**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

FORM 10-Q

**(Mark one)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.

**Forthe quarterly period ended March 31, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934.

**Forthe transition period from                             to                             **

**CommissionFile Number: 0-12798**

----

CHIRON CORPORATION

(Exact name of registrantas 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 telephonenumber, including area code)

**Not Applicable**

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

----

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

Yes x    No o

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

Yes x    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 April 28, 2005** |
|--------------------------------|------------|-------------------------------------------------------|
| Common Stock,  $0.01 par value |       | 187,458,623                                           |

 

 

----

**CHIRON CORPORATIONTABLE OF CONTENTS**
|                                                                                                                                                                    | ** ** | **Page No.** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| **PART I.   FINANCIAL  INFORMATION**                                                                                                                |       |              |   |   |
| **ITEM 1.   Financial  Statements (Unaudited)**                                                                                                          |       |              |   |   |
| Condensed  Consolidated Balance Sheets at March 31, 2005 and December 31, 2004                                                                           |       |              | 3 |   |
| Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2005 and 2004                                      |       |              | 5 |   |
| Condensed  Consolidated Statements of Comprehensive Income (loss) for the three months ended  March 31, 2005 and 2004                                    |       |              | 6 |   |
| Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2005 and 2004                                      |       |              | 7 |   |
| Notes  to Condensed Consolidated Financial Statements                                                                                                              |       |              | 8 |   |
| **ITEM 2.   Management’s  Discussion and Analysis of Financial Condition and Results of Operations**        |       |              | 20 |   |
| **ITEM 3.   Quantitative  and Qualitative Disclosures About Market Risk**                                                                                |       |              | 49 |   |
| **ITEM 4.   Controls and  Procedures**                                                                                                                   |       |              | 49 |   |
| **PART II.   OTHER  INFORMATION**                                                                                                                   |       |              |   |   |
| **ITEM 1.   Legal  Proceedings**                                                                                                                         |       |              | 52 |   |
| **ITEM 2.   Unregistered  Sales of Equity Securities and Use of Proceeds**                                                                               |       |              | 53 |   |
| **ITEM 3.   Defaults Upon  Senior Securities**                                                                                                           |       |              | 53 |   |
| **ITEM  4.   Submission of  Matters to a Vote of Security Holders**                                                                                      |       |              | 53 |   |
| **ITEM 5.   Other  Information**                                                                                                                         |       |              | 53 |   |
| **ITEM 6.   Exhibits**                                                                                                                                   |       |              | 54 |   |
| **SIGNATURES**                                                                                                                                                     |       |              | 56 |   |

 

2

----

**Item 1**.                        FinancialStatements

**CHIRON CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS(Unaudited)(In thousands, except share data)**
| ** **                                                       | ** ** | **March 31,  2005** | ** ** | ** December 31,   2004** | ** ** |
|------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|
| **ASSETS**                                                       |       |                     |       |                                    |       |   |   |
| Current assets:                                                  |       |                     |       |                                    |       |   |   |
| Cash and cash equivalents                                        |       | $                        | 198,770    |                                    |       | $ | 209,509 |   |   |
| Short-term investments in marketable debt securities             |       | 430,668                  |       |                                    | 394,112    |   |   |
| Total cash and short-term investments                            |       | 629,438                  |       |                                    | 603,621    |   |   |
| Accounts receivable, net of allowances                           |       | 378,790                  |       |                                    | 402,094    |   |   |
| Inventories, net of reserves                                     |       | 233,257                  |       |                                    | 221,154    |   |   |
| Assets held for sale                                             |       | 1,275                    |       |                                    | —     |   |   |
| Current net deferred income tax asset                            |       | 65,342                   |       |                                    | 71,287     |   |   |
| Derivative financial instruments                                 |       | 7,833                    |       |                                    | 4,969      |   |   |
| Other current assets                                             |       | 92,709                   |       |                                    | 90,898     |   |   |
| Total current assets                                             |       | 1,408,644                |       |                                    | 1,394,023  |   |   |
| Non-current investments  in marketable debt securities           |       | 402,841                  |       |                                    | 409,421    |   |   |
| Property, plant,  equipment and leasehold improvements, at cost: |       |                     |       |                                    |       |   |   |
| Land and buildings                                               |       | 381,014                  |       |                                    | 379,861    |   |   |
| Laboratory, production and office equipment                      |       | 668,221                  |       |                                    | 637,394    |   |   |
| Leasehold improvements                                           |       | 132,850                  |       |                                    | 125,858    |   |   |
| Construction-in-progress                                         |       | 206,630                  |       |                                    | 225,482    |   |   |
|                                                             |       | 1,388,715                |       |                                    | 1,368,595  |   |   |
| Less accumulated depreciation and amortization                   |       | (583,698                 | )          |                                    | (569,180   | ) |   |
| Property, plant, equipment and leasehold  improvements, net      |       | 805,017                  |       |                                    | 799,415    |   |   |
| Purchased  technologies, net                                     |       | 210,960                  |       |                                    | 216,037    |   |   |
| Goodwill                                                         |       | 845,825                  |       |                                    | 861,394    |   |   |
| Other intangible  assets, net                                    |       | 432,906                  |       |                                    | 457,707    |   |   |
| Investments in  equity securities and affiliated companies       |       | 76,512                   |       |                                    | 100,951    |   |   |
| Non-current notes  receivable                                    |       | 7,500                    |       |                                    | 7,500      |   |   |
| Other non-current  assets                                        |       | 58,368                   |       |                                    | 59,055     |   |   |
|                                                             |       | $                        | 4,248,573  |                                    |       | $ | 4,305,503 |   |   |

 

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

3

----

**CHIRON CORPORATIONCONDENSED CONSOLIDATED BALANCE SHEETS (Continued)(Unaudited)(In thousands, except share data)**
| ** **                                                                                                             | ** ** | **March 31,  2005** | ** ** | ** December 31,   2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                         |       |                     |       |                                    |       |   |   |
| Current liabilities:                                                                                                   |       |                     |       |                                    |       |   |   |
| Accounts payable                                                                                                       |       | $                        | 122,878    |                                    |       | $ | 129,942 |   |   |
| Accrued compensation and related expenses                                                                              |       | 73,889                   |       |                                    | 79,113     |   |   |
| Derivative financial instruments                                                                                       |       | —                   |       |                                    | 10,395     |   |   |
| Current portion of long-term debt and capital lease                                                                    |       | 1,137                    |       |                                    | 2,687      |   |   |
| Current portion of unearned revenue                                                                                    |       | 59,745                   |       |                                    | 35,651     |   |   |
| Income taxes payable                                                                                                   |       | 23,689                   |       |                                    | 16,363     |   |   |
| Other current liabilities                                                                                              |       | 169,420                  |       |                                    | 160,293    |   |   |
| Total current liabilities                                                                                              |       | 450,758                  |       |                                    | 434,444    |   |   |
| Long-term debt                                                                                                         |       | 938,112                  |       |                                    | 936,652    |   |   |
| Long-term portion  of capital lease                                                                                    |       | 156,890                  |       |                                    | 156,952    |   |   |
| Non-current  derivative financial instruments                                                                          |       | —                   |       |                                    | 156        |   |   |
| Non-current net  deferred income tax liability                                                                         |       | 35,929                   |       |                                    | 60,427     |   |   |
| Non-current  unearned revenue                                                                                          |       | 41,074                   |       |                                    | 26,175     |   |   |
| Other non-current  liabilities                                                                                         |       | 73,410                   |       |                                    | 79,643     |   |   |
| Minority interest                                                                                                      |       | 10,000                   |       |                                    | 9,350      |   |   |
| Total liabilities                                                                                                      |       | 1,706,173                |       |                                    | 1,703,799  |   |   |
| Commitments and  contingencies                                                                                         |       |                     |       |                                    |       |   |   |
| Stockholders’ equity:                                                                                             |       |                     |       |                                    |       |   |   |
| Common stock                                                                                                           |       | 1,917                    |       |                                    | 1,917      |   |   |
| Additional paid-in capital                                                                                             |       | 2,533,597                |       |                                    | 2,527,709  |   |   |
| Deferred stock compensation                                                                                            |       | (17,515                  | )          |                                    | (13,825    | ) |   |
| Accumulated deficit                                                                                                    |       | (34,420                  | )          |                                    | (11,843    | ) |   |
| Accumulated other comprehensive income                                                                                 |       | 267,751                  |       |                                    | 330,491    |   |   |
| Treasury stock, at cost (4,370,000 shares at  March 31, 2005 and 4,804,000 shares at December 31, 2004) |       | (208,930                 | )          |                                    | (232,745   | ) |   |
| Total stockholders’ equity                                                                                        |       | 2,542,400                |       |                                    | 2,601,704  |   |   |
|                                                                                                                   |       | $                        | 4,248,573  |                                    |       | $ | 4,305,503 |   |   |

 

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

4

----

**CHIRON CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(In thousands, except per share data)**
| ** **                                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| Revenues:                                                                                             |       |                                             |       |   |   |
| Product sales, net                                                                                    |       | $                                                | 277,163    |   | $ | 281,066 |   |
| Revenues from joint business arrangement                                                              |       | 36,058                                           |       | 30,361 |   |
| Collaborative agreement revenues                                                                      |       | 4,527                                            |       | 6,515 |   |
| Royalty and license fee revenues                                                                      |       | 80,061                                           |       | 54,792 |   |
| Other revenues                                                                                        |       | 9,547                                            |       | 6,938 |   |
| Total revenues                                                                                        |       | 407,356                                          |       | 379,672 |   |
| Operating expenses:                                                                                   |       |                                             |       |   |   |
| Cost of sales (excludes amortization expense related  to acquired developed products)            |       | 162,960                                          |       | 126,701 |   |
| Research and development                                                                              |       | 109,839                                          |       | 98,410 |   |
| Selling, general and administrative                                                                   |       | 131,908                                          |       | 104,740 |   |
| Amortization expense of  intangible assets acquired in business combinations and asset purchases |       | 21,263                                           |       | 21,332 |   |
| Other operating expenses                                                                              |       | 7,146                                            |       | 2,116 |   |
| Total operating expenses                                                                              |       | 433,116                                          |       | 353,299 |   |
| (Loss) income  from operations                                                                        |       | (25,760                                          | )          | 26,373 |   |
| Interest expense                                                                                      |       | (7,079                                           | )          | (5,925 | ) |
| Interest and  other income, net                                                                       |       | 21,447                                           |       | 16,074 |   |
| Minority interest                                                                                     |       | (530                                             | )          | (620 | ) |
| (Loss) income  from continuing operations before income taxes                                         |       | (11,922                                          | )          | 35,902 |   |
| Provision for  (benefit of) income taxes                                                              |       | (2,980                                           | )          | 8,975 |   |
| (Loss) income  from continuing operations                                                             |       | (8,942                                           | )          | 26,927 |   |
| Gain from discontinued  operations, net of taxes                                                      |       | —                                           |       | 12,845 |   |
| Net (loss) income                                                                                     |       | $                                                | (8,942     | ) | $ | 39,772 |   |
| Basic (loss) earnings  per share:                                                                     |       |                                             |       |   |   |
| (Loss) income from continuing operations                                                              |       | $                                                | (0.05      | ) | $ | 0.14 |   |
| Net (loss) income                                                                                     |       | $                                                | (0.05      | ) | $ | 0.21 |   |
| Diluted (loss) earnings per  share:                                                                   |       |                                             |       |   |   |
| (Loss) income from continuing operations                                                              |       | $                                                | (0.05      | ) | $ | 0.14 |   |
| Net (loss) income                                                                                     |       | $                                                | (0.05      | ) | $ | 0.21 |   |

 

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

5

----

**CHIRON CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME(LOSS)(Unaudited)(In thousands)**
| ** **                                                                                                                                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| Net (loss) income                                                                                                                                                                              |       | $                                                | (8,942     | ) | $ | 39,772 |   |
| Other comprehensive  (loss) income:                                                                                                                                                            |       |                                             |       |   |   |
| Change in foreign currency translation adjustment  during the period                                                                                                                           |       | (50,562                                          | )          | (21,628 | ) |
| Unrealized  (losses) gains from investments:                                                                                                                                                   |       |                                             |       |   |   |
| Net unrealized holding (losses) gains arising during  the period, net of tax benefit (provision) of $2,046 and ($2,498) for the three  months ended March 31, 2005 and 2004, respectively |       | (3,191                                           | )          | 1,277 |   |
| Reclassification adjustment for net gains included  in net (loss) income, net of tax provision of $5,553 and $6,388 for the three  months ended March 31, 2005 and 2004, respectively     |       | (8,987                                           | )          | (3,268 | ) |
| Net unrealized losses from investments                                                                                                                                                         |       | (12,178                                          | )          | (1,991 | ) |
| Other comprehensive loss                                                                                                                                                                       |       | (62,740                                          | )          | (23,619 | ) |
| Comprehensive (loss)  income                                                                                                                                                                   |       | $                                                | (71,682    | ) | $ | 16,153 |   |

 

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

6

----

**CHIRON CORPORATIONCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(In thousands)**
| ** **                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| Net cash provided  by operating activities                                     |       | $                                                | 57,226     |   | $ | 11,080 |   |
| Cash flows from  investing activities:                                         |       |                                             |       |   |   |
| Purchases of investments in marketable debt  securities                        |       | (321,571                                         | )          | (202,899 | ) |
| Proceeds from sales of investments in marketable  debt securities              |       | 37,548                                           |       | 30,634 |   |
| Proceeds from maturities of investments in  marketable debt securities         |       | 249,657                                          |       | 78,908 |   |
| Capital expenditures                                                           |       | (48,447                                          | )          | (44,600 | ) |
| Purchases of equity securities and interests in  affiliated companies          |       | (1,559                                           | )          | (2,390 | ) |
| Proceeds from sale of equity securities and  interests in affiliated companies |       | 8,274                                            |       | 3,537 |   |
| Cash paid for acquisitions, net of cash acquired                               |       | (1,292                                           | )          | (1,006 | ) |
| Other, net                                                                     |       | (1,809                                           | )          | (766 | ) |
| Net cash used in investing activities                                          |       | (79,199                                          | )          | (138,582 | ) |
| Cash flows from  financing activities:                                         |       |                                             |       |   |   |
| Repayment of debt and capital leases                                           |       | (64                                              | )          | (84 | ) |
| Payments to acquire treasury stock                                             |       | —                                           |       | (8,459 | ) |
| Proceeds from re-issuance of treasury stock                                    |       | 9,970                                            |       | 35,603 |   |
| Proceeds from issuance of debt                                                 |       | —                                           |       | 973 |   |
| Net cash provided by financing activities                                      |       | 9,906                                            |       | 28,033 |   |
| Effect of exchange rate changes on cash and cash  equivalents                  |       | 1,328                                            |       | (5,722 | ) |
| Net decrease in cash and cash equivalents                                      |       | (10,739                                          | )          | (105,191 | ) |
| Cash and cash  equivalents at beginning of the period                          |       | 209,509                                          |       | 364,270 |   |
| Cash and cash  equivalents at end of the period                                |       | $                                                | 198,770    |   | $ | 259,079 |   |

 

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

7

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS March 31, 2005 (Unaudited)**

**Note** 1—Basisof Presentation

The information presented in the CondensedConsolidated Financial Statements at March 31, 2005, and for the threemonths ended March 31, 2005 and 2004, is unaudited but includesadjustments, consisting only of all normal recurring adjustments, which ChironCorporation believes to be necessary for fair presentation of the periodspresented.

The Condensed ConsolidatedBalance Sheet amounts at December 31, 2004, have been derived from auditedfinancial statements. Historically, Chiron’s operating results have variedconsiderably from period to period due to the nature of Chiron’s collaborative,royalty and license arrangements and the seasonality of certain vaccineproducts. In addition, the mix of products sold and the introduction of newproducts will affect comparability from quarter to quarter. As a consequence,Chiron’s interim results in any one quarter are not necessarily indicative ofresults to be expected for a full year. This information should be read inconjunction with Chiron’s audited Consolidated Financial Statements as of andfor the year ended December 31, 2004, which are included in the AnnualReport on Form 10-K filed by Chiron with the Securities and ExchangeCommission.

*Principles ofConsolidation*

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

*Use of Estimatesand Reclassifications*

The preparation of financial statements requiresmanagement to make estimates, assumptions and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosures of contingent assets and liabilities. On an on-going basis,management evaluates its estimates, including those related to investments;inventories; derivatives; capital leases; intangible assets; goodwill;purchased in-process research and development; product discounts, rebates andreturns; bad debts; collaborative, royalty and license arrangements;restructuring; pension and other post-retirement benefits; income taxes; andlitigation and other contingencies. Chiron bases its estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources. Actual results may differ from thoseestimates under different assumptions or conditions.

Chiron, prior to filing its financial statements on Form 10-Q,publicly releases an unaudited condensed balance sheet and statement ofoperations. Between the date 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 first quarter of 2005.

8

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note1—Basis of Presentation (Continued)**

Chiron currently owns certain manufacturing andinspection equipment which are no longer useful and became available for salein the first quarter of 2005. Chiron has committed to a plan to sell theseassets and is actively marketing these assets. These assets are classified as “Assetsheld for sale” in the Condensed Consolidated Balance Sheet at March 31,2005.

Certain previouslyreported amounts have been reclassified to conform to the current yearpresentation.

