Richard Gregory, Et Al. V. Chiron Corporation, Et Al. 04-CV-04293-Chiron Corporation's Corrected Exhibits in Support Of

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington , D .C . 20549

FORM 1O--Q

(Mark One)

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

For the quarterly period ended June 30, 2003

O R

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

For the transition period from t o

Commission File Number : 0-12798

CHIRON CORPORATIO N (Exact name of registrant as specified in its charter)

Delaware 94-2754624 (State or other jurisdiction of _ (I .R .S . Employer Identification No,) incorporation or organization )

4560 Horton Street, Emeryville, California 94608 (Address of principal executive offices) (Zip code)

(510)655-873 0 (Registrant's telephone number, including area code)

Not Applicabl e (Former name, former address and former fiscal year, if changed since last report)

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

YesIJ No ❑

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

Yes O No ❑

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

Title of Class Outstanding at July 31, 2003 Common Stock, $0.01 par value 186,524,841

I CHIRON CORPORATION TABLE OF CONTENTS

Page No .

PART I. FINANCIAL INFORMATIO N

ITEM 1 . Financial Statements (Unaudited )

Condensed Consolidated Balance Sheets at June 30,200 3 and December 31, 2002 3

Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2003 and 2002 5

Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 200 3 and 2002 6

Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002 7

Notes to Condensed Consolidated Financial Statements 8

ITEM 2 . Management's Discussion and Analysis of Financial Condition and Results of Operations 27

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 58

ITEM 4 . Controls and Procedures 58

PART 11. OTHER INFORMATION

ITEM 1 . Legal Proceedings 60

ITEM 4 . Submission of Matters to a Vote of Security Holders 64

ITEM 6 . Exhibits and Reports on Form 8-K 6 5

SIGNATURES 68

1 Item 1 . Financial Statements

CHIRON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands, except share data )

June30, December31, 2003 200 2

ASSETS Current assets : Cash and cash equivalent s $ 876 .043 $ 247,95 0 Short-term investments in marketable debt securities 271,290 626,13 0

Total cash and short-term investments 1,147,333 874,08 0 Accounts receivable, net 289,380 278,62 5 Current portion of notes receivable 750 71 8 Inventories, net of reserve s 196,005 146,00 5 Current net deferred income tax assets 40,734 38,450 Derivative financial instruments 12,201 12,006 Other current assets 55,478 35,83 8

Total current assets 1,741,881 1,385,72 2

Noncurrent investments in marketable debt securities 119,171 4l 4,44 7

Property, plant, equipment and leasehold improvements, at cost: Land and buildings 176,070 168,144 Laboratory, production and office equipment 461,059 418,25 5 Leasehold improvements 102,234 93,46 3 ) Construction-in-progres s 83,382 74,71 7

822,745 754,579 Less accumulated depreciation and amortization (418,841) (381,021) .

Property, .plant, equipment and leasehold improvements, net 403,904 373,55 8

Purchased technologies, net 246,949 257,61 3 Goodwill 243,476 239,746 Other intangible assets, net 146,502 147,08 9 Investments in equity securities and affiliated companies - 113,504 87,16 7 Noncurrent notes receivabl e 8,959. 8,93 9 Noncurrent derivative financial instruments 11,504 9,00 7 Other noncurrent assets 41,201 37,05 6

$ .3,077,051 . $ 2,960,344

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

3 CIIIRON CORPORATIO N CC . . - : .ENSED CONSOLIDATED BALANCE SHEET S (Conttu,ued) (Unaudited ) (In thousands, except share data)

June 30, 4ecember 31 , 2003 2002

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities : Accounts payable $ 67,211 $ 59,02 2 Accrued compensation and related expenses - 50,016 59,49 8 Derivative financial instruments 182 _ Short- term borrowings - 7 1 Current port ion of unearned revenue 45 .712 26,61 0 Income taxes payable 1,073 21,88 3 Other current liabilities 119,067 131,552

Total current liabilities 283,261 298,63 6

Long-term debt 421,073 416,95 4 Noncurrent derivative financial instruments - 25 3 Noncurrent net deferred income tax liabilities 46,867 45,74 3 Noncurrent unea rned revenue 54 .711 62,58 0 Other noncurrent liabi lities 41 .857 35,81 3 Minority interest 6,1 15 5,35 5

Total liabilities 853,884 865,334

Commitments and contingencie s

Put options - 19,05 4

Stockholders' equity : Common stock 1,91 7 1,91 7 Additional paid-in capital 2,476,039 2,445,20 8 Deferred stock compensation ( 11,560) (11,349) Accumulated deficit (128,093 ) ( 221,236 ) Accumulated other comprehensive income 96,875 54,86 1 Treasury stock , at cost (5,437,000 shares at June 30, 2003 and 4,830,000 shares at December 31 , 2002 ) ( 212,011) (193,445)

Total stockholders' equity . 2,223 , 167 2,075,95 6

$ 3,077, 051 $ 2,960,34 4

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

4 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited )

(In thousands, except per share data )

Three Months Ended Six Months Ended June 30, Jnne30 ,

2003 2002 2003 200 2

Revenues : Product sales, ne t 5 245,928 5 211,293 S 464,548 $ 384,87 7 Earnings of unconsolidated joint business 27,475 27,394 53 .927 46,192 Collaborative agreement revenues 3,624 6,602 7,738 12,809 Royalty and license fee revenues 66,876 45,494 120,300 90,372 Other revenues 6,369 8,495 24,794 17,22 5

