even after a product isapproved and launched, general usage or post-marketing studies may identifysafety or other previously unknown problems with the product which may resultin regulatory approvals being suspended, limited to narrow indications orrevoked, or which may otherwise prevent successful commercialization.

 

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*Conflicts with or decisions by third parties wecollaborate with could harm our business.*

 

An important part of our business strategy dependsupon collaborations with third parties, including research collaborations andjoint efforts to develop and commercialize new products. As circumstanceschange, Chiron and our strategic partners may develop conflicting priorities orother conflicts of interest. We may experience significant delays and incursignificant expenses in resolving these conflicts and may not be able toresolve these matters on acceptable terms. Even without conflicts of interest,we may disagree with our strategic partners as to how best to realize the valueassociated with a current product or a product in development. In some cases,the strategic partner may have responsibility for formulating and implementingkey strategic or operational plans. In addition, merger and acquisitionactivity within the pharmaceutical and biotechnology industries may affect ourstrategic partners, causing them to reprioritize their efforts related to theresearch collaborations and other joint efforts with us. Decisions by corporatepartners on key clinical, regulatory, marketing (including pricing), inventorymanagement and other issues may prevent successful commercialization of theproduct or otherwise impact our profitability.

 

*If we fail to obtain or maintain the regulatoryapprovals we need to market our products, our business will suffer.*

 

We must obtain and maintain regulatory approval inorder to market most of our products. Generally, these approvals are on aproduct-by-product and country-by-country basis. In the case of therapeuticproducts, a separate approval is required for each therapeutic indication.Product candidates that appear promising based on early, and even large-scale,clinical trials may not receive regulatory approval. The results of clinicaltrials often are susceptible to varying interpretations that may delay, limitor prevent approval or result in the need for post-marketing studies. Inaddition, regulations may be amended from time to time. Revised regulations mayrequire 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.

 

*Our products are complex and difficult to manufactureon a large-scale basis, which could cause us to delay product launches,experience shortages of products or prevent us from offering products on avolume basis.*

 

Most of our products are biologics. Manufacturingbiologic products is complex. Unlike chemical pharmaceuticals, a biologicproduct generally cannot be sufficiently characterized (in terms of itsphysical and chemical properties) to rely on assaying of the finished productalone to ensure that the product will perform in the intended manner.Accordingly, it is essential to be able to both validate and control themanufacturing process, that is, to show that the process works and that theproduct is made strictly and consistently in compliance with that process.Slight deviations anywhere in the manufacturing process, including qualitycontrol, labeling and packaging, may result in unacceptable changes in theproducts that may result in lot failures or product recalls, or liability to athird party to the extent we are contract manufacturing products in ourfacilities for such third party. Manufacturing processes which are used toproduce the smaller quantities of material needed for research and developmentpurposes may not be successfully scaled up to allow production of commercialquantities at reasonable cost or at all. All of these difficulties arecompounded when dealing with novel biologic products that require novelmanufacturing processes. Additionally, manufacturing is subject to extensivegovernment regulation. Even minor changes in the manufacturing process requireregulatory approval, which, in turn, may require further clinical studies. Forsome of our products, we rely on others to supply raw materials and tomanufacture those products according to regulatory requirements.

 

In addition, any prolonged interruption in ouroperations or those of our partners could result in our inability to satisfythe product demands of our customers. A number of factors could causeinterruptions, including equipment malfunctions or failures, interruptions dueto labor action, damage to a facility due to natural disasters, such as anearthquake, suspension of power supplied to these facilities arising out ofregional power shortages or terrorist activities and armed conflict, includingas a result of the disruption of operations of our subsidiaries and ourcustomers, suppliers, distributors, couriers, collaborative partners, licenseesand clinical trial sites.

 

*Our mishandling of hazardous materials could result insubstantial costs and harm to our business.*

 

In connection with our research and manufacturingactivities, we utilize some hazardous materials. We believe we take great careto ensure we have appropriate procedures and permits in place for storing andhandling such hazardous materials. We could be subject to loss of our permits,government fines or penalties and/or other adverse governmental action if suchhazardous materials are stored, handled or released into the environment inviolation of law or any permit. A substantial fine or penalty, the payment ofsignificant environmental remediation costs or the loss of a permit or otherauthorization to operate or engage in our ordinary course of business couldresult in material, unanticipated expenses and the possible inability tosatisfy customer demand.