*Stock-BasedCompensation*

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

Thefollowing table illustrates the effect on net income (loss) and related netincome (loss) per share, had compensation cost for the stock-based employeecompensation been determined based upon the fair value method:
| ** **                            | ** **                                                                                                                                       | **Three Months Ended  March 31,**               | ** ** |
|---------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------|------------|
| ** **                            | ** **                                                                                                                                       | **2005**                                                       | ** ** | **2004** | ** ** |
| ** **                            | ** **                                                                                                                                       | **(in thousands, except  per share data)** | ** ** |
| Net income  (loss):                   |                                                                                                                                             |                                                           |       |   |   |
| As reported                           |                                                                                                                                             | $                                                              | (8,942     | ) | $ | 39,772 |   |
| Add:                                  | Stock-based  employee compensation expense included in reported net income (loss), net of  related tax effects                                   |                                                           | 1,061      |   | 1,340 |   |
| Less:                                 | Total stock-based  employee compensation expense determined under fair value based method  for all awards, net of related tax effects  |                                                           | 16,674     |   | 21,507 |   |
|                                  | Proforma                                                                                                                                         |                                                           | $          | (24,555 | ) | $ | 19,605 |   |
| Basic net income  (loss) per share:   |                                                                                                                                             |                                                           |       |   |   |
| As reported                           |                                                                                                                                             | $                                                              | (0.05      | ) | $ | 0.21 |   |
| Proforma                              |                                                                                                                                             | $                                                              | (0.13      | ) | $ | 0.10 |   |
| Diluted net  income (loss) per share: |                                                                                                                                             |                                                           |       |   |   |
| As reported                           |                                                                                                                                             | $                                                              | (0.05      | ) | $ | 0.21 |   |
| Proforma                              |                                                                                                                                             | $                                                              | (0.13      | ) | $ | 0.10 |   |

 

9

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note2—New Accounting Standards**

In December 2004, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards No. 123(revised 2004),*Share-Based Payment*(SFAS 123(R)), which requires the cost resulting from all share-basedpayment transactions to be recognized in the consolidated financial statements.That cost will be measured based on the fair value of the equity instrumentsissued or on the fair value of liabilities incurred. Under SFAS 123(R),the fair-value-based method for recognition or disclosure of compensationexpense will be applied using the modified prospective application transitionmethod or the modified retrospective application transition method. Chironcurrently measures compensation expense for its stock-based employeecompensation under the intrinsic method. We are currently evaluating transitionmethods, option valuation methodologies and assumptions in light of SFAS 123(R),and therefore cannot estimate the impact of our adoption at this time, althoughwe expect that its adoption will have a material impact on Chiron’sconsolidated financial statements. Current option values determined using theBlack-Scholes-Merton formula, used for purposes of proforma disclosure, may notbe indicative of results from the valuation methodologies Chiron finally adopts.The effective date of SFAS 123(R) is the first reporting periodbeginning after June 15, 2005. However, on April 14, 2005, theSecurities and Exchange Commission (SEC) announced the adoption of a new rule thatamends the compliance date of SFAS 123(R). The SEC’s new rule allowscalendar year companies to implement SFAS 123(R) at the beginning of2006, which makes SFAS 123(R) effective for Chiron in the firstquarter of 2006.

On October 22, 2004,the American Jobs Creation Act of 2004 (the Act) was signed into law. The Actincludes a temporary incentive for U.S. multinationals to repatriateaccumulated income earned outside the U.S. at an effective tax rate of 5.25%.On December 21, 2004, the FASB issued Staff Position 109-2,*Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provisions within the American Jobs Creation Act of 2004(*FSP 109-2*).*FSP 109-2 allows companies additional time to evaluate the effect of thelaw on whether unrepatriated foreign earnings continue to qualify forSFAS No. 109’s exception to recognizing deferred tax liabilities andwould require explanatory disclosures from those who need the additional time.Through March 31, 2005, Chiron has not provided deferred taxes on foreignearnings because such earnings were intended to be indefinitely reinvestedoutside the U.S. Whether Chiron will ultimately take advantage of thisprovision depends on a number of factors including reviewing futureCongressional and regulatory guidance before a decision can be made. Until thattime, Chiron will make no change in its current intention to indefinitelyreinvest accumulated earnings of its foreign subsidiaries. If Chironrepatriates these earnings, a one-time tax charge to Chiron’s consolidatedresults of operations could occur. Chiron will continue to evaluate the impactof this provision in 2005.

**Note 3—Inventories**

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

10

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note3—Inventories (Continued)**

Inventories, net ofreserves consisted of the following:
| ** **      | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **      | ** ** | **(in thousands)**  | ** ** |
| Finished goods  |       | $                        | 57,046     |                        |       | $ | 59,206 |   |   |
| Work-in-process |       | 107,518                  |       |                        | 116,660    |   |   |
| Raw materials   |       | 68,693                   |       |                        | 45,288     |   |   |
|            |       | $                        | 233,257    |                        |       | $ | 221,154 |   |   |

 

**Note 4—Income Taxes**

The effective tax rate forthe three months ended March 31, 2005 and 2004 was 25% of pretax income (loss)from continuing operations. The effective tax rate may be affected in futureperiods by changes in management’s estimates with respect to our deferred taxassets and other items affecting the overall tax rate.

**Note 5—ComprehensiveIncome (Loss)**

For the three months endedMarch 31, 2005 and 2004, the foreign currency translation component ofcomprehensive income (loss) relates to permanent investments in non-U.S.subsidiaries, and accordingly, was not adjusted for income taxes.

**Note 6—Treasury Stock**

Treasury stock is statedat cost. Gains on reissuance of treasury stock are credited to “Additional paid-incapital”. Losses on reissuance of treasury stock are charged to “Additionalpaid-in capital” to the extent of available net gains on reissuance of treasurystock. Otherwise, losses are charged to “Accumulated deficit.” Chiron chargedlosses of $13.6 million and $25.4 million for the three months ended March 31,2005 and 2004, respectively, to “Accumulated deficit” in the CondensedConsolidated Balance Sheets.

**Note 7—Earnings(Loss) Per Share**

Basic earnings per share is based upon theweighted-average number of common shares outstanding. Diluted earnings pershare is based upon the weighted-average number of common shares and dilutivepotential common shares outstanding. Dilutive potential common shares couldresult from (i) the assumed exercise of outstanding stock options andequivalents, which are included under the treasury-stock method; (ii) performancebased share rights awards to the extent that dilutive shares are assumedissuable; (iii) the assumed exercise of outstanding put options, which areincluded under the reverse treasury-stock method; and (iv) convertiblenotes and debentures, which are included under the if-converted method, ifapplicable. Due to rounding, quarterly amounts may not sum to full yearamounts.

11

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note7—Earnings (Loss) Per Share (Continued)**

Contingently convertible debt instruments (“CoCos”)are included in diluted earnings per share, if dilutive. For the three monthsended March 31, 2005, Chiron’s $500.0 million contingently convertibledebentures due 2033 (“2033 Debentures”) and Chiron’s $385.0 millioncontingently convertible debentures due 2034 (“2034 Debentures”) were excludedfrom the computations of diluted earnings per share as the inclusion of each ofthese CoCos would be antidilutive.

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  March 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| (Loss) income  (Numerator):                                                            |       |                                             |       |   |   |
| (Loss) income from continuing operations                                               |       | $                                                | (8,942     | ) | $ | 26,927 |   |
| Shares (Denominator):                                                                  |       |                                             |       |   |   |
| Weighted-average common shares outstanding                                             |       | 187,108                                          |       | 187,809 |   |
| Effect of  dilutive securities:                                                        |       |                                             |       |   |   |
| Stock options and equivalents                                                          |       | —                                           |       | 4,190 |   |
| Weighted-average common shares outstanding, plus  impact from assumed conversions |       | 187,108                                          |       | 191,999 |   |
| Basic (loss) earnings per share                                                        |       | $                                                | (0.05      | ) | $ | 0.14 |   |
| Diluted (loss)  earnings per share                                                     |       | $                                                | (0.05      | ) | $ | 0.14 |   |

 

Thefollowing table sets forth the computations for basic and diluted earnings(loss) per share on net income (loss) (in thousands, except per share data):
| ** **                                                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| (Loss) income  (Numerator):                                                            |       |                                             |       |   |   |
| Net (loss) income                                                                      |       | $                                                | (8,942     | ) | $ | 39,772 |   |
| Shares (Denominator):                                                                  |       |                                             |       |   |   |
| Weighted-average common shares outstanding                                             |       | 187,108                                          |       | 187,809 |   |
| Effect of  dilutive securities:                                                        |       |                                             |       |   |   |
| Stock options and equivalents                                                          |       | —                                           |       | 4,190 |   |
| Weighted-average common shares outstanding, plus  impact from assumed conversions |       | 187,108                                          |       | 191,999 |   |
| Basic (loss) earnings per share                                                        |       | $                                                | (0.05      | ) | $ | 0.21 |   |
| Diluted (loss)  earnings per share                                                     |       | $                                                | (0.05      | ) | $ | 0.21 |   |

 

12

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note7—Earnings (Loss) Per Share (Continued)**

Stock options to purchase 22.4 million shares and7.0 million shares with exercise prices greater than the average marketprices of common stock were outstanding during the three months ended March 31,2005 and 2004, respectively. These options were excluded from the respectivecomputations of diluted earnings per share, as their inclusion would beantidilutive.

The dilutive effect of CoCos must be included indiluted earnings per share regardless of whether the triggering contingency hasbeen satisfied, if dilutive. For the three months ended March 31, 2005 and2004, 7.3 million shares of common stock issuable upon conversion of the 2033Debentures were excluded from the computations of diluted earnings per share astheir inclusion would be antidilutive.

If the 2034 Debentures are tendered for conversion,the value (“Conversion Value”) of cash and shares of Chiron’s common stock, ifany, to be received by a holder converting $1,000 principal amount of thedebentures will be determined by multiplying the applicable conversion rate bya weighted average price. Chiron will deliver the Conversion Value to debentureholders as follows: (1) an amount in cash (“Principal Return”) equal tothe lesser of (a) the aggregate Conversion Value of the debentures to beconverted and (b) the aggregate principal amount of the debentures to beconverted and (2) if the aggregate Conversion Value of the debentures tobe converted is greater that the Principal Return, an amount in shares (“NetShares”) equal to the aggregate Conversion Value less the Principal Return (“NetShare Amount”). The number of Net Shares to be paid will be determined bydividing the Net Share Amount by a weighted average price. If dilutive, commonshares to be added to the diluted shares outstanding would be determined by thenet share settlement of the 2034 Debentures. For the three months ended March 31,2005, the assumed conversion of the 2034 Debentures was not dilutive.

In addition, for the three months ended March 31,2005 and 2004, 0.6 million shares and 8.5 million shares of common stockissuable upon conversion of the Liquid Yield Option Notes were excluded fromthe computations of diluted earnings per share as their inclusion would beantidilutive.

All potential commonshares have been excluded from the computation of diluted loss per share forthe three months ended March 31, 2005, as their inclusion would beantidilutive. These potential common shares included stock options to purchase1.2 million shares of common stock, 0.6 million shares of common stock issuableupon conversion of the Liquid Yield Option Notes and 7.3 million sharesissuable upon conversion of the Convertible Debentures.

**Note 8—DiscontinuedOperations**

In a strategic effort to focus on its core businessesof blood-testing, vaccines and biopharmaceuticals, Chiron completed the sale ofChiron Diagnostics to Bayer in 1998.

13

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note8—Discontinued Operations (Continued)**

Chiron and BayerCorporation, or Bayer, were involved in a dispute with respect to theirrespective rights to certain royalty refunds receivable for which a settlementwas reached in 2004. Under this settlement agreement, Chiron made a settlementpayment to Bayer in 2004. This settlement includes an agreement that alloutstanding 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 in excess following thissettlement. This settlement resulted in a net gain of $12.8 million forthe three months ended March 31, 2004. This net gain primarily relates toa tax benefit as a result of the settlement payment to Bayer.

**Note 9—IntangibleAssets**

Intangibleassets subject to amortization consisted of the following (in thousands):
| ** **                                       | ** ** | **March 31, 2005** | ** ** | **December 31, 2004**     | ** ** |
|--------------------------------------------------|------------|------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **Gross  Carrying  Value**   | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying  Value** | ** ** | **Gross  Carrying  Value** | ** ** | **Accumulated   Amortization** | ** ** | **Net Carrying  Value** | ** ** |
| Purchased  technologies                          |       | $                            | 332,746    |                                |       | $ | 121,786 |   |   |   | $ | 210,960 |   |   | $ | 333,085 |   |   | $ | 117,048 |   |   |   | $ | 216,037 |   |   |
| Patents                                          |       | $                            | 135,375    |                                |       | $ | 73,684 |   |   |   | $ | 61,691 |   |   | $ | 132,385 |   |   | $ | 71,616 |   |   |   | $ | 60,769 |   |   |
| Trademarks                                       |       | 63,401                       |       |                                | 25,427     |   |   |   | 37,974 |   |   | 65,609 |   |   | 25,450 |   |   |   | 40,159 |   |   |
| Licenses and  technology rights                  |       | 46,190                       |       |                                | 33,439     |   |   |   | 12,751 |   |   | 47,745 |   |   | 34,079 |   |   |   | 13,666 |   |   |
| Developed product  technologies                  |       | 366,122                      |       |                                | 89,087     |   |   |   | 277,035 |   |   | 374,025 |   |   | 77,253 |   |   |   | 296,772 |   |   |
| Customer  relationships                          |       | 29,729                       |       |                                | 12,211     |   |   |   | 17,518 |   |   | 31,234 |   |   | 12,421 |   |   |   | 18,813 |   |   |
| Know how(1)                                      |       | 13,501                       |       |                                | 7,427      |   |   |   | 6,074 |   |   | 14,185 |   |   | 7,548 |   |   |   | 6,637 |   |   |
| Databases                                        |       | 7,100                        |       |                                | 2,130      |   |   |   | 4,970 |   |   | 7,100 |   |   | 2,012 |   |   |   | 5,088 |   |   |
| Other                                            |       | 24,785                       |       |                                | 9,892      |   |   |   | 14,893 |   |   | 34,893 |   |   | 19,090 |   |   |   | 15,803 |   |   |
| Total other intangible  assets                   |       | $                            | 686,203    |                                |       | $ | 253,297 |   |   |   | $ | 432,906 |   |   | $ | 707,176 |   |   | $ | 249,469 |   |   |   | $ | 457,707 |   |   |
| Total intangible assets  subject to amortization |       | $                            | 1,018,949  |                                |       | $ | 375,083 |   |   |   | $ | 643,866 |   |   | $ | 1,040,261 |   |   | $ | 366,517 |   |   |   | $ | 673,744 |   |   |

----

(1)          Upon acquisition of a100% interest in Chiron Behring by the second quarter 1998, Chiron acquired aportfolio of products that were created by Behring and are currently being soldinternationally. These products embody Chiron Behring’s proprietary “know-how”consisting of unpatented technology and trade secrets. Since the unpatentedtechnology and trade secrets meet the separability criterion, Chiron hasrecognized them collectively as a separate intangible asset apart from goodwillin accordance with SFAS No. 141, “Business Combinations”.

14

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note9—Intangible Assets (Continued)**

Aggregate futureamortization expense is expected to be as follows (in thousands):
| For the three  months ended March 31, 2005                         |   | $ | 24,414  |   |
|-------------------------------------------------------------------------|--------|---|---------|--------|
| For the remaining  nine months in the year ended December 31, 2005 |   | $ | 73,402  |   |
| For the year  ended December 31, 2005                              |   | $ | 97,816  |   |
| For the year  ended December 31, 2006                              |   | $ | 107,204 |   |
| For the year  ended December 31, 2007                              |   | $ | 105,398 |   |
| For the year  ended December 31, 2008                              |   | $ | 79,862  |   |
| For the year  ended December 31, 2009                              |   | $ | 54,832  |   |
| For the year ended  December 31, 2010                              |   | $ | 53,329  |   |

 

Thechanges in the carrying value of goodwill by reporting unit consisted of thefollowing (in thousands):
| ** **                            | ** ** | **Biopharmaceuticals** | ** ** | **Vaccines** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|------------------------|------------|--------------|------------|-----------|------------|
| Balance as of  December 31, 2004 |       |                   | $          | 192,186      |       |      | $          | 669,208 |   | $ | 861,394 |   |
| Effect of exchange rate changes       |       |                   | —     |         |       | (15,569   | )          | (15,569 | ) |
| Balance as of  March 31, 2005    |       |                   | $          | 192,186      |       |      | $          | 653,639 |   | $ | 845,825 |   |

 

**Note 10—SegmentInformation**

Chiron is organized based on the products and servicesthat it offers. Under this organizational structure, there are three reportablesegments: (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. Chiron’s alliance withGen-Probe is focused on developing and commercializing nucleic acid testingproducts using Transcription-Mediated Amplification technology to screendonated blood and plasma products for viral infection. Chiron’s joint businessarrangement with Ortho-Clinical Diagnostics is operated under 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. The blood-testing segment also earns royalties from third partiesbased on their sales of immunodiagnostic and nucleic acid testing probediagnostic products utilizing Chiron’s hepatitis C virus and HIV-relatedpatents, for use in blood screening and plasma fractionation markets. Thevaccines segment consists principally of adult and pediatric vaccines for viraland bacterial infections. Chiron sells these vaccines primarily in the U.S.,Germany, Italy, and the United Kingdom, as well as in other internationalmarkets. The vaccines segment is also involved in the development of novelvaccines and vaccination technology. The biopharmaceuticals segment consists oftherapeutic products and services, with an emphasis on the treatment of cancerand infectious and pulmonary diseases, using the development and acquisition oftechnologies related to therapeutic proteins, antibodies and small molecules.The biopharmaceuticals segment earns royalties on third party sales of severalproducts, including BETAFERON® interferon 

15

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note10—Segment Information (Continued)**

beta-1b and earnslicense fees for technologies, such as hepatitis C virus-related patents, usedby third parties to develop therapeutic products.

Revenues and expenses associated with Chiron’sresearch and development activities specifically benefit each of the reportablesegments and as such, have been included in the results of operations of therespective reportable segment.

Chiron views certain other revenues and expenses,particularly certain royalty and license fee revenues primarily related to HIVand hepatitis C virus related patents, and unallocated corporate expenses, asnot belonging to any one reportable segment. As a result, Chiron has aggregatedthese items into an “Other” segment.