Total revenue s 350,272 299,278 671,307 551,47 5

Operating expenses : Cost of sales 97,420 76,225 -. 183,009 142,39 1 Research and development 89,915 83,530 172,045 162,30 3 Selling, general and administrative 79,707 71,093 152,749 133,86 3 Amortization expens e 7,701 7,446 15,314 14,82 4 Write-off of purchased in-process research and development' - - -- 54,78 1 Restructuring and reorganization charges 519 - 675 ---- Other operating expenses - 1,259 899 2,794 5,48 2

Total operating expenses 276,521 239,193 526.586 513,644

Income from operations 73,751 60,085 144,721 37,83 1 Interest expense (2,839) (3,133) (6,301) (6,288 ) Interest and other income, net 11,613 12,613 25,931 32,760 Minority interes t (581) (464) (981) (883 )

Income from continuing operations before income taxes 81,944 69,101 163,370 63,42 0 Provision for income taxe s 20,485 18,657 40,842 31,91 3

Income from continuing operations 61,459 50,444 122,528 31,50 7 Gain on disposal of discontinued operations 538 --- 1,964 - - -

Net incom e $ 61,997 5 50,444 $ 124,492 S 31,507 - rr~~ a..ww~rrrrrr_ ~~rn ~r~ ~

Basic earnings per share : Income from continuing operations $ 0.33 $ 0.27 $ 0.66 $ 0.1 7

Net income $ 0 .33 $ 0.27 S 0.67 $ 0 .1 7 rrrr~rr_~ w..~w~wrrrr_ ~ arrrr r_

Diluted earnings per share : income from continuing operations - $ 0 .32 $ 0 .26 $ 0 .65 S 0.16 ~w~w ~rrrrrr~ w~rrr ~~

Net income $ 0,33 S 0 .26 $ 0 .66 $ 0.1 6 .~.re ~~ .rr .rrr e

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

5 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME .

(Unaudited) .

(In thousands , except per share data )

Three Months Ended Six Months Ended Jnne30, June 39 ,

2003 2002 2003 290 2

Net incoioe $ 61,997 $ 50,444 $ 124,492 $ 31,507

Other comprehensive income ( loss) : Change in foreign currency translation adjustment during the period, net of tax provision of $7,294 for the three months ended June 30, 2002 and $6,449 for the six months ended June 30, 2002 35,823 61,668 45,118 55,23 3 Net unrealized derivative loss arising during the period, net of tax benefit of $72 for the three months ended June 30 , 2002 - (118) - - Unrealized gains ( losses) from investments : Net unrealized holding gains ( losses) arising during the period, net o f tax (provision ) benefit of ($1,541) and $651 for the three month s ended June 30 , 2003 and 2002, respectively, and ($1,284) and $3,532 for the six months ended June 30, 2003 and 2002, respectively 3,083 658 2,640 (5,623 ) Reclassification adjustment for net gains included in net income, net of tax provision of $1,834 and $1,891 for the three months ended Jun e 30, 2003 and 2002, respectively, and $3,626 and $3,587 for the si x months ended June 30, 200.3 and 2002, respectively (2,940) (3,065) (5,744) (5,802)

Net unrealized gains (losses) from investments 143 (2,407) .(3,104) (11,425)

Other comprehensive income 35,966 59,143 42,014 43,80 8

Comprehensive income $ 97,963 5 109,587 S 166,506 S 75,31 5

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement. 6 CI{IRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOW S

(Unaudited )

(in thousands)

Six Months Ende d 3 une 30,

2003 2002

Net cash provided by operating activities $ 113,177 $ 82,56 6

Cash flows from investing activities : - Purchases of investments in marketable debt securities (277,514) (320,675) Proceeds from sales and maturities of investments in marketable debt securities 917,794 . 311,11 3 Capital expenditures (52,371) (54,323 ) Proceeds from sales of assets 182 Purchases of equity securities and interests in affiliated companies (36,889) (3,093 ) Proceeds from sale of equity securities and interests in affiliated companies 7,428 13,41 5 Cash paid for acquisitions , net of cash acquired (1,180) (55,284 ) Other, net (777) (877)

Net cash provided by ( used in ) investing activities 556,491 (109,542)

Cash flows from financing activities : Netrepaymetttofshort-term borrowings (71) (308) Repayment of debt (95 ) Payments to acquire treasury-stock (68,079) . (45,116 ) Proceeds from reissuance of treasury stock 24,526 18,02 7 Proceeds from put options 2,144 2,02 8

Net cash used in financing activities (41,575) (25,369 )

Net increase (decrease) in cash and cash equivalents 628,093 (52,345), Cash 'and cash equivalents at beginning of the period 247,950 320,67 3

Cash and cash equivalents at end of the period . $ 876,043 $ 268,32 8

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

7 CHIRON CORPORATIO N

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2003

(Unaudited)

Note 1-The Company and Summary of Significant Accounting Policie s

Basis of Presentation

The information presented in the condensed consolidated financial statements at June 30, 2003, and for the three and six months ended June 30, 2003 and 2002, is unaudited but includes all normal recurring adjustments, which Chiron Corporation believes to be necessary for fair presentation ofthe periods presented .

The condensed consolidated balance sheet amounts at December 31, 2002, have been derived from audited financial statements . Historically, Chiron's operating results have varied considerably from period to period due to the nature of Chiron's collaborative, royalty and license arrangements and the seasonality of certain vaccine products. In addition, the mix of products sold and the introduction of new products will affect comparability from quaver to quarter . As a consequence, Chiron's interim results in any one quarter are not necessarily indicative of results to be expected for a full year . This information should be read in conjunction with Chiron's audited consolidated financial statements for the year ended December 31, 2002, which are included in the Annual Report o n Form 10-K filed by Chiron with the Securities and Exchange Commission .