 

*If any of our third party suppliers or manufacturerscannot adequately meet our needs, our business could be harmed.*

 

We use raw materials and other supplies thatgenerally are available from multiple commercial sources. Certain manufacturingprocesses, however, use materials that are available from sole sources, or thatare in short supply, or are difficult for the supplier to produce and certifyin accordance with our specifications. From time to time, concerns are raisedwith respect to potential contamination of biological materials that aresupplied to us. These concerns can further tighten market conditions formaterials that may be in short supply or available from limited sources.Moreover, regulatory approvals to market our products may be conditioned uponobtaining certain materials from specified sources. Our ability to substitutematerial from an alternate source may be delayed

 

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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 powdered tobramycin, the primarybasic raw material in TOBI® tobramycin, from two of the principal worldwidesuppliers of the drug. We anticipate that either one of these suppliers alonewill be able to supply sufficient quantities to meet current needs; however,there can be no assurance that these suppliers will be able to meet futuredemand in a timely and cost-effective manner. As a result, our operations couldbe adversely affected by an interruption or reduction in the supply of bulkpowdered tobramycin.

 

We have entered into contracts with third parties forthe production and packaging of TOBI®. Over time, we can use alternativeproduction and packaging sources. However, if the contracted third partiesbecome unable to produce or package sufficient quantities of TOBI due to workstoppages or other factors, our operations could be disrupted until alternativesources are secured.

 

We have entered into contracts with third parties forthe packaging of the pre-filled diluent syringe for Betaseron®. Over time, wecan use alternative packaging sources. However, if the contracted third partiesbecome unable to produce or package sufficient quantities of the pre-filleddiluent syringe for Betaseron® due to work stoppages or other factors, ouroperations could be disrupted until alternative sources are secured.

 

In connection with the production of our flu vaccineproducts, we must purchase large quantities of chicken eggs. For Fluvirin®vaccine, we purchase those eggs and incubation services from a single supplierin the United Kingdom and, pursuant to the contract with that supplier, we arerequired to make specified minimum purchases from that supplier through 2007.If our supplier were to fail to supply eggs in sufficient quantities orquality, including as a result of any health or other issues related to thechickens, our business would be materially adversely affected.

 

We are a key provider for the blood screening fieldof nucleic acid testing and immunodiagnostics. In nucleic acid testing, we relyon our collaborative partner, Gen-Probe, to manufacture the West Nile virusassay, currently in use on an investigational-use basis in the U.S. and theProcleix® HIV-1/ HCV Assay. We currently source the related instrument systemfrom third party suppliers. Currently, Gen-Probe is the only manufacturer ofnucleic acid testing products using Transcription-Mediated Amplificationtechnology. In immunodiagnostics, under the Ortho-ClinicalDiagnostics, Inc. contract, we manufacture bulk reagents and antigens andconfirmatory test kits sold in the clinical diagnostics and blood screeningfields. While we and our partners work to mitigate the risks associated withbeing a key provider, there can be no assurance that our partner, Gen-Probe,will be able to provide sufficient quantities of the Procleix® HIV-1/ HCV Assayor that we will be able to manufacture sufficient bulk reagents and antigensand confirmatory test kits for immunodiagnostic products. Our difficulties ordelays or those of our partners’ could cause a public health concern for theblood supply, as well as increase costs and cause loss of revenue or marketshare.

 

*If we cannot obtain necessary licenses to third partypatents for the manufacture or sale of our products, we may have to withdrawfrom the market or delay the introduction of the affected product.*

 

Third parties, including competitors, have patentsand patent applications in the U.S. and other significant markets that may beuseful or necessary for the manufacture, use or sale of certain products andproducts in development by our strategic partners and us. It is likely thatthird parties will obtain these patents in the future. Certain of these patentsmay be broad enough to prevent or delay us and our strategic partners frommanufacturing or marketing products important to our current and future business.We cannot accurately predict the scope, validity and enforceability of thesepatents, if granted, the extent to which we may wish or need to obtain licensesto these patents, and the cost and availability of these licenses. If we do notor cannot obtain these licenses, products may be withdrawn from the market ordelays could be encountered in market introduction while an attempt is made todesign around these patents, or we could find that the development, manufactureor sale of such products is foreclosed. We could also incur substantial costsin licensing or challenging the validity and scope of these patents.