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

16

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note 10—SegmentInformation (Continued)**

Thefollowing segment information excludes all significant intersegmenttransactions as these transactions are eliminated for management reportingpurposes (in thousands):
| ** **                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| *Revenues*                                                    |       |                                             |       |   |   |
| Blood-testing:                                                |       |                                             |       |   |   |
| Product sales, net:                                           |       |                                             |       |   |   |
| PROCLEIX® products                                  |       | $                                                | 64,431     |   | $ | 61,886 |   |
| Ortho-Clinical  Diagnostics                                   |       | 6,462                                            |       | 6,234 |   |
| Total product  sales, net                                     |       | 70,893                                           |       | 68,120 |   |
| Revenues from  joint business arrangement                     |       | 36,058                                           |       | 30,361 |   |
| Collaborative  agreement revenues                             |       | 1,882                                            |       | 2,064 |   |
| Royalty and  license fee revenues                             |       | 25,204                                           |       | 16,434 |   |
| Other revenues                                                |       | 76                                               |       | 195 |   |
| Total  blood-testing revenues                                 |       | 134,113                                          |       | 117,174 |   |
| Vaccines:                                                     |       |                                             |       |   |   |
| Product sales, net:                                           |       |                                             |       |   |   |
| Influenza vaccines                                            |       | 3,571                                            |       | 7,705 |   |
| Meningococcus  vaccines                                       |       | 9,153                                            |       | 4,549 |   |
| Travel vaccines                                               |       | 43,759                                           |       | 23,010 |   |
| Pediatric and  other vaccines                                 |       | 30,493                                           |       | 51,182 |   |
| Total product  sales, net                                     |       | 86,976                                           |       | 86,446 |   |
| Collaborative  agreement revenues                             |       | 2,242                                            |       | 3,966 |   |
| Royalty and  license fee revenues                             |       | 1,416                                            |       | 2,650 |   |
| Other revenues                                                |       | 3,276                                            |       | 3,643 |   |
| Total vaccines  revenues                                      |       | 93,910                                           |       | 96,705 |   |
| Biopharmaceuticals:                                           |       |                                             |       |   |   |
| Product sales, net:                                           |       |                                             |       |   |   |
| BETASERON® interferon beta-1b                       |       | 26,634                                           |       | 30,136 |   |
| TOBI® tobramycin                                    |       | 52,935                                           |       | 52,524 |   |
| PROLEUKIN® aldesleukin                              |       | 29,535                                           |       | 31,868 |   |
| Other                                                         |       | 10,190                                           |       | 11,972 |   |
| Total product  sales, net                                     |       | 119,294                                          |       | 126,500 |   |
| Collaborative  agreement revenues                             |       | 403                                              |       | 485 |   |
| Royalty and  license fee revenues                             |       | 18,626                                           |       | 17,297 |   |
| Other revenues                                                |       | 6,195                                            |       | 3,100 |   |
| Total  biopharmaceuticals revenues                            |       | 144,518                                          |       | 147,382 |   |
| Other:                                                        |       |                                             |       |   |   |
| Royalty and  license fee revenues                             |       | 34,815                                           |       | 18,411 |   |
| Total revenues                                                |       | $                                                | 407,356    |   | $ | 379,672 |   |
| *Income (loss) from continuing  operations*                   |       |                                             |       |   |   |
| Blood-testing                                                 |       | $                                                | 74,359     |   | $ | 63,640 |   |
| Vaccines                                                      |       | (85,399                                          | )          | (50,039 | ) |
| Biopharmaceuticals                                            |       | (6,108                                           | )          | 19,249 |   |
| Other                                                         |       | (8,612                                           | )          | (6,477 | ) |
| Segment (loss)  income from operations                        |       | (25,760                                          | )          | 26,373 |   |
| Interest expense                                              |       | (7,079                                           | )          | (5,925 | ) |
| Interest and other  income, net                               |       | 21,447                                           |       | 16,074 |   |
| Minority interest                                             |       | (530                                             | )          | (620 | ) |
| (Loss) income from  continuing operations before income taxes |       | $                                                | (11,922    | ) | $ | 35,902 |   |

 

17

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note 11—Commitmentsand Contingencies**

On October 5, 2004, the U.K. regulatory body, theMedicines and Healthcare products Regulatory Agency, or MHRA, sent Chiron aletter prohibiting us from releasing any FLUVIRIN® influenza vaccinedoses manufactured at our Liverpool facility since March 2, 2004 andsuspending our license to manufacture influenza virus vaccine in our Liverpoolfacility for three months (later extended for an additional three months). Inthat letter, the MHRA asserted that our manufacturing process did not complywith U.K. good manufacturing practices regulations. Following the MHRA’sdecision and an inspection by the Food and Drug Administration, or FDA, the FDAsent Chiron a warning letter citing violations of good manufacturing practices.Chiron provided the FDA with a written response to the warning letter on January 7,2005. As a result of the suspension of Chiron’s license, Chiron did not releaseany FLUVIRIN product during the 2004-2005 influenza season.

On March 2, 2005, the MHRA notified us that ithad lifted the license suspension, giving Chiron clearance to initiate fullproduction of FLUVIRIN® vaccine, conditioned on the understandingthat Chiron’s commitment to remediation will continue and will be subject tofurther inspections by the MHRA. The FDA is still expected to conduct a fullinspection to determine whether deficiencies noted in the warning letter theFDA issued in December 2004 have been resolved. If Chiron fails toadequately address the matters discussed in the warning letter, the FDA maymodify Chiron’s U.S. license in an adverse manner, take action that couldresult in imposition of fines, require temporary or permanent cessation offuture selling of FLUVIRIN vaccine or take other action that could reduceChiron’s ability to market FLUVIRIN vaccine.

Chiron received a grand jury subpoena issued by theU.S. Attorney’s Office for the Southern District of New York in October 2004requesting production of certain documents relating to FLUVIRIN vaccine and thesuspension by the MHRA of our license. In February 2005, after havingpreviously commenced an informal inquiry, the Securities and ExchangeCommission, or SEC, notified Chiron that it would commence a formal investigationinto whether Chiron or its employees have violated any federal securities lawsin connection with these developments regarding FLUVIRIN vaccine, and in April 2005,Chiron received a subpoena from the SEC requesting production of certain documentsrelating to its Liverpool facility and FLUVIRIN vaccine. Chiron also received avoluntary request for information from the United States House ofRepresentatives Committee on Energy and Commerce requesting production ofcertain documents. Numerous documents have been collected and produced inresponse to these requests, and several witnesses have been interviewed by theU.S. Attorney’s Office and the SEC staff and additional interviews areanticipated. Additional investigations regarding these matters may arise. Inaddition, Chiron and certain of our officers and directors have also been namedas defendants in several putative shareholder class action and derivativelawsuits alleging various claims arising out of or relating to thesedevelopments regarding FLUVIRIN vaccine. Chiron has been contacted by certainparties who may bring claims against us as a result of Chiron’s inability tosupply FLUVIRIN vaccine in the 2004-2005 season, including the U.S.Centers for Disease Control and Prevention and certain distributors of FLUVIRINvaccine who have suggested that they are entitled to compensation under theircontracts for the 2004-2005 season. It is not possible to predict whetherany of these claims will be pursued and, if so, whether those claims will beupheld. Investigations, litigation and disputes have caused Chiron to incursubstantial 

18

----

**CHIRON CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) March 31, 2005 (Unaudited)**

**Note11—Commitments and Contingencies (Continued)**

expense, and have requiredsignificant time and attention from Chiron’s management and will continue to doso in the future and could result in civil and/or criminal penalties againstChiron. The results of any such investigations, proceedings or disputes couldhave a material adverse effect on Chiron’s consolidated financial position andresults of operations and/or cash flow.

In addition to the investigations, inquiry andlawsuits related to the recent FLUVIRIN vaccine developments, Chiron is partyto various claims, investigations and legal proceedings arising in the ordinarycourse of business. These claims, investigations and legal proceedings relatedto intellectual property rights, contractual rights and obligations, employmentmatters, claims of product liability and other issues. While it is possiblethat an adverse determination of any of such ordinary course matters could havea material adverse impact in any future period, management does not believe,based upon information known to it, that the final resolution of any theseordinary course matters will have a material adverse effect upon Chiron’sconsolidated financial position and results of operations or cash flows.

Chiron’s tax filings are presently under examinationin several domestic and international tax jurisdictions. While there is noassurance that Chiron will prevail in all tax examinations in the event thetaxing authorities disagree with Chiron’s interpretation of the tax law, Chiron’smanagement does not believe, based upon information known to it, that the finalresolution of any of these audits will have a material adverse effect uponChiron’s consolidated financial position and results of operations or cashflows. Adequate provisions have been made for these tax examinations.

19

----

**Item 2**.                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations

***Forward-Looking Statements***

This Form 10-Qcontains forward-looking statements regarding our expectations, hopes orintentions regarding the future, including statements relating to sales growth,product development initiatives, new product marketing, acquisitions,competition, and licensing activities that involve risks and uncertainties andare subject to change. The forward-looking statements contained in this Form 10-Qreflect our current expectations on the date of this Form 10-Q. Actualresults, performance or outcomes may differ materially from currentexpectations. Our actual performance may differ from current expectations dueto many factors, including additional adverse developments resulting from thesuspension from October 5, 2004 through March 2, 2005 of Chiron’s UKlicense to manufacture FLUVIRIN® influenza virus vaccine, theannouncement of such suspension and the litigation and investigations relatingto these matters, the outcome of clinical trials, regulatory review andapprovals, manufacturing capabilities, intellectual property protections anddefenses, stock price and marketing effectiveness. In particular, there can beno assurance that we will increase sales of existing products, successfullydevelop and receive approval to market new products, or achieve marketacceptance for such new products. No assurances can be given that additionalissues with respect to FLUVIRIN® vaccine or Chiron’s manufacturinggenerally will not arise in the future, or that we will successfully addressmatters raised in a warning letter from the U.S. Food and Drug Administrationwith respect to our FLUVIRIN vaccine manufacturing facilities. There can be noassurance that our out-licensing activity will generate significant revenue, orthat our in-licensing activities will fully protect us from claims ofinfringement by third parties. In addition, we may engage in businessopportunities, the successful completion of which is subject to certain risks,including approval by Novartis, regulatory approvals and the integration ofoperations. We havediscussed the important factors, which we believe could cause actual results todiffer from what is expressed in the forward-looking statements, under thecaption “Factors That May Affect Future Results” in this Form 10-Q.We do not undertake an obligation to update the forward-looking informationcontained in this Form 10-Q.

***Introduction***

We are a global biopharmaceutical company thatparticipates in three healthcare markets: blood-testing, vaccines, andbiopharmaceuticals. Our revenues consist of product sales, revenues from ajoint business contractual arrangement, collaborative agreement revenues,royalty and license fee revenues, and other revenues, primarily consisting ofcontract manufacturing and grant revenues. Our research and development effortsare focused on developing products for cancer and infectious and pulmonarydisease.

The blood-testing segment consists of an alliance withGen-Probe and our one-half share in the pretax operating earnings generated bythe joint business contractual arrangement with Ortho-Clinical Diagnostics. Ouralliance with Gen-Probe is focused on developing and commercializing nucleicacid testing products using transcription-mediated amplification technology toscreen donated blood and plasma products for viral infection. Our jointbusiness arrangement with Ortho-Clinical Diagnostics is operated under acontractual arrangement and is not a separate and distinct legal entity.Through our joint business contractual arrangement with Ortho-ClinicalDiagnostics, we sell a line of immunodiagnostic tests to detect hepatitisviruses and retroviruses and provide supplemental tests and microplate andchemiluminescent instrument systems to automate test performance and datacollection. The blood-testing segment also earns royalties from third partiesbased on their sales of immunodiagnostic and nucleic acid testing probediagnostic products utilizing our hepatitis C virus and HIV-related patents,for use in blood screening and plasma fractionation markets.

The vaccines segment consists of more than 20pediatric and adult vaccines including influenza, meningococcal, travel andpediatric vaccines. We sell these vaccines primarily in the U.S., Germany,Italy and the United Kingdom, as well as in other international markets. Ourvaccines segment is also involved 

20

----

in the development ofother novel vaccines and vaccination technology. We acquired a number ofvaccines including FLUVIRIN® influenza virus vaccine as part of our July 8,2003 acquisition of PowderJect.

The biopharmaceuticals segment consists of therapeuticproducts and services, with an emphasis on the treatment of cancer, infectiousand pulmonary diseases. Our in-house capabilities span three types oftherapeutics, including small molecules, therapeutic proteins and monoclonalantibodies. Our products include TOBI® (tobramycin solution forinhalation) for pseudomonal lung infections in cystic fibrosis patients,PROLEUKIN® (aldesleukin) for cancer (metastatic melanoma and renalcell 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 biopharmaceuticalssegment earns royalties on third party sales of several products, includingBETAFERON® interferon beta-1b, and earns license fees fortechnologies, such as hepatitis C virus-related patents, used by third partiesto develop therapeutic products.

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

***FLUVIRIN® Influenza Virus Vaccine RecentEvents***

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 that time to delay releasing anyFLUVIRIN vaccine doses pending completion of internal investigations. On October 5,2004, the U.K. regulatory body, the Medicines and Healthcare productsRegulatory Agency, or MHRA, sent us a letter prohibiting us from releasing anyFLUVIRIN® influenza vaccine doses manufactured at our Liverpoolfacility since March 2, 2004 and suspending our license to manufactureinfluenza virus vaccine in our Liverpool facility for three months (laterextended for an additional three months). In that letter, the MHRA assertedthat our manufacturing process did not comply with U.K. good manufacturingpractices regulations. Following the MHRA’s decision and an inspection by theFood and Drug Administration, or FDA, the FDA sent us a warning letter citingviolations of good manufacturing practices. We provided the FDA with a writtenresponse to the warning letter on January 7, 2005. As a result of thesuspension of our license, we did not release any FLUVIRIN product during the2004-2005 influenza season.

On March 2, 2005, the MHRA notified us that ithad lifted the license suspension, giving Chiron clearance to initiate fullproduction of FLUVIRIN® vaccine, conditioned on the understandingthat Chiron’s commitment to its remediation plan will continue and will besubject to further inspections by the MHRA. The FDA is still expected toconduct a full inspection to determine whether deficiencies noted in thewarning letter the FDA issued in December 2004 have been resolved. If wefail to adequately address the matters discussed in the warning letter, the FDAmay modify our U.S. license in an adverse manner, take action that could resultin imposition of fines, require temporary or permanent cessation of futureselling of FLUVIRIN vaccine or take other action that could reduce our abilityto market FLUVIRIN vaccine.

We received a grand jury subpoena issued by the U.S.Attorney’s Office for the Southern District of New York in October 2004requesting production of certain documents relating to FLUVIRIN vaccine and thesuspension by the MHRA of our license. In February 2005, after havingpreviously commenced an informal inquiry, the Securities and ExchangeCommission, or SEC, notified us that it would commence a formal investigationinto whether we or our employees have violated any federal securities laws inconnection with these developments regarding FLUVIRIN vaccine, and in April 2005,we received a subpoena from the SEC requesting production of certain documentsrelating to our Liverpool facility and FLUVIRIN vaccine. We also received avoluntary request for information from the United States House ofRepresentatives Committee on Energy and Commerce requesting production ofcertain documents. 

21

----

Numerous documents havebeen collected and produced in response to these requests, and severalwitnesses have been interviewed by the U.S. Attorney’s Office and the SEC staffand additional interviews are anticipated. Additional investigations regardingthese matters may arise.

In addition, we and certain of our officers anddirectors have also been named as defendants in several putative shareholderclass action and derivative lawsuits alleging various claims arising out of orrelating to these developments regarding FLUVIRIN vaccine, including the U.S.Centers for Disease Control and Prevention and certain distributors of FLUVIRINvaccine who have suggested that they are entitled to compensation under theircontracts for the 2004-2005 season. It is not possible to predict whether anyof these claims will be pursued and, if so, whether those claims will beupheld. Investigations, litigation and disputes have caused us to incursubstantial expense and have required significant time and attention from ourmanagement and will continue to do so in the future and could result in civiland/or criminal penalties against Chiron. The results of any suchinvestigations, proceedings or disputes could have a material adverse effect onour consolidated financial position and results of operations and/or cash flow.

Our inability to supply FLUVIRIN vaccine during the2004-2005 influenza season may also lead to loss of market share in the2005-2006 season and future seasons. Following the announcement of our licensesuspension, competitors announced plans to introduce influenza vaccine productsin the United States and are seeking expedited regulatory approval to do so.Even though the license suspension has been lifted, some of our customers maychoose to purchase flu vaccine from other providers as their products becomeavailable in the United States. Loss of market share could have a materialadverse effect on our business and results of operations. We also expect toincur expenses in connection with ongoing FLUVIRIN vaccine matters, which couldbe material, including in connection with (1) our continuing remediationefforts at our Liverpool facility; and (2) responding to the U.S. Attorneyfor the Southern District of New York, the SEC, the United States House ofRepresentatives Committee on Energy and Commerce and the private lawsuits andother claims and investigations that may arise.

For additional informationconcerning the risks we face as a result of these FLUVIRIN vaccinedevelopments, see “Factors That May Affect Future Results—The recentdevelopments with respect to FLUVIRIN® vaccine will harm ourbusiness and results of operations.” For additional information on the U.S.Attorney’s investigation, SEC investigation and private lawsuits and otherclaims, see Part II, Item 1. “Legal Proceedings” of this report on Form 10-Q.