Principles of Consolidatio n

The condensed consolidated financial statements include the accounts of Chiron and its majority--owned subsidiaries . For consolidated majority-owned subsidiaries in which Chiron owns less than 100%, Chiron records minority interest in the condensed consolidated financial statements to account for the ownership interest of the minority owner. Investments in joint ventures, limited partnerships and interests in which Chiron has an equity interest of 50% or less, are accounted for using either the equity or cost method based on Chiron's ownership levels and the ability, of Chiron to exert significant influence over the entity's operating, investing and financing decisions . All significant intercompany accounts and transactions have been eliminated in consolidation ,

On July 1, 2002, Chiron completed its acquisition of Pulmopharm GmbH, a distributor of T01310 products in Germany and Austria by purchasing the remaining 80.1% ownership that Chiron did not previously own. Previously, Chiron owned 19.9% of Pulmopharm and accounted for the investment under the. equity method . Chiron accounted for the acquisition using the purchase method of accounting and included Pulmopharm's operating results in its consolidated operating results beginning on July 1, 2002 . Pulmopharm is part of Chiron's biopharrtraceuticals segment (see Note 5) .

On February 20, 2002, Chiron acquired Matrix Pharmaceutical, Inc ., a company that was developing tezacitabine, a drug to treat cancer . Chiron included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in its consolidated operating results beginning on March 1, 2002 (see Note 5).

Chiron is a limited partner of several venture capital funds . Chiron is obligated to pay $60.0 million over ten years in equity contributions to these venture capital funds, of which approximately $28 .7 million was paid through June 30, 2003 . Chiron accounts for these investments under the equity method of accounting .

8 . Use of Rslimates and Reclassrfrcalion s

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

Chiron's blood testing segment consists of Chiron's one-half interest in . the pretax operating earnings of its joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Chiron's joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the first quarter 2003, Chiron had accounted for revenues from non-U_S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter . More current information of non-U .S . affiliate sales of the joint business contractual arrangement became available in the first quarter 2003, and as a result, Chiron is able to recognize revenues from non-U .S . affiliate sales on a one-month lag. The effect of this change, net of tax, was an increase to net income by $3 .2 million for earnings of unconsolidated joint business for the six months ended June 30, 2003 .

Chiron recognizes a portion of revenue for product sales of Betaseron® upon shipment to its marketing partner, and the remainder based on a contractual percentage of sales by its marketing partner. Chiron also earns royalties on the marketing partner's European sales of Betaferon® in those cases where Chiron does not supply the product . Prior to the first quarter 2002, Chiron had accounted for revenues from non-U .S . product sales on a one-quarter lag and royalties as a percentage of forecast received from its marketing partner, with an adjustment of the estimate to, actual in the subsequent quarter . More current information of non-U .S . Betaseron® sales became available in 2002, and as a result, Chiron is able to recognize revenues from Betaseron® product sales and Betaferosi® royalties on a .current basis. The effect of this change, net of tax, was a decrease in net loss for the first quarter 2002 and an increase in net income for the six . months ended June 30, 2002 by $3 . 1 million for product sales and $2 .8 million for royalties.

Revenue Recognitio n

tI sale, lease or rental of equipment and revenue from providing field service for the instruments . In the case of assay sales and equipment rentals included as part of the assay contract (commonly referred to as "reagent rental" agreements), revenue is recorded based upon the reported results obtained from the customer for the use of assays to screen donations or upon sale and delivery of the assays depending on the underlying contract . In the case of equipment sales or leases, revenue is recorded upon the sale and transfer of the title to the instrument or ratably over the life of the lease term . For the provision of service on the instruments , revenue is recognized ratably over the life of the service agreement term.

Invenlories

Inventories are stated at the lower of cost or market using the moving weighted-average cost method. Inventory that is obsolete (inventory that will no longer be used in the manufacturing process), expired, or in excess of forecasted usage is written down to its market value, inventories, net of reserves consisted of the following (in thousands) :

June 30, December 31, 2003 2002

Finished goods $ 49,881 $ 32,697 Work-in-process 99,306 77,232 Raw materials 46,818 36,076

$ 196,005 $ 146,005

Income Taxes

The reported effective tax rate for 2003 is 25% of pretax income from operations. The effective tax rate may be affected in future periods by changes in Chiron's estimates with respect to the deferred tax assets, acquisitions and other items affecting the overall tax :rate. Income tax expense for the six months ended June 30, 2002, was based on an estimated annual effective tax rate on pretax income from continuing operations of approximately 27%, excluding the write-off of purchased in-process research and development related to the acquisition of Matrix Pharmaceutical, Inc. (see Note 5) .

Put-Options

Chiron has used written put options to reduce the effective costs of repurchasing its common stock, The put option contracts provide that Chiron, at its choice, can settle with cash or through physical delivery of shares and, accordingly, the fair value of such put option contracts (premiums received) is initially classified in equity. However, because either settlement choice could require Chiron to deliver cash if the put option is exercised, an amount equal to the cash redemption value of the' put option contracts is classified as temporary equity until expiration of the option .

10 of Stock-Based Compensatio n

Chiron measures compensation expense for its stock-based employee compensation plans using the intrinsic method prescribed . by Accounting Principles Board Opinion No . 25, "Accounting for Stock Issued to Employees" and related Interpretations, including Financial Accounting Standards Board, referred to as FASB, Interpretation No . 44 "Accounting for Certain Transactions Involving Stock Compensation ." Compensation expense is based on the difference, if any, between the fair value of Chiron's common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant . This amount is recorded as "Deferred stock compensation" in the Condensed Consolidated Balance Sheets and amortized as a charge to operations over the vesting period of the applicable options or share rights . Compensation expense is included primarily in "Selling, general and administrative" in the Condensed Consolidated Statements of Operations .