 

*Because most of our products are based on technologiesthat are unfamiliar to the healthcare community, they may not be accepted byhealthcare providers and patients, which could harm our business.*

 

We may experience difficulties in launching newproducts, many of which are novel products based on technologies that areunfamiliar to the healthcare community. We have no assurance that healthcareproviders and patients will accept such products. In addition, governmentagencies, as well as private organizations involved in healthcare, from time totime publish guidelines or recommendations to healthcare providers andpatients. Such guidelines or recommendations can be very influential and mayadversely affect the usage of our products directly (for example, byrecommending a decreased dosage of our product in conjunction with aconcomitant therapy or a government entity withdrawing its recommendation toscreen blood donations for certain viruses) or indirectly (for example, byrecommending a competitive product over our product).

 

*If we are unable to avoid significant exposure toproduct liability claims, our business could be harmed.*

 

We are exposed to product liability and other claimsin the event that the use of our products is alleged to have resulted inadverse effects. While we will continue to take precautions, we may not avoidsignificant product liability exposure. Although we maintain product liabilityinsurance, there is no guarantee that this coverage will be sufficient. It isnot feasible to obtain adequate insurance coverage for certain products and weare self-insured in relation to these products. If we are sued for any injurycaused by our products, we could suffer a significant financial loss.

 

As we are a key provider for the blood screeningfield of nucleic acid testing and immunodiagnostics, we may have product

 

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liabilityin addition to contract exposure, in the event that our difficulties or delaysor those of our partners could cause a public health concern for the bloodsupply.

 

*If we are unable to successfully compete in the highlycompetitive healthcare industry, our business could be harmed.*

 

We operate in a highly competitive environment, andthe competition is expected to increase. Competitors include largepharmaceutical, chemical and blood testing companies, compounding pharmacies,and biotechnology companies. Some of these competitors, particularly largepharmaceutical and blood testing companies, have greater resources than us.Accordingly, even if we are successful in launching a product, we may find thata competitive product dominates the market for any number 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.

 

The technologies applied by our competitors and usare rapidly evolving, and new developments frequently result in pricecompetition and product obsolescence. In addition, we may be impacted bycompetition from generic forms of our products or substitute products.

 

*Our patents may not prevent competition or generaterevenues.*

 

We seek to obtain patents on many of our inventions.Without the protection of patents, competitors may be able to use ourinventions to manufacture and market competing products without being requiredto undertake the lengthy and expensive development efforts made by us andwithout having to pay royalties or otherwise compensate us for the use of theinvention. We have no assurance that patents and patent applications owned orlicensed to us will provide substantial protection. Important legal questionsremain to be resolved as to the extent and scope of available patent protectionfor biotechnology products and processes in the U.S. and other importantmarkets. We do not know how many of our pending patent applications will begranted, or the effective coverage of those that are granted. In the U.S. andother important markets, the issuance of a patent is neither conclusive as toits 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 infringers 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 of our products may be adversely affected by theavailability and amount of reimbursement to the user of our products from thirdparties, such as the government and insurance companies.*

 

In the U.S. and other significant markets, sales ofour products may be affected by the availability of reimbursement from thegovernment or other third parties, such as insurance companies. It is difficultto predict the reimbursement status of newly approved, novel biotechnologyproducts, and current reimbursement policies for existing products may change.In certain foreign markets, governments have issued regulations relating to thepricing and profitability of pharmaceutical companies. There have beenproposals in the U.S. (at both the federal and state level) to implement suchcontrols. If the United States Congress enacts legislative proposals addressingparallel importation currently being deliberated, revenues from certainproducts may be affected by this change in U.S. policy. The growth of managedcare in the U.S. also has placed pressure on the pricing of healthcareproducts. These pressures can be expected to continue.

 

*If our efforts to integrate acquired or licensedbusinesses or technologies into our business are not successful, our business couldbe harmed.*

 

As part of our business strategy, we expect tocontinue to grow our business through in-licensing, collaborations oracquisitions of products or companies. The failure to adequately address thefinancial, operational or legal risks raised by such transactions, could harmour business. Financial aspects related to these transactions may alter ourfinancial position, reported operating results or stock price, and include:

 

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•*                                         *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 could harm our existingoperations or prevent realization of anticipated benefits from suchtransactions 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;and

 

•*                                         *Subsequent loss of key personnel.

 

Legal risks may include requirements to obtain theconsent of our stockholders or a third party, or the approval of variousregulatory authorities.

 

If such efforts to integrate acquired or licensedbusinesses or technologies into our business are not successful, our businesscould be harmed.

 

*If we cannot initiate and maintain revenue-generatingrelationships with third parties, we may not be able to grow our revenues inthe near to medium term.*

 

Many products in our current pipeline are inrelatively early stages of research or development. Our ability to growearnings in the near- to medium-term may depend, in part, on our ability toinitiate and maintain other revenue generating relationships with thirdparties, such as licenses to certain of our technologies, and on our ability toidentify and successfully acquire rights to later-stage products from thirdparties. We may fail to establish such other sources of revenue.