***Restated Second-Quarter and Third-Quarter 2004Financial Statements***

During our 2004 year-end financial statement reviewand Section 404 Sarbanes-Oxley review, we determined that certain sales ofthe travel vaccine recorded as revenues in the second quarter of 2004 shouldnot have been recorded as revenue at that time, and that portions of thosesales should have been recorded as revenues in the third and fourth quarters of2004 and possibly in later quarters. As a result, we restated the financialstatements included in our Quarterly Reports on Form 10-Q for suchquarters and filed amended Form10-Q’s for such quarters on April 6, 2005.

In light of the fact thatwe were already in contact with the SEC in relation to their investigationdescribed above under “FLUVIRIN® Influenza Virus Vaccine RecentEvents,” we informed the SEC of these matters, and adjustments we made after January 26,2005 to the fourth quarter and full-year 2004 financial information we releasedon January 26, 2005, and have been providing the SEC information.

22

----

***Summary Consolidated Financial Data***

Followingis an analysis and discussion of our operating results on a consolidated basis,which is followed by a description of our most critical accounting policies anduse of estimates and more detailed analysis and discussion of our operatingresults by segment and our liquidity and capital resources.
| ** **                                    | ** ** | **Three Months Ended March 31,**                       | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **200**5                                                                   | ** ** | **200**4          | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **                                    | ** ** | **($ in 000’s, except per share data)** | ** ** |
| Product sales,  net                           |       |                                                                       | $          | 277,163           |       |                  |       | $ | 281,066 |   |   |   | $ | (3,903 | ) |   |   | (1.4 | )% |   |
| Revenues from  joint business arrangement     |       |                                                                       | 36,058     |              |       |                  | 30,361     |   |   |   | 5,697 |   |   |   | 18.8 | % |   |
| Royalty and  license fee revenues             |       |                                                                       | 80,061     |              |       |                  | 54,792     |   |   |   | 25,269 |   |   |   | 46.1 | % |   |
| Total revenues                                |       |                                                                       | 407,356    |              |       |                  | 379,672    |   |   |   | 27,684 |   |   |   | 7.3 | % |   |
| Gross profit  margin                          |       |                                                                       | 41         | %                 |       |                  | 55         | % |   |   |   |   |   |   |   |   |   |
| Research and  development expenses            |       |                                                                       | 109,839    |              |       |                  | 98,410     |   |   |   | 11,429 |   |   |   | 11.6 | % |   |
| Selling, general  and administrative expenses |       |                                                                       | 131,908    |              |       |                  | 104,740    |   |   |   | 27,168 |   |   |   | 25.9 | % |   |
| Income (loss) from  continuing operations     |       |                                                                       | (8,942     | )                 |       |                  | 26,927     |   |   |   | (35,869 | ) |   |   | (133.2 | )% |   |
| Diluted earnings  (loss) per share:           |       |                                                                       |       |              |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations     |       |                                                                       | $          | (0.05             | )          |                  |       | $ | 0.14 |   |   |   | $ | (0.19 | ) |   |   | (135.7 | )% |   |

 

Loss from continuing operations was $8.9 million or$0.05 per diluted share for the three months ended March 31, 2005. Incomefrom continuing operations was $26.9 million or $0.14 per diluted share for thethree months ended March 31, 2004. For the first quarter 2005, we incurred$16.0 million of FLUVIRIN vaccine remediation costs and $10.0 million of legalcosts associated with the FLUVIRIN vaccine-related developments. In addition,our Liverpool facility was not in flu production during the first quarter 2005,therefore idle facility costs increased by $13.0 million as compared with thefirst quarter 2004. Total revenues were $407.4 million and $379.7 million forthe three months ended March 31, 2005 and 2004, respectively. Revenuesincreased primarily due to increased royalty and license fee revenues andhigher revenues from the joint business arrangement with Ortho-ClinicalDiagnostics. The increase in total revenues was attributable in part to themovement in exchange rates, in particular the movements in the Euro and BritishPound against the U.S. dollar. The movement in exchange rates addedapproximately 1.0% to our total revenues for the three months ended March 31,2005. However, since our Euro and British Pound denominated expenses have alsoincreased due to the movement in exchange rates, our loss per share fromcontinuing operations increased $0.01 per diluted share for the three monthsended March 31, 2005, due to higher expenses compared to revenuesdenominated in Euros and British Pounds.

For the three months ended March 31, 2005,product sales decreased compared with the three months ended March 31,2004 primarily due to declines in sales of pediatric and other vaccines,BETASERON® interferon beta-1b and PROLEUKIN® aldesleukin,offset by increases in sales of travel vaccines, Meningococcus vaccines andPROCLEIX® assays and systems, as discussed below.

Revenues from the joint business arrangement increasedprimarily due to higher profits from Ortho’s foreign affiliates. Royalty andlicense fee revenues increased, primarily due to our September 2004settlement agreement with Roche regarding our HIV patent in the US.

The decline in gross profit margins for the threemonths ended March 31, 2005 as compared with the three months ended March 31,2004 was primarily due to $13.0 million of increased idle facility costs as aresult of the delay in commercial production of FLUVIRIN vaccine for the2005-2006 season and $16.0 million of FLUVIRIN vaccine remediation costs includedin cost of sales for the three months ended March 31, 2005. Also,contributing to the decrease was planned idle facility time forBiopharmaceuticals manufacturing. Gross profit margins do not includeamortization expense of intangible assets from acquired developed productsrelated to business combinations.

23

----

The main components of the increase in research anddevelopment expenses for the three months ended March 31, 2005 as comparedwith the three months ended March 31, 2004 relate to development effortsin our oncology franchise, development of new processes and procedures inexisting manufacturing facilities for BETAFERON interferon beta-1b, anddevelopment efforts for CUBICIN® (daptomycin for injection),tifacogin and blood-testing programs. This increase was partially offset byresearch and development programs that have been discontinued or disposed ofprior to the first quarter of 2005.

The increase in selling, general and administrativeexpenses for the three months ended March 31, 2005 as compared with thethree months ended March 31, 2004 was due partially to approximately $10.0million in legal expenses associated with the FLUVIRIN developments discussedabove under “FLUVIRIN® Influenza Virus Vaccine Recent Events”. Theincrease also reflects $3.0 million due to the movement in the Euro and BritishPound exchange rates. The remaining increase in selling, general andadministrative expenses reflects a broad range of activities, significant amongthem on-going marketing and pre-launch programs to support the continued growthof our business, investment in geographic penetration and corporate governancecosts.

The effective tax rate forthe three months ended March 31, 2005 and 2004 was 25% of pretax income (loss)from continuing operations. The effective tax rate may be affected in futureperiods by changes in management’s estimates with respect to our deferred taxassets and other items affecting the overall tax rate.

***Critical Accounting Policies and the Use 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 in Part II,Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in our Annual Report on Form 10-K for the yearended December 31, 2004.

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

24

----

**Results ofOperations**

***Blood-testing***
| ** **                                    | ** ** | **Three Months Ended March 31,**               | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **200**5                                                      | ** ** | **200**4          | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **                                    | ** ** | **($ in 000’s, except percentages)** | ** ** | ** **        | ** ** | ** **            | ** ** |
| Product sales, net:                           |       |                                                          |       |              |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| PROCLEIX® products                       |       |                                                          | $          | 64,431            |       |                  |       | $ | 61,886 |   |   |   | $ | 2,545 |   |   |   | 4.1 | % |   |
| Ortho-Clinical Diagnostics                    |       |                                                          | 6,462      |              |       |                  | 6,234      |   |   |   | 228 |   |   |   | 3.7 | % |   |
|                                          |       |                                                          | 70,893     |              |       |                  | 68,120     |   |   |   | 2,773 |   |   |   | 4.1 | % |   |
| Revenue from  joint business arrangement      |       |                                                          | 36,058     |              |       |                  | 30,361     |   |   |   | 5,697 |   |   |   | 18.8 | % |   |
| Collaborative  agreement revenues             |       |                                                          | 1,882      |              |       |                  | 2,064      |   |   |   | (182 | ) |   |   | (8.8 | )% |   |
| Royalty and  license fee revenues             |       |                                                          | 25,204     |              |       |                  | 16,434     |   |   |   | 8,770 |   |   |   | 53.4 | % |   |
| Other revenues                                |       |                                                          | 76         |              |       |                  | 195        |   |   |   | (119 | ) |   |   | (61.0 | )% |   |
| Total  blood-testing revenues                 |       |                                                          | $          | 134,113           |       |                  |       | $ | 117,174 |   |   |   | $ | 16,939 |   |   |   | 14.5 | % |   |
| Gross profit margin                           |       |                                                          | 44         | %                 |       |                  | 43         | % |   |   |   |   |   |   |   |   |   |
| Research and  development expenses            |       |                                                          | $          | 7,804             |       |                  |       | $ | 5,109 |   |   |   | $ | 2,695 |   |   |   | 52.8 | % |   |
| Selling, general and  administrative expenses |       |                                                          | $          | 11,775            |       |                  |       | $ | 9,257 |   |   |   | $ | 2,518 |   |   |   | 27.2 | % |   |

 

**Product sales**

*PROCLEIX® Products  *OnFebruary 27, 2002, the U.S. Food and Drug Administration approved thePROCLEIX*®* HIV-1/ HCVAssay. We have marketed the PROCLEIX® HIV-1/HCV Assay in Europesince 1999. On January 15, 2004, the PROCLEIX® ULTRIOTM HIV-1/HCV/HBVAssay received European CE marking for use on the semi-automated PROCLEIXSystem, and on December 14, 2004 the PROCLEIX ULTRIO Assay receivedEuropean CE marking for use on the fully automated, high throughput PROCLEIX®TIGRIS®System. Under a collaboration agreement with Gen-Probe, we market and sell thePROCLEIX*®* HIV-1/ HCVAssay, the PROCLEIX ULTRIOTM Assay and the related instrument system. Inaddition to selling directly in the U.S., we also sell in various internationalmarkets, directly and through distributors. We record revenue based upon thereported results obtained from the customer from the use of assays to screendonations or upon sale and delivery of the assays, depending on the underlyingcontract. In the case of equipment sales or leases, we record revenue upon thesale and transfer of the title of the instrument or ratably over the life ofthe lease term, respectively. For provision of service on the instruments, werecognize revenue ratably over the life of the service agreement.

The increase in product sales for the three monthsended March 31, 2005 as compared with the three months ended March 31,2004 was primarily due to $3.9 million from price increases from theconversion to the PROCLEIX® ULTRIOTM HIV-1/HCV/HBV Assay from thePROCLEIX® HIV-1/HCV Assay and continued penetration into severalmarkets abroad. This increase was offset by a decline of $1.3 million fromthe U.S. market primarily due to decreased donations resulting in lower salesin the U.S. of the PROCLEIX® HIV-1/HCV Assay.

**Revenue from joint businessarrangement  **The increase in revenue from joint businessarrangement for the three months ended March 31, 2005 as compared with thethree months ended March 31, 2004 was primarily due to (i) $8.5 millionfrom an increase in profitability from Ortho-Clinical Diagnostics’ foreignaffiliates and (ii) $1.2 million from an increase in royalties. Theseincreases were partially offset by $4.0 million lower profits fromOrtho-Clinical Diagnostics’ U.S. operations.

**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 

25

----

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  **Ourblood-testing segment earns royalties from third parties based on their salesof immunodiagnostic and nucleic acid testing probe diagnostic productsutilizing our hepatitis C virus (HCV) and HIV-related (HIV) patents, for use inthe blood screening and plasma fractionation markets. Our blood-testing segmentalso earns license fees related to our HCV and HIV patents for technologiesused by third parties to develop products for use in the blood screening andplasma fractionation markets. The increase in royalty and license fee revenuesfor the three months ended March 31, 2005 as compared with the threemonths ended March 31, 2004 was primarily due to (i) $5.3 millionfrom the Roche settlement reached in September 2004 as discussed belowunder “Other—Royalty and license fee revenues—Roche Settlement”, (ii) $2.0million for the remainder of the fee under our licensing agreement reached in2004 with Laboratory Corporation of America Holdings (LabCorp) for our HCVintellectual property for nucleic acid testing (NAT) and (iii) $0.7 millionin royalty fees from the blood transfusion centers of the German Red Cross.

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 licensee commercializes a productusing our technology. However, we have no assurance that the licensee will meettheir development objectives or commercialize a product using our technology.In addition, our ability to generate additional royalty and license fee revenuesmay depend, in part, on our ability to market and capitalize on ourtechnologies.

**Gross profit margin  **Grossprofit margin was consistent for the three months ended March 31, 2005 ascompared with the three months ended March 31, 2004.

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

**Research and development  **Theincrease in research and development expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to $2.6 million for research activities focused primarily on variantCreutzfeldt-Jakob disease (vCJD).

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  **Theincrease in selling, general and administrative expenses for the three monthsended March 31, 2005 as compared with the three months ended March 31,2004 was primarily due to (i) $1.7 million from the geographicexpansion of our customer base for the PROCLEIX® HIV-1/HCV Assayparticularly in Latin America and Asia markets and (ii) $0.7 millionfor the increase in technical training.

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

26

----

***Vaccines***
| ** **                                    | ** ** | **Three Months Ended March 31,**          | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**                                                      | ** ** | **2004**          | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **                                    | ** ** | **($ in 000’s, except percentages)** | ** ** |
| Product sales, net:                           |       |                                                          |       |              |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Influenza  vaccines:                          |       |                                                          |       |              |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| Other Influenza vaccines                      |       |                                                          | $          | 3,571             |       |                  |       | $ | 5,260 |   |   |   | $ | (1,689 | ) |   |   | (32.1 | )% |   |
| FLUVIRIN vaccine                              |       |                                                          | —     |              |       |                  | 2,445      |   |   |   | (2,445 | ) |   |   | (100.0 | )% |   |
| Influenza vaccines                            |       |                                                          | 3,571      |              |       |                  | 7,705      |   |   |   | (4,134 | ) |   |   | (53.7 | )% |   |
| Meningococcus vaccines                        |       |                                                          | 9,153      |              |       |                  | 4,549      |   |   |   | 4,604 |   |   |   | 101.2 | % |   |
| Travel vaccines                               |       |                                                          | 43,759     |              |       |                  | 23,010     |   |   |   | 20,749 |   |   |   | 90.2 | % |   |
| Pediatric and other vaccines                  |       |                                                          | 30,493     |              |       |                  | 51,182     |   |   |   | (20,689 | ) |   |   | (40.4 | )% |   |
|                                          |       |                                                          | 86,976     |              |       |                  | 86,446     |   |   |   | 530 |   |   |   | 0.6 | % |   |
| Collaborative  agreement revenues             |       |                                                          | 2,242      |              |       |                  | 3,966      |   |   |   | (1,724 | ) |   |   | (43.5 | )% |   |
| Royalty and  license fee revenues             |       |                                                          | 1,416      |              |       |                  | 2,650      |   |   |   | (1,234 | ) |   |   | (46.6 | )% |   |
| Other revenues                                |       |                                                          | 3,276      |              |       |                  | 3,643      |   |   |   | (367 | ) |   |   | (10.1 | )% |   |
| Total vaccines  revenues                      |       |                                                          | $          | 93,910            |       |                  |       | $ | 96,705 |   |   |   | $ | (2,795 | ) |   |   | (2.9 | )% |   |
| Gross profit margin                           |       |                                                          | (3         | )%                |       |                  | 33         | % |   |   |   |   |   |   |   |   |   |
| Research and development expenses             |       |                                                          | $          | 33,556            |       |                  |       | $ | 34,409 |   |   |   | $ | (853 | ) |   |   | (2.5 | )% |   |
| Selling, general  and administrative expenses |       |                                                          | $          | 39,462            |       |                  |       | $ | 39,003 |   |   |   | $ | 459 |   |   |   | 1.2 | % |   |
| Amortization expense                          |       |                                                          | $          | 14,999            |       |                  |       | $ | 15,084 |   |   |   | $ | (85 | ) |   |   | (0.6 | )% |   |

 

**Product sales  **Wesell influenza, meningococcal, travel, pediatric and other vaccines in theU.S., Germany, Italy, and the United Kingdom, as well as in other internationalmarkets.

*Influenza vaccines  *Asdescribed above under “FLUVIRIN® Influenza Virus Vaccine RecentEvents,” as a result of recent developments with respect to FLUVIRIN vaccine,we had no FLUVIRIN vaccine sales in the three months ended March 31, 2005.Sales of FLUVIRIN influenza vaccine were $2.4 million for the three monthsended March 31, 2004 from the 2003-2004 influenza season. Our otherinfluenza vaccines decreased by $1.7 million due to lack of sales for thesouthern hemisphere.

*Meningococcus vaccines  *Theincrease in meningococcus vaccines sales for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to (i) $4.8 million of MENZBTM meningococcal B vaccine sales to theMinistry of Health in New Zealand and (ii) $1.8 million increase intender sales of MENJUGATE® meningococcus C conjugate vaccine toCanada. This increase is partially offset by (i) a $1.2 million decline inMENJUGATE® vaccine tender sales in Australia and (ii) $0.8million from a decline in MENJUGATE® vaccine sales to othercountries.

*Travel vaccines  *Theincrease in travel vaccines sales for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to (i) $12.0 million increase in tick-borne encephalitis (TBE)vaccine sales in the first quarter of 2005; sales in the first quarter of 2004were lower due to $15.1 million of sales in the fourth quarter of 2003; TBEvaccines are typically sold in the first half of the year, (ii) $7.9 millionfrom increased demand for our rabies vaccines in the U.S., primarily due to aproduct recall from a competitor, and increased sales to Canada and (iii) $3.7million from increased demand for our rabies vaccines in Asia. These increaseswere offset by a decline of $3.0 million in sales of Dukoral vaccine due to thedivestiture in the second quarter of 2004 of certain vaccines operations inSweden acquired in our acquisition of PowderJect.