In accordance with Statement of Financial Accounting Standards, referred to as SFAS, No . 123, "Accounting for Stock-Based Compensation," as amended by SFAS No . 148, "Accounting for Stock-Based Compensation---Transition and Disclosure," Chiron has provided, below, the pro forma disclosures of the effect, on net income and net income per share as if SFAS No . 123 had been applied in measuring compensation expense for all periods presented . Due to rounding, quarterly amounts may not sum fully to yearly amounts .

Three Months Ended Six Months Ended June 30, June 30 ,

2003 2002 2003 2002

(in thousands, except per share data)

Net income : As reported $ 61,997 S 50,444 S 124,492 S 31,507 Add : Stock-based employee compensation expens e included in reported net income, net o f related tax effects 1,750 675 2,651 1,510

Less : Total stock-based employee compensatio n expense determined under fair value based - method for all awards, net of related tax effects 19,933 15,462 38,045 29,729

Pro forma S 43,814 S 35,657 $ 89,098 $ 3,28 8 ~wwww~w.rs arr..rnrwrrrwrw.K .w r~w~wwwr .r

Basic .net income per share : As reported $ 0.33 $ 0 .27 $ 0.67 S 0 .17 Pro forma S 0.24 S 0 .19 $ 0 .48 $ 0 .02 Diluted net income per share : As reported S 0.33 S 0 .26 $ 0.66 $ 0 .16 Pro forma $ 0.23 $ 0 :18 $ 0.47 $ 0 .02

11 Comprehensive Incom e

In 2003, the foreign currency translation component of compreltensive income was not adjusted for income taxes, as it relates to permanent investments in non-U .S . subsidiaries . In 2002, the foreign currency translation component of comprehensive income included the tax effects of certain profit repatriations from Chiron's German and Italian vaccines subsidiaries . Additionally in 2002, all other foreign profits, net of the German and Italian profit repatriations, were considered permanently reinvested.

Treason Stock

Treasury stock is stated at cost, Gains on reissuance of treasury stock are credited to "Additional paid-in capital ." Losses on reissuance of treasury stock are charged to "Additional paid-in capital" to the extent of available net gains on reissuance of treasury stock . Otherwise, losses are charged to "Accumulated deficit ." Chiron charged losses of $16.3 million and $23 .8 million for the three and six months ended June 30, 2003, respectively, and $5 .4 million and S22 .9 million for the three and six months ended June 30, 2002, respectively, to "Accumulated deficit" in the Condensed . Consolidated Balance Sheets .

New Accounting Standards

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ." This Statement establishes new standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity . It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) . This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 . The adoption of SFAS No . 150 is not expected to have a material impact on the Consolidated Financial Statements .

In April 2003, the FASB issued SFAS No . 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies the accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No . 133. It requires, among other things, that contracts with comparable characteristics be accounted for similarly and clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows . SFAS No. 149 is effective generally for contracts entered into and modified after June 30, 2003. The adoption of SFAS No. 149 is not expected to have a material impact on the Consolidated Financial Statements .

In Janua ry 2003 , the FASB issued Interpretation No. 46 ( referred to as FIN No . 46), "Consolidation of Variable Interest Entities " which address the accounting for cert ain off balance sheet lease financing . The recognition provisions of FIN No. 46 will be effective for Chiron for the interim period ended September 30, 2003 . The adoption of FIN No . 46 is not expected to have a material impact on the Consolidated Financial Statements . In November 2002, the FASB issued EITF Issue No . 00--21, "Revenue Arrangements with Multiple Deliverables ." EITF Issue No. 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities . EITF Issue No. 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting . EITF Issue No . 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting . EITF Issue No. 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company . Finally, EITF Issue No. 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the, revenue accounting for an arrangement. The provisions of EITF Issue No. 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003 . The adoption of E1TF Issue No . 00-21 is not expected to have a material impact, nn the Consolidated Financial Statements .

Note 2=Earnings Per Share

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

1 3

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

Three Months Ended Six Months Ended June 30, Juue 30 ,

2003 2002 2003 2002

Income (Numerator) : Income from continuing operations 5 61,459 S 50,444 S 122,528 S 31,50 7

Shares (Denominator) : Weighted-average common shares outstanding M AU 189,579 186,5 84 189,53 6 Effect of dilutive securities : Stock options and equivalents 3,550 3,346 3,294 3,668 Put options 5 3 5

Weighted-average common shares outstanding, plus assumed issuance s 189,963 192,925 189,881 193,209

Basic earnings per share $ 0 .33 S 0 .27 S 0 .66 $ 0.17 wwwwr+.r.~~ ~rrr~ rr~~ r~~~rr

Diluted earnings per share S 0 .32 $ 0 .26 S 0 :65 S 0.16 ~~ arnrrww~ ~rr~ ~~war~r

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

Three Months Ended Six Months Ended June 30, June 30 ,

2003 2002 2003 200 2

Income (Numerator) : Net income 5 61 .997 $ 50,444 $ 124.492 $ 31,50 7

Shares (Denominator) : Weighted-average common shares outstanding 186,408 189,579 186,584 189,53 6 Effect of dilutive securities : Stock options and equivalents 3,550 3,346 3,294 3,668 Put options S -- 3 5

Weighted-average common shares outstanding, plus assumed issuance s 189,963 192,925 189,881 193,209

Basic earnings per share 0 .33 S 0.27 $ 0.67 $ 0 .17 wrnr .r . I I

Diluted earnings per share S 0 .33 S 0 .26 S 0.66 S 0 .1 6

For the three months ended June 30, 2003 and 2002, stock options to purchase 16 .8 million and 14 .1 million shares, respectively, and for the six months ended June 30, 2003 and 2002, stock options to purchase 17 .1 million and 13 .8 million, respectively, with exercise prices greater than the average market prices of common stock, were excluded from the respective computations of diluted earnings per share as their inclusion would be antidilutive .