 

*Fluctuations in interest rates and foreign currencyexchange rates could harm our business.*

 

We have significant cash balances and investments.Our financial results, therefore, are sensitive to interest rate fluctuations.In addition, we sell products in many countries throughout the world, and ourfinancial results could be significantly affected by fluctuations in foreigncurrency exchange rates or by weak economic conditions in foreign markets.

 

*Our level of debt could limit cash flow available forour operations and could adversely affect our ability to service our debt orobtain additional financing, if necessary.*

 

As of September 30, 2004, our total debt was$940.3 million. Our level of debt could restrict our operations and makeit more difficult for us to satisfy our obligations under the 2033 and the 2034convertible debentures (“the debentures”). Among other things, our level ofdebt may:

 

•*                                         *Limit our ability to obtain additionalfinancing for working capital, capital expenditures, strategic acquisitions andgeneral corporate 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 may still be able to incursubstantially more debt. The terms of our credit facility, the indenturesgoverning the debentures and the agreements governing our other debt permitadditional borrowings. Our incurrence of additional debt could furtherexacerbate the risks described above.

 

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Our ability to satisfy our obligations under thedebentures and our debt agreements will depend on our future operatingperformance, which will be subject, in part, to factors beyond our control,including general economic and business conditions. If we are unable togenerate sufficient cash flow to service our debt, we may be required torefinance 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.

 

*Our relationship with Novartis AG could limit ourability to enter into transactions, pursue opportunities in conflict withNovartis and cause the price of our common stock to decline.*

 

We have an alliance with Novartis AG, a life sciencescompany headquartered in Basel, Switzerland. Under a series of agreementsbetween Chiron and Novartis, and as a result of subsequent stock issuances byChiron, Novartis’ ownership interest in Chiron was approximately 42% as of September 30,2004. The governance agreement between Chiron and Novartis contains provisionsthat require the approval of Novartis before we enter into certain corporatetransactions. These transactions generally include significant debt or equityissuances, debt or equity 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. Inaddition, a majority of the independent directors must approve any materialtransactions between Chiron and Novartis. These provisions may limit ourability to enter into transactions with third parties otherwise viewed asbeneficial to Chiron. All of our shares owned by Novartis are eligible for salein the public market subject to compliance with the applicable securities laws.We have agreed that, upon Novartis’ request, we will file one or moreregistration statements under the Securities Act in order to permit Novartis tooffer and sell shares of our common stock. Sales of a substantial number ofshares of our common stock by Novartis in the public market could adverselyaffect the market price of our common stock.

 

*Our stock price could be volatile.*

 

The price of our stock, like that of otherpharmaceutical companies, is subject to significant volatility. Any number ofevents, both internal and external to us, may affect our stock price. Theseinclude, 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;

 

•*                                         *Impact from the recent Fluvirin developments;

 

•*                                         *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 thirdparties;

 

•*                                         *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 our research and developmentcollaborations, from time to time we may invest in equity securities of ourstrategic partners. The price of these securities also is subject tosignificant volatility and may be affected by, among other things, the types ofevents that affect our stock. Changes in the market price of these securitiesmay impact our profitability.

 

*We are subject to taxation in a number ofjurisdictions and changes to the corporate tax rate and laws of any of thesejurisdictions could increase the amount of corporate taxes we have to pay.*

 

We pay taxes principally in the U.S., Germany, Italy,The Netherlands and, with the acquisition of PowderJect, the United Kingdom.All of these jurisdictions have in the past and may in the future make changesto their corporate tax rates and other tax laws, which could increase ourfuture tax provision. We have negotiated a number of rulings regarding incomeand other taxes that are subject to periodic review and renewal. If suchrulings are not renewed or are substantially modified, income taxes payable inparticular jurisdictions could increase. While we believe that all material taxliabilities are reflected properly in our balance sheet, we are presently underaudit in several jurisdictions and may be subject to further audits in thefuture, and we have no assurance that we will prevail in all cases in the eventthe taxing authorities disagree with our interpretations of the tax law. Inaddition, we have assumed liabilities for all income taxes incurred prior tothe sales of our former subsidiaries, PowderJect Vaccines, Inc., SBLVaccin AB, Chiron Vision (subject to certain limitations) and ChironDiagnostics. 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.