*Pediatric and other vaccines  *Salesof our pediatric and other vaccines decreased for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 primarily dueto (i) $8.7 million decline in Polio vaccine sales due to a lack ofproduct availability as a result of 

27

----

manufacturing upgradesthat have delayed manufacturing, (ii) $5.3 million decline due to the planneddivestiture of certain vaccines operations in Sweden in the second quarter of2004 acquired from our acquisition of PowderJect and (iii) $2.3 milliondecline in measles, mumps and rubella vaccines sales due to a lack of productavailability as a result of manufacturing upgrades that have delayedmanufacturing.

Certain of our vaccine products are seasonal,particularly our influenza vaccines, which have higher sales primarily in thesecond half of the year. Our tick-borne encephalitis vaccine is also seasonalwith higher sales typically in the first half of the year. Certain of ourvaccines require regulatory approval for production or sale of the product andsales may fluctuate depending on these regulatory approvals. We expectincreased competition for our influenza vaccines business in the future as aresult of the recent FLUVIRIN vaccine developments. For more information onthis, see “—FLUVIRIN® Influenza Virus Vaccine Recent Events” above.In addition, we expect MENJUGATE® meningococcus C conjugate vaccinesales to continue to fluctuate as public health authorities consider adoptionof broad vaccination programs and competitive pressures continue to increase.

**Collaborative agreement revenues  **Werecognize collaborative agreement revenues for fees received as we performresearch services and achieve specified milestones. Collaborative agreementrevenues for the three months ended March 31, 2005 as compared with thethree months ended March 31, 2004 decreased primarily due to $1.0 millionin lower milestone payments related to an agreement to supply MENZBTMmeningococcal B vaccine to the Ministry of Health in New Zealand.

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 thenature of our collaborative agreement revenues, results in any one period arenot necessarily indicative of results to be achieved in the future. Inaddition, the collaboration agreements typically provide for certain milestonepayments and various royalties on future product sales if the collaborativepartners commercialize 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  **Ourvaccines segment earns royalties on third party sales of, and license fees on,several products.

*GlaxoSmithKline  *Anagreement with GlaxoSmithKline plc provides for royalties on sales of certainvaccine products. Under this agreement, royalties were $0.9 million and$1.9 million for the three months ended March 31, 2005 and 2004,respectively. This decrease was primarily due to lower sales and royalty rates.

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

**Other revenues**

Other revenues recognized in our vaccines segment didnot fluctuate significantly for the three months ended March 31, 2005 ascompared with the three months ended March 31, 2004. Other revenues 

28

----

recognized in our vaccinessegment primarily consist of grant revenues and contract manufacturing revenuesand may fluctuate due to the nature of the revenues recognized and the timingof events giving rise to these revenues.

**Gross profit margin  **Grossprofit margin decreased for the three months ended March 31, 2005 ascompared with the three months ended March 31, 2004 primarily due to $16.0million of FLUVIRIN vaccine remediation costs charged to cost of sales and$13.0 million increase in idle facility costs charged to cost of sales as ourLiverpool facility was not in FLUVIRIN vaccine production during the firstquarter of 2005 due to FLUVIRIN vaccine remediation activities.

Vaccines gross profit margin does not includeamortization expense of intangible assets from acquired developed productsrelated to business combinations. Such amortization expense is included in thecaption “amortization expense of intangible assets acquired in businesscombinations and asset purchases”.

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  **Thedecrease in research and development expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to the second quarter 2004 divestiture of certain research and developmentoperations, acquired in the acquisition of PowderJect. The divested operationsincluded $4.2 million in research and development expenses for the three monthsended March 31, 2004. This decrease was partially offset by an increase of$1.7 million from our flu cell culture development program.

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 in selling,general and administrative expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was due to (i) anadditional $2.3 million from the establishment of sales and marketingoperations in the U.S., (ii) $1.7 million for executive severance and(iii) $2.0 million due to the movement in the Euro and British pound toU.S. Dollar exchange rate. These increases were partially offset by a reductionof $2.0 million as a result of the planned divestiture of certainPowderJect operations in the second quarter 2004 and (iii) $1.5 millionfrom the recovery of bad debt.

29

----

***Biopharmaceuticals***
| ** **                                    | ** ** | **Three Months Ended March 31,**          | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**                                                      | ** ** | **2004**          | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **                                    | ** ** | **($ in 000’s, except percentages)** | ** ** |
| Product sales, net:                           |       |                                                          |       |              |       |                  |       |   |   |   |   |   |   |   |   |   |   |
| BETASERON® interferon beta-1b            |       |                                                          | $          | 26,634            |       |                  |       | $ | 30,136 |   |   |   | $ | (3,502 | ) |   |   | (11.6 | )% |   |
| TOBI® tobramycin                         |       |                                                          | 52,935     |              |       |                  | 52,524     |   |   |   | 411 |   |   |   | 0.8 | % |   |
| PROLEUKIN® aldesleukin                   |       |                                                          | 29,535     |              |       |                  | 31,868     |   |   |   | (2,333 | ) |   |   | (7.3 | )% |   |
| Other                                         |       |                                                          | 10,190     |              |       |                  | 11,972     |   |   |   | (1,782 | ) |   |   | (14.9 | )% |   |
|                                          |       |                                                          | 119,294    |              |       |                  | 126,500    |   |   |   | (7,206 | ) |   |   | (5.7 | )% |   |
| Collaborative  agreement revenues             |       |                                                          | 403        |              |       |                  | 485        |   |   |   | (82 | ) |   |   | (16.9 | )% |   |
| Royalty and  license fee revenues             |       |                                                          | 18,626     |              |       |                  | 17,297     |   |   |   | 1,329 |   |   |   | 7.7 | % |   |
| Other revenues                                |       |                                                          | 6,195      |              |       |                  | 3,100      |   |   |   | 3,095 |   |   |   | 99.8 | % |   |
| Total  biopharmaceutical revenues             |       |                                                          | $          | 144,518           |       |                  |       | $ | 147,382 |   |   |   | $ | (2,864 | ) |   |   | (1.9 | )% |   |
| Gross profit margin                           |       |                                                          | 72         | %                 |       |                  | 76         | % |   |   |   |   |   |   |   |   |   |
| Research and development expenses             |       |                                                          | $          | 67,729            |       |                  |       | $ | 58,567 |   |   |   | $ | 9,162 |   |   |   | 15.6 | % |   |
| Selling, general  and administrative expenses |       |                                                          | $          | 37,897            |       |                  |       | $ | 31,926 |   |   |   | $ | 5,971 |   |   |   | 18.7 | % |   |
| Amortization expense                          |       |                                                          | $          | 6,264             |       |                  |       | $ | 6,248 |   |   |   | $ | 16 |   |   |   | 0.3 | % |   |

 

**Product sales  **Biopharmaceuticalproduct sales in 2005 and 2004 consisted principally of BETASERON®interferon beta-1b, TOBI® tobramycin and PROLEUKIN®aldesleukin products.

*BETASERON®interferon beta-1b  *We manufacture interferon beta-1b,which is marketed by Schering AG and its affiliates, including BerlexLaboratories, Inc. (collectively, Schering), under the trade namesBETASERON® (in the U.S and other non-European markets) and BETAFERON®(in Europe). Boehringer Ingelheim also supplies BETAFERON® interferonbeta-1b to Schering for sale in Europe. For product we manufacture, werecognize a portion of revenue for product sales upon shipment to Schering andthe remainder based on a contractual percentage of sales by Schering, both ofwhich we record as product sales. For product manufactured by BoehringerIngelheim and marketed by Schering in Europe under the trade name BETAFERON®,we receive royalties calculated at the same percentage of sales less the amountpaid or incurred by Schering for supply costs, which we record in royalty andlicense fee revenues.

The decrease in BETASERON®product sales for the three months ended March 31, 2005 as compared withthe three months ended March 31, 2004 primarily related to (i) $3.6 millionfrom reduced shipments to Berlex and (ii) $1.0 million from inventoryordering patterns. These decreases were partially offset by (i) $0.6million from price increases and (ii) $0.6 million from the change inforeign exchange rates.

*TOBI®tobramycin solution for inhalation  *We sell TOBI®solution directly in the U.S. and certain international markets. The increasein sales for the three months ended March 31, 2005 as compared with thethree months ended March 31, 2004 was primarily due to (i) $2.9 milliondue to price increases, (ii) $1.3 million due to increased patientdemand in the U.S. and (iii) $0.8 million due to the benefit of themovement in the Euro to U.S. Dollar exchange rate. These increases werepartially offset by $4.6 million reduction due to wholesaler orderingpatterns.

*PROLEUKIN®(aldesleukin)  *The decrease in sales for PROLEUKIN(aldesleukin) for the three months ended March 31, 2005 as compared withthe three months ended March 31, 2004 was primarily due to (i) $1.9million due to a decrease in patient demand as a result of increased competitionand (ii) $1.2 million for wholesaler inventory ordering patterns. Thesedecreases were partially offset by (i) $0.8 million for price increasesand (ii) $0.4 million due to the benefit of the movement in the Euro toU.S. Dollar exchange rate.

30

----

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  **Werecognize collaborative agreement revenues for fees received as we performresearch services and achieve specified milestones.

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 thenature of our collaborative agreement revenues, results in any one period arenot necessarily indicative of results to be achieved in the future. Inaddition, the collaboration agreements typically provide for certain milestonepayments and various royalties on future product sales if the collaborativepartners commercialize a product using our technology. Also, our ability togenerate additional collaborative agreement revenues may depend, in part, onour ability to initiate and maintain relationships with potential and currentcollaborative partners.

**Royalty and license fee revenues  **Ourbiopharmaceuticals segment earns royalties on third party sales of severalproducts, including BETAFERON® interferon beta-1b and recombinantinsulin and glucagon products. Our biopharmaceuticals segment also earnslicense fees for technologies, such as hepatitis C virus-related patents, usedby third parties to develop therapeutic products.

*BETAFERON® interferonbeta-1b  *BETAFERON product royalties were $15.5 millionand $13.8 million for the three months ended March 31, 2005 and 2004,respectively.

The increase in BETAFERON® productroyalties for the three months ended March 31, 2005 as compared with thethree months ended March 31, 2004 was primarily due to (i) $0.8million due to favorable movement in the Euro to U.S. Dollar exchange rate, (ii) $0.4million from price increases and (iii) $0.2 million from an increase indemand.

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

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

**Other revenues**

*Contract manufacturing revenues  *Ourbiopharmaceuticals segment recognized contract manufacturing revenues of $6.1million and $2.8 million for the three months ended March 31, 2005and 2004, respectively. The fluctuation resulted from the timing of contractmanufacturing activities.

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. There can be no assurance thatwe will be successful in obtaining additional revenues or that these revenueswill not decline.

31

----

**Gross profit margin  **Thedecrease in gross profit margin for the three months ended March 31, 2005as compared with the three months ended March 31, 2004 was primarily dueto a planned increase in idle time for manufacturing facilities.

Biopharmaceutical gross profit margin does not includeamortization expense of intangible assets from acquired developed productsrelated to business combinations. Such amortization expense is included in thecaption “amortization expense of intangible assets acquired in businesscombinations and asset purchases”.

Biopharmaceutical gross profit margin may fluctuatesignificantly in future periods due to production yields, increased cost toproduce the BETASERON® pre-filled diluent syringe and as thebiopharmaceutical product and customer mix changes.

**Research and development expense  **Theincrease in research and development expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to (i) $3.4 million increase in expense related to the development ofnew processes and performance of test runs related to installed equipment ofour existing manufacturing facilities to support the supply of BETAFERON®interferon beta-1b to Schering, (ii) $2.5 million for developmentactivities related to CUBICIN® (daptomycin for injection) fortreatment of complicated skin and soft tissue infections, (iii) $2.1million for activities related to the development of tifacogin, (iv) $1.9million for the progression of phase 1 clinical studies of our oncologycompound CHIR-258 and (v) $3.5 million for research and early stagedevelopment activities, primarily related to oncology compounds. Theseincreases are partially offset by (i) a $2.3 million decrease related tothe discontinued development of tezacitabine in the first quarter of 2004 basedon an analysis of the data from a Phase II trial in patients with gastro esophagealcancer and (ii) $1.9 million decrease in expenses related to the SILCAATtrial.

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 expense  **The increase inselling, general and administrative expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to (i) $1.9 million of pre-launch costs for CUBICIN (daptomycinfor injection), (ii) $1.4 million for increased TOBI sales and marketingactivities, (iii) $0.9 million of pre-launch costs for PULMINIQTM(cyclosporine, USP) inhalation solution, (iv) $1.0 million for increasedmarketing and medical activities in Europe and other international markets and (v) $0.4million due to movement in the Euro to U.S. Dollar exchange rate.

**Other**

Weview certain other revenues and expenses, particularly certain royalty andlicense fee revenues primarily related to HIV and HCV-related patents, and unallocatedcorporate expenses, as not belonging to any one reportable segment. As aresult, we have aggregated these items into an “Other” segment.
| ** **                                    | ** ** | **Three Months Ended March 31,**          | ** ** | **$ Change** | ** ** | **% Change**     | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **2005**                                                      | ** ** | **2004**          | ** ** | **Three Months** | ** ** | **Three Months** | ** ** |
| ** **                                    | ** ** | **($ in 000’s, except percentages)** | ** ** |
| Royalty and  license fee revenues             |       |                                                          | $          | 34,815            |       |                  |       | $ | 18,411 |   |   |   | $ | 16,404 |   |   |   | 89.1 | % |   |
| Selling, general  and administrative expenses |       |                                                          | 42,774     |              |       |                  | 24,554     |   |   |   | 18,220 |   |   |   | 74.2 | % |   |
| Interest expense                              |       |                                                          | 7,079      |              |       |                  | 5,925      |   |   |   | 1,154 |   |   |   | 19.5 | % |   |
| Interest and other  income, net               |       |                                                          | 21,447     |              |       |                  | 16,074     |   |   |   | 5,373 |   |   |   | 33.4 | % |   |

 

**Royalty and license fee revenues  **Ourother segment earns royalties on third party sales of, and license fees on,several products. The majority of royalty and license fee revenues related tothe use of our HCV and HIV-related patents for diagnostic testing purposes byvarious third parties.

32

----

*Roche settlement  *InOctober 2000, we entered into three license agreements with Roche andseveral of its affiliated companies related to the settlement of certainlitigation in the U.S. and certain other countries for use of our HCV and HIVnucleic acid testing intellectual property. Two agreements relate to *in vitro* diagnostics products. The thirdagreement relates to blood screening.

Under the hepatitis C virus agreement, we received$85.0 million, of which we recognized $40.0 million in the fourth quarter2000. We deferred the remaining $45.0 million, which becomes nonrefundableratably through 2005. In the first quarter 2001, we began recognizing portionsof the $45.0 million based upon the greater of (i) the scheduledquarterly minimum non-refundable amount or (ii) the actual earned creditsas royalties on future sales related to Roche’s use of our HCV-related patentin its *in vitro* diagnosticproducts. The agreement also provides for royalties on future sales related toRoche’s use of our HCV-related patent in its *invitro* diagnostic products, which commenced in the first quarter2001. Royalty revenues under the hepatitis C virus agreement increased for thethree months ended March 31, 2005 as compared with the three months ended March 31,2004, by $1.8 million and 15.2%.

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 of TechnicalAppeals upheld our HIV-related patent. Royalty revenues recognized under thisagreement increased by $11.1 million for the three months ended March 31,2005 as compared with the three months ended March 31, 2004. This increaseis mainly due to a settlement agreement with Roche, described in more detailbelow, under which we recognized revenues for a portion of a nonrefundableroyalty payment.

An HIV-related patent directed to nucleic acid testingmethods 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 ofits licensing 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, during thethird quarter 2004, we recognized $10.0 million in license fees and$21.8 million in royalties up until June 30, 2004, which hadpreviously been deferred, of which $16.3 million has been recognized asrevenue in our other segment and $5.5 million has been recognized asrevenue in our blood testing segment. During the third quarter 2004, we alsorecognized $0.8 million in interest on the license fee. Also under thesettlement agreement, in the first quarter of 2005, we received 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 incrementsover the quarters of 2005 and 2006. As such, Chiron expects to recognize$64.0 million of the payment as revenue over 2005 and 2006. The remaining$14.0 million is nonrefundable and was recognized as revenue in the thirdquarter 2004, of which, $9.3 million has been recognized as revenue in ourother segment and $4.7 million has been recognized as revenue in ourblood-testing segment. Currently, the applicable issued HCV-related patentsexpire in 2015 for the U.S. and in 2010 for Europe. Currently, the applicableissued HIV-related patent in Europe expires in 2005. For the three months endedMarch 31, 2005, we recognized $10.7 million of revenue for this settlementin our other segment and $5.3 million of revenue for this settlement in ourblood-testing segment. Revenues earned from diagnostic products are included inour other segment and revenues earned from blood screening are included in ourblood-testing segment.

33

----

*Bayer  *Across-license agreement provides for royalties to us on HIV and hepatitis Cvirus products sold by Bayer Corporation. Royalties increased for the threemonths ended March 31, 2005 as compared with the three months ended March 31,2004 due to a fee of $1.8 million for a license agreement in the first quarterof 2005.

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

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

**Selling,general, and administrative  **The increase in selling,general and administrative expenses for the three months ended March 31,2005 as compared with the three months ended March 31, 2004 was primarilydue to (i) $10.0 million of legal costs associated with the FLUVIRINvaccine-related developments discussed above under “FLUVIRIN®Influenza Virus Vaccine Recent Events”, (ii) $3.7 million in employee relatedexpenses, (iii) $2.2 million in consulting expenses and (iv) $1.6million for corporate governance costs. These increases were offset by lowerfacility and depreciation expenses of $3.2 million.

**Interest expense  **Theincrease in interest expense for the three months ended March 31, 2005 ascompared with the three months ended March 31, 2004 primarily related tointerest expense recognized on the $385.0 million convertible debenturesthat were issued on June 22, 2004 partially offset by the interest expenserecognized on the Liquid Yield Option Notes (LYONs), which were put to us in June 2004.The $385.0 million convertible debentures incur interest at a higher rate thanthe LYONs.