4 Also excluded from the computations o, d earnings per share for each of the three and six months June 30, 2003 and June 30, 2002 were 5 .2 million shares of common stock issuable ut,un conversion of the Liquid Yield Option Notes, as their inclus . .,.i would be antidilutive .

Note 3-Put Option s

In May 2003, Chiron entered into a contract with a third party to sell put options on Chiron stock, entitling the holder to sell to Chiron 0 .5 million shares at $43 .89 per share. The option expired June 30, 2003 . On June 30, 2003, Chiron's closing stock price was $43 .86 . The third party elected to exercise a portion of the options . As a result, Chiron repurchased 0 .2 million shares .

In February 2003, Chiron entered into a contract with a third party to sell put options on Chiron stock, entitling the holder to sell to Chiron 0 .5 million shares at $36.79 per share . The option expired unexercised on May 5, 2003 .

As ofDecember 31, 2002, Chiron had an outstanding put option contract with a third pa rty entitling the holder to sell to Chiron 0 .5 million shares at $38 .11 per share . The option expired unexercised on January 29, 2003 . This put option contract was initially classified as equity . However, because the settlement options available to Chiron could require Chiron to deliver cash if the put option was exercised by the counter-party, the cash redemption value, totalin g $19 .1 million, was reclassified from "Additional paid-in capital" to "Put options" in temporary equity in the Condensed Consolidated Balance Sheet at December 3l, 2002 . Upon expiration, the options were not exercised and the temporary equity of $19 .1 million was reclassified to permanent equity in the first quarter 2003 .

Note 4-Discontinued Operation s

In a strategic effort to focus on its core businesses of biopharmaceuticals, vaccines and blood testing, Chiron completed the sale of Chiron Diagnostics and Chiron. Vision in 1998 and 1997, respectively . Discontinued operations had no impact on basic earnings per share for the three months ended June 30, 2003 . Diluted earnings per share from discontinued operations was $0 .01 for the three months ended June 30, 2003 . Basic and diluted earnings per share from discontinued operations were $0 .01 for the six months ended June 30, 2003 . There was no activity related to discontinued operations during the three and six months ended June 30, 2002 .

In the second quarter, 2003, Chiron reversed approximately $0.5 million related to unutilized reserves for Chiron Diagnostics and Chiron Vision, which was recorded as a "Gain on disposal of discontinued operations" for the three months ended June 30, 2003 .

In the first quarter 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement, agreement, Chiron was required to make a payment to Bayer during the,first quarter 2003 . Chiron utilized an ainount previously reserved for indemnity obligations, based upon the settlement agreement with Bayer. These amounts resulted in a net charge of $7.6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of $1 .4 million which was recorded as a "Gain on disposal of discontinued operations" for the six months ended June 30, 2003 .

15 Income Taxes

In connection with the sale of Chiron Diagnostics and Chiron Vision , Chiron recorded cumulative net deferred tax assets of $0 .2 million and $8 . 5 million at June 30, 2003 and December 31, 2002, respectively , principally attributable to the timing of the deduction of ce rtain expenses associated with these sales . Chiron also recorded corresponding valuation allowances of $0 .2 million and $ 8 .5 million at June 30, 2003 and December 31, 2002, respectively, to offset these deferred tax assets , as management believes that it is more likely than not that the deferred tax assets to which the valuation allowance relates will not be realized . The future recognition of these deferred tax assets will be repo rt ed as a component of "Gain ( loss) on disposal ofdiscontinued operations . "

Note 5-Acquisition s

Pulmopharm GmbH On July 1, 2002, Chiron completed its acquisition of Pulmophatm GmbH, a distributor of TOBIt9 products in Germany and Austria by purchasing the remaining 80, I% ownership that Chiron did not previously own . Previously, Chiron owned 19.9% of Pulmopharm and accounted for the . investment under the equity method . Chiron's acquisition of all of the remaining outstanding shares of common stock of Pulmopharm, including estimated acquisition costs, resulted in a total purchase price of approximately $3.7 million. The acquisition resulted in the recognition of $3 .8 million of intangible assets relating to the distribution rights, $ I .2 million of goodwill, $0 .3 million of tangible assets and $1 .6 million of deferred tax liabilities on the acquisition date. In addition, on the acquisition date, the carrying value of the original investment in Pulmopharm, which totaled $0.3 million, was reclassified to goodwill . Chiron accounted for the acquisition using the purchase method of accounting and included Pulmopharm's operating results in its consolidated operating results beginning on July 1, 2002 . Pulmopharrn is part of Chirons biopharmaceuticals segment .

Matrix Pharmaceutical, Inc . On February 20, 2002, Chiron acquired Matrix Pharmaceutical, Inc., a company that was developing tezacitabine, a drug to treat cancer. Chiron acquired all of the outstanding shares of common stock of Matrix Pharmaceutical at $2 .21 per share, which, including acquisition costs, resulted in a total purchase price of approximately $67 .0 million . Matrix Pharmaceutical is part of Chiron`s biopharmaceuticals segment . Tezaditabine expanded Chiron's`portfolio of cancer therapeutics .