 

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*Volatility of earnings could negatively impact ourbusiness.*

 

Our operating results may vary considerably fromquarter to quarter. Any number of factors may affect our quarterly operatingresults. These factors include, but are not limited to the following:

 

•*                                         *Inventory management practices, includingwholesale ordering patterns;

 

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

 

•*                                         *Seasonality of certain vaccine products,including Fluvirin;

 

•*                                         *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.

 

Ourresults in any one quarter are not necessarily indicative of results to beexpected for a full year.

 

*Revisions to accounting standards, financial reportingand corporate governance requirements and tax laws could result in changes toour standard practices and could require a significant expenditure of time,attention and resources, especially by senior management.*

 

We must follow accounting standards, financialreporting and corporate governance requirements and tax laws set by thegoverning bodies and lawmakers in the U.S. and other countries where we dobusiness. From time to time, these governing bodies and lawmakers implement newand revised rules and laws. These new and revised accounting standards, financialreporting and corporate governance requirements and tax laws may requirechanges to our financial statements, the composition of our board of directors,the composition, the responsibility and manner of operation of variousboard-level committees, the information filed by us with the governing bodiesand enforcement of tax laws against us. Implementing changes required by suchnew standards, requirements or laws likely will require a significantexpenditure of time, attention and resources, especially by our seniormanagement. It is impossible to predict the impact, if any, on Chiron of futurechanges to accounting standards, financial reporting and corporate governancerequirements and tax laws. In addition, it is possible that the application ofcertain current accounting standards may change due to environmental factors,which may necessitate a change in our standard practice related to theseaccounting standards.

 

**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-K for the yearended December 31, 2004, Chiron carried out an evaluation under thesupervision and with the participation of Chiron’s management, including Chiron’sCEO and CFO, of the effectiveness of the design and operation of Chiron’sdisclosure controls and procedures. Based on that evaluation, Chiron’smanagement, including the CEO and CFO, concluded that as of September 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.

 

The management of Chiron Corporation isresponsible for establishing and maintaining adequate internal control overfinancial reporting. Chiron’s internal control system was designed to providereasonable assurance to the Company’s management and board of directorsregarding the preparation and fair presentation of published financialstatements.

 

The management of Chiron assessed theeffectiveness of the 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.*

In performing the assessment management has identified three materialweaknesses in internal control over financial reporting as of December 31,2004.

 

The first material weakness pertains to boththe design and operating effectiveness of controls relating to revenuerecognition at our vaccines subsidiary in Germany. Specifically, controlspertaining to the communication and evaluation of any special terms and otheractions of the sales organization that may affect revenue recognition were noteffective. As a result, on March 8, 2005, the Audit Committee of the Boardof Directors, following discussion with and upon the recommendation ofmanagement and following discussion with Chiron’s independent auditors,concluded that the previously issued financial statements for the second andthird quarters of 2004 should be restated to correct certain errors containedtherein and should not be relied upon. The identified errors affected productrevenue, cost of goods sold, accounts receivable, and unearned revenue for theCompany’s vaccines segment. In addition to the restatement of the financialstatements for the second and third quarters of 2004, adjustments were recordedin the consolidated financial statements for year ended December 31, 2004to correct the identified errors.

 

The second material weakness pertains to boththe design and operating effectiveness of controls relating to the annual

 

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income tax provision. Specifically, there were errors in the annual taxprovision for the year ended December 31, 2004 as a result of ineffectivecontrols relating to the design and use of analytical tools to analyze andcalculate the tax provision, the reconciliation of certain tax accounts, andthe review of those reconciliations. These errors affected income tax expenseand income tax asset and liability accounts. Adjustments were recorded in theconsolidated financial statements for year ended December 31, 2004 tocorrect the identified errors.

 

The third material weakness pertains to boththe design 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 theabove control deficiencies represents a material weakness in internal controlover financial 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 anongoing process of analyzing and attempting to improve our internal controls,including those related to the matters identified above. With regard to therevenue recognition material weakness, the Company is taking steps designed toprovide its 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 include consideration and identification ofadditional controls and reconciliations and the consideration andimplementation 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 inChiron’s internal controls over financial reporting that have materiallyaffected, or are reasonably likely to materially affect internal controls overfinancial reporting during the fiscal quarter ended September 30, 2004.Refer to Item 4(b) for a discussion of remediation activities in connectionwith the material weaknesses in internal control over financial reportingreferred to above.

 

**PART II**

 

##### **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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**CHIRONCORPORATION**

 

###### **September 30, 2004**

######  

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, Chiron has duly caused this report to be signed on itsbehalf 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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