**Interestand other income, net  **Interest and other income, net,primarily consisted of interest income on our cash and investment balances andother non-operating gains and losses. We recognized interest income of $7.2million and $5.1 million for the three months ended March 31, 2005and 2004, respectively. The increase is due to higher interest rates in thefirst quarter 2005 as compared with the first quarter 2004.

We recognized gains of$14.5 million and $9.7 million for the three months ended March 31,2005 and 2004, respectively, related to the sale of certain equity securities.The increase is due to the expiration of certain equity forward contracts.

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

**Income taxes  **Theeffective tax rate for the three months ended March 31, 2005 and 2004 was25% of pretax income (loss) from continuing operations. The effective tax ratemay be affected in future periods by changes in management’s estimates withrespect to our deferred tax assets and other items affecting the overall taxrate.

**Discontinuedoperations  **In a strategic effort to focus on our corebusinesses of blood-testing, vaccines and biopharmaceuticals, we completed thesale of Chiron Diagnostics to Bayer in 1998.

Chiron and BayerCorporation, or Bayer, were involved in a dispute with respect to theirrespective rights to certain royalty refunds receivable for which a settlementwas reached in 2004. Under this settlement agreement, we made a settlementpayment to Bayer in 2004. This settlement includes an agreement that alloutstanding items with Bayer related to the sale of Chiron Diagnostics areresolved and no future indemnity obligations are required. We releasedpreviously established reserves deemed to be in 

34

----

excessfollowing this settlement. This settlement resulted in a net gain of$12.8 million for the three months ended March 31, 2004. This netgain primarily relates to a tax benefit as a result of the settlement paymentto Bayer.

**New Accounting Pronouncements**

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 123 (revised 2004),*Share-Based Payment* (SFAS 123(R)), which requires the costresulting from all share-based payment transactions to be recognized in theconsolidated financial statements. That cost will be measured based on the fairvalue of the equity instruments issued or on the fair value of liabilitiesincurred. Under SFAS 123(R), the fair-value-based method for recognition ordisclosure of compensation expense will be applied using the modifiedprospective application transition method or the modified retrospectiveapplication transition method. We currently measure compensation expense forour stock-based employee compensation under the intrinsic method. We arecurrently evaluating transition methods, option valuation methodologies andassumptions in light of SFAS 123(R), and therefore cannot estimate the impactof our adoption at this time, although we expect that its adoption will have amaterial impact on our consolidated financial statements. Current option valuesdetermined using the Black-Scholes-Merton formula, used for purposes of proformadisclosure, may not be indicative of results from the valuation methodologieswe finally adopt. The effective date of SFAS 123(R) is the first reportingperiod beginning after June 15, 2005. However, on April 14, 2005, theSecurities and Exchange Commission (SEC) announced the adoption of a new rule thatamends the compliance date of SFAS 123(R). The SEC’s new rule allowscalendar year companies to implement SFAS 123(R) at the beginning of 2006,which makes SFAS 123(R) effective for Chiron in the first quarter of 2006.

On October 22, 2004,the American Jobs Creation Act of 2004 (the Act) was signed into law. The Actincludes a temporary incentive for U.S. multinationals to repatriateaccumulated income earned outside the U.S. at an effective tax rate of 5.25%.On December 21, 2004, the FASB issued Staff Position 109-2,*Accounting and Disclosure Guidance for the ForeignEarnings Repatriation Provisions within the American Jobs Creation Act of 2004(*FSP 109-2*).*FSP 109-2 allows companies additional time to evaluate the effect ofthe law on whether unrepatriated foreign earnings continue to qualify forSFAS No. 109’s exception to recognizing deferred tax liabilities andwould require explanatory disclosures from those who need the additional time.Through March 31, 2005, we have not provided deferred taxes on foreignearnings because such earnings were intended to be indefinitely reinvestedoutside the U.S. Whether we will ultimately take advantage of this provisiondepends on a number of factors including reviewing future Congressional andregulatory guidance before a decision can be made. Until that time, we willmake no change in our current intention to indefinitely reinvest accumulatedearnings of our foreign subsidiaries. If we repatriate these earnings, aone-time tax charge to our consolidated results of operations could occur. Wewill continue to evaluate the impact of this provision in 2005.

**Liquidity and Capital Resources**

Our capital requirements have generally been funded bycash 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 $1,032.3 millionat March 31, 2005, are invested in a diversified portfolio of fixed incomesecurities, including money market instruments, corporate notes and bonds, andgovernment agency securities issued by financial institutions and other issuerswith strong credit ratings. By policy, the amount of credit exposure to any oneinstitution is limited. Investments are generally not collateralized andprimarily mature within three years.

The recent events regarding FLUVIRIN vaccine, asdiscussed above, will continue to impact our cash flow going forward. As wecontinue to implement our remediation plan, our efforts will entail additionalcash payments, which will be material. The MHRA’s lifting of our licensesuspension is conditioned upon the understanding that our commitment toremediation will continue.

35

----

In addition, we haveincurred and expect to continue to incur substantial expense relating to theinvestigation by the U.S. Attorney’s Office for the Southern District of NewYork, the Securities and Exchange Commission formal investigation and theshareholder class action and derivative private lawsuits and other claimsarising out of or related to these developments regarding FLUVIRIN vaccine. Theresults of any such investigations, proceedings or disputes could have amaterial adverse effect on our cash flow.

Furthermore, our inabilityto supply FLUVIRIN vaccine for the 2004-2005 season may also lead to lossof market share because competitors have announced plans to introduce influenzavaccine products in the United States during the 2005-2006 season and areseeking expedited regulatory approval to do so. Even though the licensesuspension has been lifted, some of our customers may choose to purchase fluvaccine from other providers as their products become available in the UnitedStates. Loss of market share could have a material adverse effect on cash flow.

For additional informationconcerning the risks we face as a result of these FLUVIRIN vaccinedevelopments, see “Factors That May Affect Future Results—The recentdevelopments with respect to FLUVIRIN® vaccine will harm ourbusiness and results of operations.” For additional information on the U.S.Attorney’s investigation, SEC investigation, private lawsuits and other claimsarising out of or relating to the developments regarding FLUVIRIN, see Part II,Item 1. “Legal Proceedings” of this Report on Form 10-Q.

Underthe terms of the Investment Agreement between Novartis and Chiron, Novartisagreed to guarantee certain Chiron obligations up to a maximum of $702.5million. Under this agreement, Novartis has guaranteed $100.0 million under aU.S. credit facility in which there were no borrowings outstanding at March 31,2005 and $173.3 million from a lease commitment for a research and developmentfacility in Emeryville, California.

We believe that our cash,cash equivalents and marketable debt securities, together with funds providedby operations and borrowing and leasing arrangements, will be sufficient tomeet our foreseeable operating cash requirements including any cash needed forremediation efforts for our Liverpool plant, cash utilized for our stockrepurchase program and our current contractual obligations. In addition, webelieve we could access additional funds from the debt and capital marketsshould the need arise. As noted above, if we suffer a permanent loss ofFLUVIRIN influenza vaccine sales, whether through loss of regulatory approvals,market share or otherwise, it would have a material adverse effect on our cashflow.

**Sourcesand uses of cash  **We had cash and cash equivalents of$198.8 million and $259.1 million at March 31, 2005 and 2004,respectively.

*Operatingactivities  *For the three months ended March 31,2005, net cash provided by operating activities was $57.2 million ascompared with $11.1 million for the three months ended March 31,2004. The increase in cash provided by operating activities was primarily dueto (i) $78.0 million lump-sum payment received in lieu of royaltiesbeyond January 1, 2005 as part of the Roche settlement reached on September 10,2004. This increase was partially offset by costs associated with ourremediation efforts for our Liverpool plant and legal costs related to theFLUVIRIN vaccine developments discussed above.

*Investingactivities  *For the three months ended March 31,2005, net cash used in investing activities consisted of purchases ofinvestments in marketable debt securities of $321.6 million, capitalexpenditures of $48.4 million, other uses of cash of $1.8 million,purchases of equity securities and interests in affiliated companies of$1.6 million and cash paid for acquisitions net of cash acquired of$1.3 million. Included in net cash paid for acquisitions was$1.1 million for previously accrued costs in connection with acquisitioncosts related to the acquisition of PowderJect and $0.2 million of cashpaid for the acquisition of Sagres. Cash used in investing activities wasoffset by proceeds from maturities of investments in marketable debt securitiesof $249.7 million, proceeds from sales of investments in marketable debtsecurities of $37.5 million, and proceeds from the sale of equitysecurities and interests in affiliated companies of $8.3 million.

36

----

For the three months endedMarch 31, 2004, net cash used in investing activities consisted ofpurchases of investments in marketable debt securities of $202.9 million,capital expenditures of $44.6 million, purchases of equity securities andinterests in affiliated companies of $2.4 million, cash paid for direct PowderJectacquisition costs of $1.0 million and other uses of cash of$0.8 million. Cash used in investing activities was offset by proceedsfrom sales of investments in marketable debt securities of $30.6 million,proceeds from maturities of investments in marketable debt securities of $78.9million and proceeds from the sale of equity securities and interests inaffiliated companies of $3.5 million.

*Financingactivities  *For the three months ended March 31,2005, net cash provided by financing activities consisted of $10.0 millionof proceeds from the reissuance of treasury stock offset by $0.06 millionfor the repayment of debt and capital leases.

On March 10, 2005,the Board of Directors authorized Chiron to repurchase 5.0 million shares ofChiron common stock through December 31, 2005. From January 1, 2005 through March 31,2005, no shares were repurchased.

For the three months endedMarch 31, 2004 net cash provided by financing activities consisted of$35.6 million of proceeds from the reissuance of treasury stock and$1.0 million of proceeds from the issuance of debt. Cash provided byfinancing activities was offset by $8.5 million for the acquisition oftreasury stock, $0.08 million for the repayment of debt and capitalleases.

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

**Borrowingarrangements  **Under a revolving, committed,uncollateralized credit agreement with a major financial institution, we canborrow up to $100.0 million. This credit facility is guaranteed byNovartis AG under a November 1994 Investment Agreement, provides variousinterest rate options and matures in February 2006. There were noborrowings outstanding under this credit facility at March 31, 2005 and December 31,2004. In July 2003, we entered into a new six-year lease to rent aresearch and development facility in Emeryville, California. Under provisionsof the November 1994 Investment Agreement, Novartis AG guaranteed paymentson this lease commitment to a maximum of $173.3 million. In December 1999,Chiron and Novartis amended the November 1994 Investment Agreement to reducethe maximum amount of our obligations that Novartis would guarantee from$725.0 million to $702.5 million. Out of the maximum guarantee of$702.5 million, the credit agreement and lease discussed above have reduced theamount of our debt Novartis would be required to guarantee by $273.3 million.There remains $429.2 million of the guarantee available at March 31, 2005.The Novartis loan guarantee will expire on January 1, 2008 unless certaindebt ratings are triggered which would extend the guarantee on a decliningbasis ratably over the subsequent three-year period.

**Off-Balance Sheet Arrangements**

As of March 31, 2005,we did not have any off-balance sheet arrangements.

**Factors That May Affect Future Results**

As a globalbiopharmaceutical company, we are engaged in a rapidly evolving and oftenunpredictable business. The forward-looking statements contained in this Form 10-Qand in other periodic reports, press releases and other statements issued by usfrom time to time reflect our current beliefs and expectations concerningobjectives, plans, strategies, future performance and other future events. Thefollowing discussion highlights some of the factors, many of which are beyondour control, which could cause actual results to differ.

37

----

*The recentdevelopments with respect to FLUVIRIN® vaccine will harm ourbusiness and results of operations.*

During the third quarterof 2004, in conducting final internal release procedures for our FLUVIRINinfluenza virus vaccine, our quality systems identified lots that did not meetproduct sterility specifications. As a result, we determined at the time todelay releasing any FLUVIRIN vaccine doses pending completion of internalinvestigations. On October 5, 2004, the U.K. regulatory body, theMedicines and Healthcare products Regulatory Agency, or MHRA, sent us a letterprohibiting us from releasing any FLUVIRIN® influenza vaccine dosesmanufactured at our Liverpool facility since March 2, 2004 and suspendingour license to manufacture influenza virus vaccine in our Liverpool facilityfor three months (later extended for an additional three months). In thatletter, the MHRA asserted that our manufacturing process did not comply withU.K. good manufacturing practices regulations. Following the MHRA’s decisionand an inspection by the Food and Drug Administration, or FDA, the FDA sent usa warning letter on December 9, 2004 citing violations of goodmanufacturing practices. We provided the FDA with a written response to thewarning letter on January 7, 2005. In a subsequent letter to us, the FDAstated that our responses appear to be adequate, but that implementation andeffectiveness of our corrective actions and overall compliance would beevaluated in a subsequent inspection. As a result of the license suspension, wedid not release any FLUVIRIN product during the 2004-2005 influenzaseason.

On March 2, 2005, theMHRA notified us that it had lifted the license suspension, giving Chironclearance to initiate full production of FLUVIRIN vaccine, conditioned on theunderstanding that Chiron’s commitment to its remediation plan will continueand will be subject to further inspections by the MHRA. The FDA is stillexpected to conduct a full inspection to determine whether deficiencies notedin its warning letter have been resolved. If we fail to adequately address thematters discussed in the warning letter, the FDA may modify our U.S. license inan adverse manner, take action that could result in imposition of fines,require temporary or permanent cessation of future selling of FLUVIRIN vaccineor take other action that could reduce our ability to market FLUVIRIN vaccine.

We received a grand jurysubpoena issued by the U.S. Attorney’s Office for the Southern District of NewYork in October 2004 requesting production of certain documents relatingto FLUVIRIN vaccine and the suspension by the MHRA of our license. In February 2005,after having previously commenced an informal inquiry, the Securities andExchange Commission, or SEC, notified us that it would commence a formalinvestigation into whether we or our employees have violated any federalsecurities laws in connection with these developments regarding FLUVIRINvaccine, and in April 2005, we received a subpoena from the SEC requestingproduction of certain documents relating to our Liverpool facility and FLUVIRINvaccine. We also received a voluntary request for information from the UnitedStates House of Representatives Committee on Energy and Commerce requestingproduction of certain documents. Numerous documents have been collected andproduced in response to these requests, and several witnesses have been interviewedby the U.S. Attorney’s Office and the SEC staff and additional interviews areanticipated. Additional investigations regarding these matters may arise. Inaddition, we and certain of our officers and directors have also been named asdefendants in several putative shareholder class action and derivative lawsuitsalleging various claims arising out of or relating to these developmentsregarding FLUVIRIN vaccine, which are described below in Part II, Item 1, “LegalProceedings”. Certain parties with which we have contracted to supply FLUVIRINvaccine are considering claims against us as a result of our inability tosupply FLUVIRIN vaccine, and additional parties may do so in the future. On January 27,2005, the U.S. Centers for Disease Control and Prevention terminated itscontracts with Chiron for the supply of flu vaccine for default on the basis ofChiron’s failure to supply such vaccine to the U.S. government for the 2004-2005flu season. The CDC has reserved the right to hold Chiron liable for any excesscosts it may incur if it chooses to replace the flu vaccine that Chiron failedto deliver and further has reserved all other remedies provided under thecontract. Chiron maintains that its failure to deliver does not constitutedefault, because its reasons for non-performance fall within the “excusabledelay” provisions of contracts with the CDC. We have also receivedcommunications from certain distributors of 

38

----

FLUVIRINvaccine suggesting that they are entitled to compensation under their contractsfor the 2004-2005 season. It is not possible to predict whether any ofthese claims will be pursued and, if so, whether those claims will be upheld.Investigations, litigation and disputes have caused us to incur substantialexpense and have required significant time and attention from our managementand will continue to do so in the future and could result in civil actionand/or criminal penalties against Chiron. The results of any suchinvestigations, proceedings or disputes could have a material adverse effect onour consolidated financial position and results of operations and/or cash flow.From more information on these lawsuits, investigations and claims, see Part II,Item 1. “Legal Proceedings” below.

We did not release anyFLUVIRIN vaccine during the 2004-2005 influenza season. As a result, ourresults of operations for 2004 were materially adversely affected by thesematters. Additional issues with respect to FLUVIRIN vaccine could cause us tohave to recognize an impairment charge with respect to the goodwill, certainother intangible assets and the Liverpool plant resulting from the PowderJectacquisition and the new flu vaccines manufacturing facility under constructionin Liverpool, which could have a material adverse effect on our results ofoperations.

Our inability to supplyFLUVIRIN vaccine during the 2004-2005 influenza season may also lead toloss of market share in the 2005-2006 season and future seasons.Following the announcement of our license suspension, competitors announcedplans to introduce influenza vaccine products in the United States and areseeking expedited regulatory approval to do so. Even though the licensesuspension has been lifted, some of our customers may choose to purchase fluvaccine from other providers as their products become available in the UnitedStates. Loss of market share could have a material adverse effect on ourbusiness and results of operations.

Although the MHRA haslifted its suspension of our license to manufacture FLUVIRIN vaccine, we expectto incur additional expenses in connection with ongoing FLUVIRIN vaccinematters, which could be material, including in connection with (1) ourcontinuing remediation efforts at our Liverpool facility; and (2) respondingto the U.S. Attorney for the Southern District of New York, the SEC, the UnitedStates House of Representatives Committee on Energy and Commerce and theprivate lawsuits and other claims and investigations that may arise.

For additional informationon the U.S. Attorney’s investigation, SEC investigation, private lawsuits andother claims, see Part II, Item 1. “Legal Proceedings” of this report on Form 10-Q.