Chiron accounted for the acquisition as an asset purchase and included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in its consolidated operating results beginning on March 1, 2002 ; The components and allocation of the purchase price, based on their fair values, consisted of the following (in thousands) : .

Consideration and acquisition costs : Cash paid for common stock $ 58,737 Cash paid for options on common stock 2 .231 Acquisition costs 6,07 8

Total purchase price $ 67,046

1 6

Allocation of purchase price: Cash and cash equivalents $ 17,337 Assets held for sale 2,300 Deferred tax assets 10,000 Other assets 1,469 Write-off of purchase d in-process research an d development 45,181 Accounts payable (2,898) Reduction of income taxe s payable 1,739 . Accrued liabilities (8,082)

Total purchase price $ 67,046 anrrrr..~~

Acquisition costs included contractual severance and involuntary termination costs, as well as other direct acquisition costs . Approximately $5 .1 millio n represented severance payments, assumed by Chiron, to eligible employees as defined by their employment agreements .

Chiron allocated the purchase price based on the fair value of the assets acquired and liabilities assumed . Once value was allocated to tangible assets, the residual amount (which was less than the estimated fair value of the in-process research and development discussed below) was allocated to the identifiable intangible assets, including in-process research and development ; Chiron allocated a portion of the purchase price to purchased in-process research and development and wrote off $54.8 million in the first quarter 2002. Chiron allocated a portion of the purchase price to a liability for asset disposal and lease cancellation for the San Diego, California facility closed during the third quarter 2002 . In the fourth quarter 2002, Chiron found an assignee for the manufacturing facility lease and revised the allocation of the purchase price resulting in a $9 .6 million decrease to the liabilities relating to the expected exit of the facility. As a result, the revised aggregate fair value of the assets acquired and liabilities assumed, including purchased in-process research and development, exceeded the purchase price by $9.6 million. Accordingly, this excess credit of $9 .6 million was allocated to purchased in-process research and development, as an excess credit allocated to any other acquired asset would have resulted in the recording of assets below fair value and would have required a gain to be recognized as current assets were realized . Chiron does not anticipate that there willbe any alternative future use for the in-process research and development that was written . off. The write-off of purchased in-process research and development represented the fair value, calculated using probability-of-success-adjusted cash flows and a 20% discount rate, at the acquisition date. Chiron assumed cash flows from tezacitabine to commence after 2005. As with all pharmaceutical products, the probability of commercial success for any research and development project is highly uncertain .

As indicated in the above table, a portion of the purchase price was allocated to assets held for sale . In March 2002, Chiron sold the leasehold improvements and assigned the lease related to a facility located Jr) Fremont, California . Chiron received an amount equivalent to the fair value of the assets at the date of acquisition .

1 as a component of "Cash paid for acquisitions , net of cash acquired" for the six months ended June 30, 2003 .

In March 2002, Chiron paid $6 .0 million related to a bank loan assumed during the purchase of Matrix Pharmaceutical . This payment is reflected on the Condensed Consolidated Statement of Cash Flows as a component of "Cash paid for acquisitions, net of cash acquired" for the six months ended June 30, 200 2

The deferred tax assets primarily related to future utilization of net operating loss carryforwards . Chiron acquired federal and state net operating loss carryforwards and business credits attributed to Matrix Pharmaceutical of approximately $288 .7 million and $9 .5 million, respectively . The available utilization of such net operating loss and business tax credit carryforwards is limited in any one year to approximately $2 .8 million per annum over the next twenty years under provisions of the internal Revenue Code . As such, a significant portion of Matrix Pharmaceutical's net operating loss carryforwards is expected to expire unutilized .

Note 6---Restructuring and Reorganization

For the six months ended June 30, 2003, Chiron recorded restructuring and reorganization charges of $0 .7 million . The charges, included in "Restructuring and reorganization charges" in the condensed consolidated statement of operations , consisted of termination and other employee-related costs recognized in connection with the elimination of 7 positions in its Amsterdam manufacturing facility . Termination notice has been provided . However, of the 7 positions for elimination , none were terminated as of June 30, 2003 . For the six months ended June 30, 2002, Chiron had no restructuring and reorganization adjustments .

Previously, Chiron recorded restructuring and reorganization charges related to (i) the integration of its worldwide vaccines operations, (ii) the closure of its Puerto Rico and St. Louis, Missouri facilities and (iii) the ongoing restructuring of its business operations . The integration of its worldwide vaccines operations consisted of termination and other employee-related costs recognized in connection with the elimination of 28 positions, all of which had terminated as of December 31, 2000, in Chiron's Italian manufacturing facility and facility-related costs . The closure of its Puerto Rico and St . Louis facilities and the ongoing restructuring of its business operations consisted of termination and other employee-related costs recognized in connection with the elimination of 371 positions in manufacturing, research, development, sales, marketing and other administrative functions, and facility-related costs . Employee termination costs included wage continuation, advance notice pay and medical and other benefits . Facility-related costs included losses on disposal of property, plant and equipment, lease payments and other related costs. For the six months ended June 30, 2003 and 2002, Chiron had no restructuring and reorganization adjustments related to these items . Of the 371 positions for elimination, 366 were terminated as of June 30, 2003 and 363 had been terminated as of June 30, 2002 .

Chiron expects to substantially settle the restructuring and reorganization accruals within one to six years of accruing the related charges . As of June 30, 2003, $0 .9 million was included in "Other current liabilities" in the Condensed Consolidated Balance Sheet . As of December 31, 2002, $0 .2 million and $0.1 million were included in "Other current liabilities" and "Other noncurrent liabilities," respectively, in the Condensed Consolidated Balance Sheet .

I8 The activity in accrued restru cturing and reorganization for the six months ended June 30, 2003 and 2002 is summ arized as follows (in thousands) :

Amount of Amount Amount to Accrual at Total Utilized Be Utilized December 31, Restructuring Through in Futur e 2002 Charge June 30, 2003 Period s

Employee-related costs an d Other facility-related costs $ 334 $ 675 $ (150) $ 85 9

Amount of Amount Amount to Accrual at Total Utilized Be Utilize d December 31, Restructuring - Through In Future 2001 Charge June 30, 2002 Periods

Employee-related costs an d Other facility-related costs S 693 $ - S (201) $ 49 2 Itrrr r

Note 7-Intangible Asset s

In July 2001, the FASB issued SFAS No . 141, ."Business Combinations," and SFAS No . 142, "Goodwill and Other Intangible Assets Chiron adopted th e provisions of SFAS No. 141 imm ediately, and SFAS No. 142 effective January 1, 2002 . -

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

June 30, 2003 - December 31, 2002

Gross Gross - Carrying Accumulated Net Carrying Carrying Accumulated Net Carryin g Value Amortization Value Va[ue Amortization Valu e

Purchased technologies $ 331,975 S 85,026 $ 246,94 9 $ 331,94 1 $ 74,328 S 257,61 3 ~~r ~~t rrrru.irrrr.r~ ~

Patents $ 112,711 3 56,915 S 55,796 $ 106,723 5 52,136 S 54,58 7 Trademarks 56,966 17,547 39,419 53,394 14,928 38,46 6 Licenses and technology rights 37,202 19,927 17,275 35,243 16,063 19,18 0 Customer relationships 26,298 8,392 17,906 24,082 7,054 17,02 8 Knowhow(l) 11,943 5,066 6,877 10,935 4,245 6,69 0 Databases 7,100 1,301 5,799 7,100 1,065 6,035 Other 15,356 11,926 3,430 15,274 10,171 5,10 3

Total other intangible assets $ 267,576 $ 121,074 $ 146,502 5 252,751 $ 1 05,662 $ 147,089 wrttn ~ t~~ ~

Total intangible assets subject to - amortization $ 599,55! $ 206,100 $ 393,451 $ 584,692 $ 179,990 $ 404,702 .

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

l 9

Aggregate amortization expense is as follows (in thousands) :

For the six months ended June 30, 2003 (reported) - $ 27,39 9 For the remaining six months in the year ended December 31, 2003 (estimated) 27,46 1

For the year ended December 31, 2003 (estimated) S 54,86 0

For the year ended December 31, 2004 (estimated) $ 51,90 9 For the year ended December 31, 2005 (estimated) S 47,467 For the year ended December 31, 2006 (estimated) $ 45,862 For the year ended December 31, 2007 (estimated) $ 44,662 For the year ended December 31, 2008 (estimated) $ 43,846 The changes in the carrying value of goo y reporting unit consisted of the following (in thousands ,

Biopharmaceuticals Vaccines Tota t

Goodwill ( including assembled workforce) : Balance as of December 31, 2002 $ 199,225 $ 40,521 S 239,746 Effect of exchange rate changes --- 3,730 3,730

Balance as of June 30, 2003 $ 199,225 $ 44,251 S 243,476

Note 8 -Segment Informatio n

Chiron is organized based on the products and services that it offers . Under this organizational structure, there are three reportable segments : (i) biophatmaceuticals, (ii) vaccines and (iii ) blood testing . The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases , using the development and acquisition of technologies related to therapeutic proteins and small molecules . The vaccines segment consists principally of adult and pediatric vaccines for viral and bacterial infections. Chiron sells these vaccines primari ly in Germany , Italy, the United Kingdom, and other international markets . The vaccines segment is also involved in the development of novel vaccines and vaccination technology . The blood testing segment consists of an alliance with-Gen-Probe Incorporated and Chiron' s one-half interest in the pretax operating earnings of its joint business contractual arrangement with Ortho -Clinical Diagnostics, Inc., a Johnson & Johnson company. Chiron's alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription -Mediated Amplification technology to screen donated blood and plasma products for viral infection . Chiron' s joint business arrangement with Ortho - Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho-Clinical Diagnostics , Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collec ti on .

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

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

For the three and six months ended June 30, 2002, expenses of approximately $2 .5 million and $4 .4 million, respectively, previously allocated to the biopharmaceuticals segment, have been allocated to the vaccines segment to conform with the current period presentation .

The accounting policies of Chiron's reportable segments are the same as those described in Note i-The Company and Summary of Significant Accounting Policies above and in Chiron's Annual Report on Form 10-K for the year ended December 3 1 , 2002 . Chiron evaluates the performance of its segments based on each segment's income (loss) from continuing operations, excluding certain special items, such as restructuring and reorganization charges and the write-off of purchased in-process research and development, which are shown as reconciling items in the table below.