*If we fail toobtain or maintain the regulatory approvals we need to market our products orsubstantial changes in the regulatory environment occur, our business maysuffer.*

We must obtain andmaintain regulatory approval in order to market most of our products.Generally, these approvals are on a product-by-product and country-by-countrybasis. In the case of FLUVIRIN vaccine, the failure to obtain or maintain ourlicenses, or delays imposed by regulatory actions, could lead to the loss ofour entire inventory during any given season since each year’s vaccines aremanufactured to meet specific strains of flu. 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.

39

----

*If our focus on theresearch and development of emerging technologies does not result in thecreation of commercial products, our business could be harmed.*

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

*Our products arecomplex and difficult to manufacture on a large-scale basis, which could causeus to delay product launches, experience shortages of products or prevent usfrom offering products on a volume basis.*

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

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

*If we are unable tosuccessfully compete in the highly competitive healthcare industry, ourbusiness could be harmed.*

We operate in ahighly competitive environment, and the competition is expected to increase.Competitors include large pharmaceutical, chemical and blood testing companies,compounding 

40

----

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:

·       Thepossibility that the competitor may have launched its product first;

·       Thecompetitor may have greater access to certain raw materials;

·       Thecompetitor may have more efficient manufacturing processes;

·       Thecompetitor may adapt more quickly to technological change;

·       Thecompetitor may have greater marketing capabilities;

·       Thecompetitive product may have therapeutic or other advantages; or

·       Newcompetitors may enter into markets where we currently have significantcompetitive advantage.

The technologies appliedby our competitors and us are rapidly evolving, and new developments frequentlyresult in price competition and product obsolescence. In addition, we may beimpacted by competition from generic forms of our products, substitute productsor imports of products from lower priced markets.

*Conflicts with ordecisions by third parties we collaborate with could harm our business.*

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

*If any of our thirdparty suppliers or manufacturers cannot adequately meet our needs, our businesscould be harmed.*

We use raw materials and other supplies that generallyare 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 pending regulatory approval ofsuch alternate source. Although we work to mitigate the risks associated withrelying on sole suppliers, there is a possibility that material shortages couldimpact production.

41

----

We purchase bulk powdered tobramycin, the primarybasic raw material in TOBI® tobramycin, from two of the principalworldwide suppliers of the drug. We anticipate that either one of thesesuppliers alone will be able to supply sufficient quantities to meet currentneeds; however, there can be no assurance that these suppliers will be able tomeet future demand in a timely and cost-effective manner. As a result, ouroperations could be adversely affected by an interruption or reduction in thesupply of bulk powdered tobramycin.

We have entered into contracts with third parties forthe production and packaging of TOBI® tobramycin. Over time, we canuse alternative production and packaging sources. However, if the contractedthird parties become unable to produce or package sufficient quantities of TOBIsolution due to work stoppages or other factors, our operations could bedisrupted until alternative sources are secured.

We have entered into contracts with third parties forthe packaging of the pre-filled diluent syringe for BETASERON®interferon beta-1b. Over time, we can use alternative packaging sources.However, if the contracted third parties become unable to produce or packagesufficient quantities of the pre-filled diluent syringe for BETASERON®interferon beta-1b 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 haveagreed to make specified purchases from that supplier through 2009, subject toour right to terminate this agreement earlier upon payment of a terminationfee. 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 forthe blood screening field of nucleic acid testing and immunodiagnostics. Innucleic acid testing, we rely on our collaborative partner, Gen-Probe, tomanufacture the West Nile virus assay, currently in use on aninvestigational-use basis in the U.S. and the PROCLEIX® HIV-1/HCV and PROCLEIX® ULTRIOTM Assays. We currently source the relatedinstrument system from third party suppliers. Currently, Gen-Probe is the onlymanufacturer of nucleic acid testing products using Transcription-MediatedAmplification technology. 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/HCVand PROCLEIX® ULTRIOTM Assays or that we will be able to manufacturesufficient bulk reagents and antigens and confirmatory test kits forimmunodiagnostic products. Our difficulties or delays or those of our partners’could cause a public health concern for the blood supply, as well as increasecosts and cause loss of revenue or market share.

*If we cannot obtainnecessary licenses to third party patents for the manufacture or sale of ourproducts, we may have to withdraw from the market or delay the introduction ofthe affected product.*

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

42

----

patents,or we could find that the development, manufacture or sale of such products isforeclosed. We could also incur substantial costs in licensing or challengingthe validity and scope of these patents.

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

We may experiencedifficulties in launching new products, many of which are novel products basedon technologies that are unfamiliar to the healthcare community. We have noassurance that healthcare providers and patients will accept such products. Inaddition, government agencies, as well as private organizations involved in healthcare,from time to time publish guidelines or recommendations to healthcare providersand patients. Such guidelines or recommendations can be very influential andmay adversely 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 toavoid significant exposure to product liability claims, our business could beharmed.*

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 providerfor the blood screening field of nucleic acid testing and immunodiagnostics, wemay have product liability in addition to contract exposure in the event thatour difficulties or delays or those of our partners could cause a public healthconcern for the blood supply.

*If we marketproducts in a manner that violates state, federal or foreign laws that governpharmaceuticals and health care products, including FDA, FTC, and health carefraud and abuse laws, we may be subject to civil or criminal penalties,including the potential for exclusion from federal, state and foreign programs.*

The federal laws and regulations administered by theFDA and FTC place restrictions on the promotion of medical products. FDA lawand regulations prohibit the marketing and promotion of unapproved drug anddevice products and unapproved uses of approved drug and device products. FTCand FDA also place restrictions on the promotion of approved drugs and devicesto ensure that marketing material is not false or misleading. In addition tothese restrictions on the marketing of pharmaceutical products withoutregulatory approval, other types of state and federal health care fraud andabuse laws have been applied in recent years to restrict certain marketingpractices in the healthcare industry, and to otherwise determine theeligibility of pharmaceutical manufacturers to have their products reimbursedby Medicare, Medicaid, and other federal and state programs. These laws includeanti-kickback statutes, false claims statutes, and others. Likewise, variousforeign laws may restrict the manner in which healthcare products are marketedin other countries.

The federal anti-kickback statute prohibits, amongother things, knowingly offering, paying, soliciting, or receiving remunerationto induce or in return for purchasing, ordering, recommending, or arranging forthe purchase, order, or lease of any health care item reimbursable underMedicare, Medicaid, or other federally funded health care programs. Thisstatute has been interpreted broadly to apply to arrangements between drugmanufacturers on one hand and prescribers, purchasers, pharmacies, GPOs, andpharmacy benefit and formulary managers on the other, along with such indirectpurchasers as health plans. Although there are a number of statutory exemptionsand regulatory safe harbors protecting certain 

43

----

activities fromprosecution, the exemptions and safe harbors are drawn narrowly. Activitiesthat fall outside of a safe harbor are not necessarily illegal, but practicesthat involve direct or indirect remuneration intended to induce prescribing,purchasing, or recommending of products may be subject to governmental scrutinyif they do not qualify for an exemption or safe harbor. Our practices may notin all cases meet all of the criteria for safe harbor protection fromanti-kickback liability.

Federal false claims laws generally prohibit a personfrom knowingly presenting, or causing to be presented, a false claim forpayment to the federal government, or knowingly making, or causing to be made,a false statement to have a false claim paid. Recently, several pharmaceuticaland other health care companies have been subject to investigative andenforcement activity under these laws, including qui tam suits filed by “whistleblowers,”for a variety of  alleged inappropriatepromotional and marketing activities, such as providing free product to customerswith the expectation that the customers would bill federal programs for theproduct; engaging in “off-label” promotion that caused claims to be submittedto federal and state programs for non-covered off-label uses; and submittinginflated “best price” and otherwise incorrect pricing data for Medicaid rebatepurposes. In some cases, the manufacturers have been alleged to have aided andabetted in the submission of false claims.

In addition, state Attorneys General and private classaction plaintiffs have filed civil suits under the federal RICO statute and avariety of state consumer protection laws claiming that pharmaceuticalcompanies reported inflated average wholesale prices to pricing services usedby the federal programs to set reimbursement rates, and that as a result,Medicare beneficiaries, Medicaid programs and private payers overpaid for drugs.Still other manufacturers have been subject to enforcement activity for allegedviolations of such federal statutes as the Prescription Drug Marketing Act,involving pharmaceutical sampling practices. The majority of states also havestatutes or regulations similar to the federal anti-kickback law and falseclaims laws, which apply to items and services reimbursed under Medicaid andother state programs, or, in several states, apply regardless of the payor.

Sanctions under federal,state and foreign laws may include civil monetary penalties, exclusion of amanufacturer’s products from reimbursement under government programs, criminalfines, and imprisonment. Because of the breadth of these laws and thenarrowness of the safe harbors, it is possible that some of our businessactivities could be subject to challenge under one or more of such laws.

*Our mishandling ofhazardous materials could result in substantial costs and harm to our business.*

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

*Our patents may notprevent competition or generate revenues.*

We seek to obtain patentson many of our inventions. Without the protection of patents, competitors maybe able to use our inventions to manufacture and market competing productswithout being required to undertake the lengthy and expensive developmentefforts made by us and without having to pay royalties or otherwise compensateus for the use of the invention. We have no assurance that patents and patentapplications owned or licensed to us will provide substantial protection.Important legal questions remain to be resolved as to the extent and scope ofavailable patent protection for biotechnology products and processes in theU.S. and other important markets. We do not know how many of our pending patent

44

----

applicationswill be granted, or the effective coverage of those that are granted. In theU.S. and other important markets, the issuance of a patent is neitherconclusive as to its validity nor the enforceable scope of its claims. We haveengaged in significant litigation to determine the scope and validity ofcertain of our patents and expect to continue to do so. An adverse outcome oflitigation could result in the reduction or loss of royalty revenues. Engagingin patent litigation against one party may place significant royalty revenuesreceived or to be received from other parties at risk. Even if we aresuccessful in obtaining and defending patents, there can be no assurance thatthese patents will provide substantial protection. The length of time necessaryto resolve patent litigation successfully may allow infringers to gainsignificant market advantage. Third parties may be able to design around thepatents and develop competitive products that do not use the inventions coveredby our patents. Many countries, including certain countries in Europe, havecompulsory licensing laws under which a patent owner may be compelled to grantlicenses to third parties (for example, the third party’s product is needed tomeet a threat to public health or safety in that country, or the patent ownerhas failed to “work” the invention in that country, or the third party haspatented improvements). In addition, most countries limit the enforceability ofpatents against government agencies or government contractors. In thesecountries, the patent owner may be limited to monetary relief and may be unableto enjoin infringement, which could materially diminish the value of thepatent. In addition, royalty revenues may decline as patents expire.

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

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

*If our efforts tointegrate acquired or licensed businesses or technologies into our business arenot successful, our business could be harmed.*

As part of ourbusiness strategy, we expect to continue to grow our business throughin-licensing, collaborations or acquisitions of products or companies. Thefailure to adequately address the financial, operational or legal risks raisedby such transactions could harm our business. Financial aspects related tothese transactions may alter our financial position, reported operating resultsor stock price, and include:

·       Useof cash resources;

·       Potentiallydilutive issuances of equity securities;

·       Theincurrence of debt and contingent liabilities, impairment losses orrestructuring charges;

·       Largewrite-offs and difficulties in assessment of the relative percentages ofin-process research and development expense that can be immediately written offas compared to the amount which must be amortized over the appropriate life ofthe asset; and

·       Amortizationexpenses related to other intangible assets.

45

----

Operational risksthat could harm our existing operations or prevent realization of anticipatedbenefits from such transactions include:

·       Challengesassociated with managing an increasingly diversified business;

·       Difficultiesin assimilating the operations, products, technology, information systems orpersonnel of the acquired company;

·       Diversionof management’s attention from other business concerns;

·       Inabilityto maintain uniform standards, controls, procedures and policies;

·       Theassumption of known and unknown liabilities of the acquired company, includingintellectual property claims; and

·       Subsequentloss 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 tointegrate acquired or licensed businesses or technologies into our business arenot successful, our business could be harmed.

*If we cannotinitiate and maintain revenue-generating relationships with third parties, wemay not be able to grow our revenues in the near to medium-term.*

Many products in ourcurrent pipeline are in relatively early stages of research or development. Ourability to grow earnings in the near- to medium-term may depend, in part, onour ability to initiate and maintain other revenue generating relationshipswith third parties, such as licenses to certain of our technologies, and on ourability to identify and successfully acquire rights to later-stage productsfrom third parties. We may fail to establish such other sources of revenue.

*Fluctuations ininterest rates and foreign currency exchange rates could harm our business.*

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

*Our level of debtcould limit cash flow available for our operations and could adversely affectour ability to service our debt or obtain additional financing, if necessary.*

As of March 31,2005, our total debt including current portion, was $939.0 million. Ourlevel of debt could restrict our operations and make it more difficult for usto satisfy our obligations under the 2033 and the 2034 convertible debentures(the “debentures”). Among other things, our level of debt may:

·       Limitour ability to obtain additional financing for working capital, capitalexpenditures, strategic acquisitions and general corporate purposes;

·       Requireus to dedicate all or a substantial portion of our cash flow to service ourdebt, which will reduce funds available for other business purposes, such ascapital expenditures or acquisitions;

·       Limitour flexibility in planning for or reacting to changes in the markets in whichwe compete;

·       Placeus at a competitive disadvantage relative to our competitors with lessleverage;

·       Renderus more vulnerable to general adverse economic and industry conditions; and

46

----

·       Makeit more difficult for us to satisfy our financial obligations, including thoserelating to the debentures and our other debt obligations.

We and our subsidiaries may still be able to incursubstantially more debt. The terms of our credit facility, the indenturegoverning the debentures and the agreements governing our other debt permitadditional borrowings. Our incurrence of additional debt could furtherexacerbate the risks described above.

Our ability to satisfy ourobligations under the debentures and our other debt agreements will depend onour future operating performance, which will be subject, in part, to factorsbeyond our control, including general economic and business conditions. If weare unable to generate sufficient cash flow to service our debt, we may berequired to refinance all or a portion of our debt, including the debentures,obtain additional financing, sell some of our assets or operations, reduce ordelay capital expenditures, or revise or delay our strategic plans. If we arerequired to take any of these actions, it could have a material adverse effecton our business, financial condition and results of operations. In addition, wecannot assure you that we would be able to take any of these actions, thatthese actions would enable us to continue to satisfy our capital requirementsor that these actions would be permitted under the terms of our various debtinstruments, including the indenture governing the debentures.

*Our relationshipwith Novartis AG could limit our ability to enter into transactions, pursueopportunities in conflict with Novartis and cause the price of our common stockto decline.*

We have an alliance withNovartis AG, a life sciences company headquartered in Basel, Switzerland. Undera series of agreements between Chiron and Novartis, and as a result ofsubsequent stock issuances by Chiron, Novartis’ ownership interest in Chironwas approximately 42.4% as of March 31, 2005. The governance agreementbetween Chiron and Novartis contains provisions that require the approval ofNovartis before we enter into certain corporate transactions. Thesetransactions generally include significant debt or equity issuances, debt orequity repurchases, most mergers and acquisitions, the payment of cashdividends, amendments to Chiron’s certificate of incorporation or by-laws, andother transactions that would adversely impact the rights of Novartis, ordiscriminate against Novartis, as a Chiron stockholder. In addition, a majorityof the independent directors must approve any material transactions betweenChiron and Novartis. These provisions may limit our ability to enter intotransactions with third parties otherwise viewed as beneficial to Chiron. Allof our shares owned by Novartis are eligible for sale in the public marketsubject to compliance with the applicable securities laws. We have agreed that,upon Novartis’ request, we will file one or more registration statements underthe Securities Act in order to permit Novartis to offer and sell shares of ourcommon stock. Sales of a substantial number of shares of our common stock byNovartis in the public market could adversely affect the market price of ourcommon stock.

*Our stock pricecould be volatile.*

The price of ourstock, like that of other pharmaceutical companies, is subject to significantvolatility. Any number of events, both internal and external to us, may affectour stock price. These include, without limitation:

·       Fluctuationsin earnings from period to period;

·       Resultsof clinical trials conducted by us or by our competitors;

·       Announcementsby us or our competitors regarding product development efforts, including thestatus of regulatory approval applications;

·       Impactfrom the recent FLUVIRIN vaccine developments;

47

----

·       Theoutcome of legal proceedings, including claims filed by us against thirdparties to enforce our patents and claims filed by third parties against usrelating to patents held by the third parties;

·       Thelaunch of competing products;

·       Theresolution of (or failure to resolve) disputes with strategic partners;

·       Corporaterestructuring by us;

·       Thesale of a substantial number of shares held by our existing stockholders;

·       Licensingactivities by us; and

·       Theacquisition or sale by us of products, products in development or businesses.

In connection with our researchand development collaborations, from time to time we may invest in equitysecurities of our strategic partners. The price of these securities also issubject to significant volatility and may be affected by, among other things,the types of events that affect our stock. Changes in the market price of thesesecurities may impact our profitability.

*We are subject totaxation in a number of jurisdictions and changes to the corporate tax rate andlaws of any of these jurisdictions could increase the amount of corporate taxeswe have to pay.*

We pay taxes principally in the U.S., Germany, Italy,and the United Kingdom. All of these jurisdictions have in the past and may inthe future make changes to their corporate tax rates and other tax laws, whichcould increase our future tax provision. Specifically, on October 22,2004, the American Jobs Creation Act of 2004 (the Act) was signed into law. TheAct includes an elimination of the tax benefit of the Extraterritorial IncomeExclusion over 2005 and 2006.

We have negotiated anumber of rulings regarding income and other taxes that are subject to periodicreview and renewal. If such rulings are not renewed or are substantiallymodified, income taxes payable in particular jurisdictions could increase.While we believe that all material tax liabilities are reflected properly inour balance sheet, we are presently under audit in several jurisdictions andmay be subject to further audits in the future, and we have no assurance thatwe will prevail in all cases in the event the taxing authorities disagree withour interpretations of the tax law. In addition, we have assumed liabilitiesfor all income taxes incurred prior to the sales of our former subsidiaries,including PowderJect Vaccines, Inc., SBL Vaccin AB, and PowderJectResearch Limited. 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.

*Our earnings resultsmay be inconsistent and cause volatility in our stock price.*

Our operatingresults may vary considerably from quarter to quarter. Any number of factorsmay affect our quarterly operating results. These factors include, but are notlimited to the following:

·       Inventorymanagement practices, including wholesale ordering patterns;

·       Thelevel of pre-clinical and clinical trial-related activities;

·       Seasonalityof certain vaccine products;

·       Thetender driven nature of certain vaccine products;

·       Thenature of our collaborative, royalty and license arrangements and other revenuesources;

·       Foreigncurrency exchange rate fluctuations; and

48

----

·       Thelevel of product reserves due to various issues, including seasonalitypatterns, excess and obsolete inventory, and production yields.

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

*Revisions toaccounting standards, financial reporting and corporate governance requirementsand tax laws could result in changes to our standard practices and couldrequire a significant expenditure of time, attention and resources, especiallyby senior management.*

We must follow accounting standards, financialreporting and corporate governance requirements and tax laws set by the governingbodies and lawmakers in the U.S. and other countries where we do business. Fromtime to time, these governing bodies and lawmakers implement new and revised rules andlaws. These new and revised accounting standards, financial reporting andcorporate governance requirements and tax laws may require changes to ourfinancial statements, the composition of our board of directors, thecomposition, the responsibility and manner of operation of various board-levelcommittees, the information filed by us with the governing bodies andenforcement of tax laws against us. Implementing changes required by such newstandards, requirements or laws likely will require a significant expenditureof time, attention and resources, especially by our senior management. It isimpossible to completely predict the impact, if any, on Chiron of futurechanges to accounting standards, financial reporting and corporate governancerequirements and tax laws.

It is possible that theapplication of certain current accounting standards may change due toenvironmental factors, which may necessitate a change in our standard practicerelated to these accounting standards. In particular, effective January 1,2006 we will be required to adopt SFAS No. 123(R) requiring us toapply a fair-value based method to account for costs related to share-basedpayments including stock options and employee stock purchase plans. We expectthe adoption of SFAS 123(R) to materially impact our results ofoperations.

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

**Marketrisk management  **Our cash flow and earnings are subjectto fluctuations due to changes in foreign currency exchange rates, changes ininterest rates and changes in the fair value of equity securities held forsale. We attempt to limit our exposure to some or all of these market risksthrough the use of various financial and derivative instruments. During thefirst quarter of 2005, we added a new hedging instrument to our foreigncurrency hedging strategy. We purchased $41.1 million of British Pounddenominated fixed-income securities to create a natural hedge against a portionof our British Pound currency exposures. We manage our exposures to marketrisks as discussed in further detail in Part II, Item 7A, “Quantitativeand Qualitative Disclosures About Market Risk” in our annual Report on Form 10-Kfor the year ended December 31, 2004.

**Item 4.**                        Controlsand Procedures

**(a) Evaluation of disclosurecontrols and procedures  **As of the end of the periodcovered by this report, Chiron carried out an evaluation under the supervisionand with the participation of Chiron’s management, including Chiron’s CEO andCFO, of the effectiveness of Chiron’s disclosure controls and procedurespursuant to Exchange Act Rule 13a-15(e) or 15d-15(e).Based on that evaluation, which included consideration of the design andimplementation of additional controls and procedures described below, Chiron’smanagement, including the CEO and CFO, concluded that Chiron’s disclosurecontrols and procedures were effective in timely alerting them to material informationrelating to Chiron required to be included in Chiron’s periodic SEC filings.

49

----

**(b) Changes in internal controls  **Exceptas set forth below, there have been no significant changes in Chiron’s internalcontrols over financial reporting that have materially affected, or arereasonably likely to materially affect internal controls over financialreporting during the most recent fiscal quarter.

The management of Chiron assessed the effectiveness ofthe Company’s internal control over financial reporting as of December 31,2004. In performing the assessment management identified three materialweaknesses in internal control over financial reporting as of December 31,2004. As a result of the material weaknesses described below, management determinedthat, as of December 31, 2004, the Company’s system of internal controlover financial reporting was not effective based on the criteria in*Internal Control—Integrated Framework*.

The first material weakness pertains to both thedesign and operating effectiveness of controls relating to revenue recognitionat our vaccines subsidiary in Germany. Specifically, controls pertaining to thecommunication and evaluation of any special terms and other actions of thesales organization that may affect revenue recognition were not effective. As aresult, on March 8, 2005, the Audit Committee of the Board of Directors,following discussion with and upon the recommendation of management andfollowing discussion with Chiron’s independent auditors, concluded that the previouslyissued financial statements for the second and third quarters of 2004 should berestated to correct certain errors contained therein and should not be reliedupon. The identified errors affected product revenue, cost of goods sold,accounts receivable, and unearned revenue for the Company’s vaccines segment.In addition to the restatement of the financial statements for the second andthird quarters of 2004, adjustments were recorded in the consolidated financialstatements for year ended December 31, 2004 to correct the identifiederrors.

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

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

During the firstquarter of fiscal year 2005, and in connection with the preparation of ourcondensed consolidated financial statements for the quarter ended March 31,2005, we designed and implemented additional controls and procedures relatingto revenue recognition at our vaccines subsidiary in Germany to address thefirst material weakness identified above. Such additional controls andprocedures included, among others:

·        Providingour sales force with training regarding the applicable accounting principlesand procedures for the communication of special terms and conditions and theimpact of their activities on our revenue recognition; and

·        Reviewof a significant sample of supporting sales documentation, including customeragreements, to identify sales transactions in the first quarter with specialterms and conditions to determine that the sales were recognized in accordancewith applicable accounting principles

In addition, duringthe first quarter of 2005, and in connection with the preparation of ourcondensed consolidated financial statements for the quarter ended March 31,2005, we designed and implemented 

50

----

additionalcontrols and procedures relating to the timely recording of legal servicesinvoices payable and estimating the accrual for unbilled legal services toaddress the third material weakness identified above. Such additional controlsand procedures included, among others:

·        Designingof new procedures for invoice processing and procedures for the accrual ofunbilled services and communication of the new procedures to individualsintegral to the process; and

·        Completionof training and awareness workshops relating to the new processes

In addition, we are in the process of establishing aremediation plan to address the ineffective controls related to the annual taxprovision process. The remediation plan is expected to include considerationand identification of additional controls and reconciliations and theconsideration and implementation of different analytical tools in order toenhance the analysis and calculation of the tax provision.

51

----

**PART II**

**Item 1**.Legal Proceedings

We are party to certainlawsuits and legal proceedings, which are described in Part I, Item 3. “LegalProceedings” of our Annual Report on Form 10-K for the year ended December 31,2004. The following is a description of material developments during the periodcovered by this Quarterly Report and certain other events and should be read inconjunction with the Annual Report on Form 10-K for the year ended December 31,2004.

*Average WholesalePrice Litigation*

In November 2004, the County of Nassau filed acomplaint in the United States District Court for the Eastern District of NewYork against numerous biotechnology and pharmaceutical companies, includingChiron, in connection with setting average wholesale prices for variousproducts, including TOBI® solution, which are reimbursed by Medicaid.In March 2005, the County of Nassau filed an amended complaint with the InRe Pharmaceutical Industry Average Wholesale Price Litigation pre-trial proceedingsin the United States District Court for the District of Massachusetts. Plaintiffalleges that defendants violated federal racketeering laws, federal and statelaws on Medicaid fraud, and state laws on unfair trade practice, breach ofcontract, fraud and unjust enrichment by devising and implementing a fraudulentpricing scheme against Medicaid beneficiaries, and seeks declaratory relief, aswell as compensatory and punitive damages.

It is not known when noron what basis this matter will be resolved.

*FLUVIRIN®influenza virus vaccine*

For a discussion ofdevelopments related to FLUVIRIN® influenza virus vaccine, see “Item 2—Management’sDiscussion and Analysis of Financial Condition and Results of Operations,Factors That May Affect Future Results.”

**FLUVIRIN® vaccineSecurities Class Actions**

Between October 2004 and December 2004, fivesecurities class action lawsuits were filed against Chiron and certain Chironofficers on behalf of purchasers of Chiron securities for class periods rangingfrom July 23, 2003 through October 13, 2004. Four of the suits werefiled in the United States District Court for the Northern District ofCalifornia. One action, although originally filed in the United States DistrictCourt for the Eastern District of Pennsylvania, was later transferred to theUnited States District Court for the Northern District of California. In March 2005,the Court named lead counsel, and in April 2005, plaintiffs filed aconsolidated complaint. Plaintiffs allege, among other things, that thedefendants violated certain provisions of the federal securities laws by makingfalse statements preceding the suspension of Chiron’s license to manufactureFLUVIRIN vaccine, and seek unspecified monetary damages and other relief fromall defendants. The trial is scheduled to begin on May 1, 2006.

It is not known when nor on what basis these matterswill be resolved.

In December 2004, a complaint was filed in the UnitedStates District Court for the District of Connecticut alleging that plaintiffssuffered injuries as a result of the flu vaccine they had received. In April2005, the Court ordered the dismissal of the matter with respect to Chiron, andthe matter is thus concluded.

*Innogenetics N.V.*

In November 2000,Innogenetics N.V. brought a complaint against Chiron and Ortho-Clinical DiagnosticsSystems, Inc. before the Commission. Innogenetics N.V. alleges that Chironand Ortho violate 

52

----

Articles81 and 82 of the Treaty relating to competitive practices. Pursuant to thecomplaint, the Commission has sought information from Chiron and Ortho-ClinicalDiagnostics Systems, Inc. related to hepatitis C virus and HIV licensingpractices in the European Union. In March 2005, Innogenetics withdrew itscomplaint, and the matter is thus concluded.

*LaboratoryCorporation of America Holdings*

In August 2003, Chiron filed a complaint in theUnited States District Court for the Northern District of California againstLaboratory Corporation of America Holdings, Laboratory Corporation of Americaand National Genetics Institute (collectively, the “Defendants”), seekingdamages and an injunction against Defendants’ manufacture, use and sale ofcertain HIV assays for infringing Chiron’s U.S. Patent No. 6,531,276 (the “276patent”). In February 2004, Chiron voluntarily dismissed this case withoutprejudice and refiled the complaint before the United States District Court forthe Central District of California. In April 2005, the Court stayed thecase pending the outcome of two interferences declared by the U.S. Patent andTrademark Office regarding the ‘276 patent.

It is not known when noron what basis this matter will be resolved.

*Investigation ofEmployee of Italian Subsidiary*

A sales employee of anindirect, wholly-owned Italian subsidiary of Chiron is the subject of aninvestigation by Italian authorities in Genoa, Italy in connection with alarger investigation by such authorities into the purchasing activities of aGenoa hospital. We believe that the employee is one of a number of individualsfrom a variety of companies being investigated by such authorities with respectto sales to the hospital.  We furtherbelieve that the investigation of the employee of our Italian subsidiaryconcerns alleged undue influence by the employee in the bidding process for thesupply of blood testing products to the hospital.  In August 2004, the hospital awarded Chiron acontract for the supply blood testing products. The employee is also thesubject of a similar investigation by Italian authorities in Milan, Italy. Inconnection with the Genoa investigation, authorities placed the employee underhouse arrest. At this time, we are not aware of any investigation of Chironwith respect to these matters. However, no assurance can be given that Chironwill not become the subject of criminal or civil charges, fines or penalties, orincur other damages or costs, in connection with these matters.

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

(c)   Our Board of Directors authorized the repurchase of our commonstock on the open market to offset the dilution associated with the issuance ofnew shares under the stock option and stock purchase plans and the granting ofshare rights. On March 10, 2005, the Board of Directors authorized Chironto repurchase 5.0 million shares of Chiron common stock through December 31,2005. There were no stock repurchases in the first quarter of 2005.

**Item3.**Defaults Upon SeniorSecurities

None.

**Item4.**Submission of Matters to aVote of Security Holders

None.

**Item 5.**Other Information

None.

53

----

**Item 6.**Exhibits

*(a)  *Exhibits
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **Exhibit** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|
| 3.01             |       | Restated Certificate of Incorporation of Chiron, as  filed with the Office of the Secretary of State of Delaware on  August 17, 1987, incorporated by reference to Exhibit 3.01 of  Chiron’s report on Form 10-K for fiscal year 1996.                                                                                                                              |
| 3.02             |       | Certificate of Amendment  of Restated Certificate of Incorporation of Chiron, as filed with the Office  of the Secretary of State of Delaware on December 12, 1991, incorporated  by reference to Exhibit 3.02 of Chiron’s report on Form 10-K for  fiscal year 1996.                                                                                               |
| 3.03             |       | Certificate of Amendment of Restated Certificate of  Incorporation of Chiron, as filed with the Office of the Secretary of State  of Delaware on May 22, 1996, incorporated by reference to  Exhibit 3.04 of Chiron’s report on Form 10-Q for the period ended  June 30, 1996.                                                                                 |
| 3.04             |       | Bylaws of Chiron, as  amended and restated, incorporated by reference to Exhibit 99.1 of  Chiron’s current report on Form 8-K dated March 10, 2005.                                                                                                                                                                                                                 |
| 4.01             |       | Indenture between Chiron  and State Street Bank and Trust Company, dated as of June 12, 2001,  incorporated by reference to Exhibit 4.01 of Chiron’s report on  Form 10-Q for the period ended June 30, 2001.                                                                                                                                                  |
| 4.02             |       | Registration Rights  Agreement between Chiron and Merrill Lynch & Co., Inc., and  Merrill Lynch, Pierce, Fenner & Smith, Incorporated, incorporated by reference to  Exhibit 4.02 of Chiron’s report on Form 10-Q for the period ended  June 30, 2001.                                                                                       |
| 4.03             |       | Form of Liquid  Yield Option NoteTM due 2031 (Zero Coupon—Senior) (included as exhibits A-1  and A-2 to the Indenture filed as Exhibit 4.01 to Chiron’s report on  Form 10-Q for the period ended June 30, 2001), incorporated by reference to  Exhibit 4.03 of Chiron’s report on Form 10-Q for the period ended  June 30, 2001. |
| 4.04             |       | Indenture between Chiron  and U.S. Bank National Association, as trustee, dated as of July 30,  2003, incorporated by reference to Exhibit 4.1 of Chiron’s registration  statement on Form S-3 filed with the Commission on September 23,  2003.                                                                                                               |
| 4.05             |       | Registration Rights  Agreement dated as of July 30, 2003, between Chiron and Morgan  Stanley & Co., Goldman, Sachs & Co., Banc of America  Securities LLC and BNP Paribas Securities Corp., incorporated by reference to  Exhibit 4.3 of Chiron’s registration statement on Form S-3 filed  with the Commission on September 23, 2003.       |
| 4.06             |       | Form of Convertible  Debentures (included in Exhibit 4.04), incorporated by reference to  Exhibit 4.2 of Chiron’s registration statement on Form S-3 filed  with the Commission on September 23, 2003.                                                                                                                                                    |
| 4.07             |       | Indenture between Chiron  and U.S. Bank National Association, as trustee, dated as of June 22,  2004, incorporated by reference to Exhibit 4.07 of Chiron’s report on  Form 10-Q for the period ended June 30, 2004.                                                                                                                                           |
| 4.08             |       | Registration Rights  Agreement dated as of June 22, 2004, between Chiron, Credit Suisse First  Boston, LLC and Morgan Stanley & Co., Goldman, Sachs & Co.,  Incorporated, incorporated by reference  to Exhibit 4.08 of Chiron’s report on Form 10-Q for the period  ended June 30, 2004.                                                    |

54

----

 
| 4.09   |   | Specimen of Convertible  Debentures (included as Exhibit A to the Indenture referenced as  Exhibit 4.07 of Chiron’s report on Form 10-Q for June 30,  2004) issued on June 22, 2004,  incorporated by reference to Exhibit 4.09 of Chiron’s report on  Form 10-Q for the period ended June 30, 2004.                                                                                                                                                                                   |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.331 |   | Modified Blood Screening Instrument—eSAS 2 Addendum  Amending the Agreement entered into as of June 11, 1998, between Chiron  and Gen-Probe, effective as of January 1, 2002. (We have omitted certain  information from the Addendum and filed it separately with the Securities and  Exchange Commission pursuant to our request for confidential treatment under  Rule 24b-2. We have identified the omitted confidential information by  the following statement: “Confidential Treatment Requested”.) |
| 10.332 |   | Amendment No. 6,  effective as of January 1, 2004, amending the Agreement dated  June 11, 1998, between Chiron and Gen-Probe Incorporated. (We have  omitted certain information from the Amendment and filed it separately with  the Securities and Exchange Commission pursuant to our request for  confidential treatment under Rule 24b-2. We have identified the omitted  confidential information by the following statement: “Confidential Treatment  Requested”.)                                  |
| 10.614 |   | Compromise Agreement  dated February 18, 2005, between John A. Lambert and Chiron.*                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.615 |   | Letter agreement dated  February 28, 2005 (agreed to on March 4, 2005), between Jack  Goldstein and Chiron.*                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 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.                                                                                                                                                                                                                                                                                                                                                                       |

 

----

*                                         Managementcontract, compensatory plan or arrangement.

55

----

**CHIRON CORPORATIONMarch 31, 2005**

**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, Chiron has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                        | CHIRON  CORPORATION |
|------------------------|---------------------|
| DATE: May 6, 2005 |                |
|                   | BY:                 | /s/  HOWARD H. PIEN |
|                   |                | Howard H. Pien |
|                   |                | *Chief Executive Officer* |
| DATE: May 6, 2005 |                | * * |
|                   | BY:                 | /s/  DAVID V. SMITH |
|                   |                | David V. Smith |
|                   |                | *Vice President and Chief Financial Officer* |

 

56

----