2 1

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

Three Months Ended Six Months Ended June 30 , June 30 ,

2003 2002 2003 200 2

Revenues Biopharmaceuticals : Product sales, net $ 107,267 $ 104,065 5 208,952 S 194,50 1 Collaborative agreement . revenues 1,118 3 .428 3,282 7,01 5 Royalty and license fee revenues 20,758 16,424 38,574 33,737 Other revenue s 3,151 1,907 18,785 6,644

Total biopharmaceuticals revenues $ 132,294 3 125,824 3 269,593 5 241,897 Vaccines : Product sales, ne t $ 85,557 $ 72,602 $ 153,961 $ 130,60 0 Collaborative agreement revenues - 166 333 167 33 3 Royalty and license fee revenues 3,343 2,791 6,529 5,43 4 Other revenue s 3,218 5,218 6,009 9,09 8

Total vaccines revenues $ 92,284 $ 80,944 $ 166,666 $ 145,46 5

Blood testing: Product sales, ne t $ 53,104 $ 34,626 $ 101,635 5 59,77 6 Earnings of unconsolidated joint business 27,475 27,394 53,927 46,192 Collaborative agreement revenues 2,340 2,841 4,289 5,46 1 Royalty and license fee revenues 23,160 12,573 38,796 22,76 2 Other revenue s --- 41 -- 4 1

Total blood testing revenues S 106,079 $ 77,475 5 198,647 $ 134,23 2

Other: Royalty and license fee revenues $ 19,615 5 13,706 5 36,401 S 28,43 9 Other revenue s -- 1,329 - 1,44 2

Total other revenues $ 19,615 5 15 .035 5 36,401 $ 29,88 1

Total revenues $ 350,27 2 S 299,278 $ 671,30 7 S 551,47 5 ~rrt ~rrr r~r~rr ~ ~Yrr~rs

i Income (loss) from continuing operation s Biopharmaceuticals $ 8,872 $ 4,745 5 33,971 5 12,979 Vaccines 794 13,281 (4,508) 8,978 Blood testing 62,441 43,630 113,003 73,113 Other 2,163 (1,571) 2,930 (2,458)

Segment income - from operations 74,270 60,085 145,396 92,02 .Operating expens e reconciling items: Write-off of -purchased in-process research and development - (54,7$1 } Restructuring and reorganization charges (519) - (675) -

Income from operations 73,751 60,085 144,721 37,83 1 Interest expense (2,839) (3,133) (6,301) (6,288) Interest and other income, net 11,613 12,613 25,931 32,760 Minority interest (581) (464) (981) (883)

Income from continuin g operations before incom e taxes $ 81,944 $ 69,101 $ 163,370 $ 63,420 ; ~rrrr rr~rrr~i~rw~wwww wwrrrir u.rwrr r Note 9-Commitments and Contingencie s

Effective June 2003, Chiron and SynCo Bio Partners B .V., a related party, executed a seven and a half-year contract manufacturing agreement . Under this agreement, SynCo agreed to provide services related to the production of certain of Chiron's vaccine products for the European and U .S . markets . Chiron has a firm binding order for products to be delivered by SynCo in 2004, 2005 and 2006 under this agreement . Chiron's minimum purchase obligation under this agreement, subject to adjustment depending on the quantities purchased by Chiron in years 2007 through 2010, inflation and movement in the Euro to U .S. Dollar exchange rate, is expected to be approximately $34 .0 million over the term of the agreement.

Simultaneously in June 2003, Chiron and SynCo Bio Partners B.V . executed an FDA compliance agreement . Under this agreement, Chiron will fund certain costs required to bring SynCo's Amsterdam manufacturing facility into compliance to support approval by the U .S . Food and Drug Administration to manufacture Certain vaccine products for the U .S. market . Chiron's funding commitment under this agreement is expected to be approximately $10 .0 million through the first quarter 2005 .

In July 2003, Chiron entered into a new six-year lease to rent a research and development facility in Emeryville, California following the expiration of the existing lease . Effective July 1, 2003, Chiron accounted for this new lease as a capital lease and, as a result, recorded the leafed facility and the corresponding liability on its balance sheet. The amount recorded on the balance sheet for the leased facility is $157.5 million . At the inception of the lease, the future minimum lease payments, exclusive of a residual value guarantee, are approximately $15 .7 million over the lease term. The interest payment s

23 represent variable-rate interest payments indexed to a three-month London interbank offered rate plus 40 basis points . The lease provides a S 156 .0 million residual value guarantee from Chiron to the lessors in the event of property value declines . Consequently, Chiron's maximum payment obligation i s $156.0 million upon termination of the lease on or before July t, 2009 . On or before July 1, 2009, Chiron can choose to either purchase the facility from the lessors or sell the facility to a third party . This option accelerates if Chiron defaults on its lease payments or in the event of other defined events . As of July 1, 2003, Novartis AG had guaranteed (under provisions of the Investment Agreement) payments on this lease commitment, including payment of the residual value guarantee, to a maximum of $173 .3 million .

Chiron is limited partner of several venture capital funds, as discussed in Note I -"The Company and Summary of Significant Accounting Policies ." In the second quarter 2003, Chiron became a limited partner of two additional venture capital funds . Chiron is obligated to pay $15 .0 million over ten years in equity contributions to these two new venture capital funds, of which $ 1 . 0 million was paid through June 30, 2003 .

In April 2003, Chiron entered into a 15-year lease to rent an office building in Uxbridge, United Kingdom . The total minimum lease payments over the term of the lease are approximately 9 .8 million British Pounds ($16 .4 million at June 30, 2003) . After 10 years, Chiron has the option to terminate or continue the lease, with one--year prior notice . This lease is accounted for as an operating lease.

There were no amounts drawn against any outstanding letters of credit at June 30, 2003 . Effective April 1, 2003, the amount of insurance-related letters of credit was increased by $4 .8 million.

Effective February 2003, Chiron and Baxter Pharmaceutical Solutions LLC executed an eight-year manufacturing and supply agreement . Under this agreement, Baxter agreed to perform certain manufacturing procedures and supply Chiron with a key component fora certain biopharmaceutical product . Chiron has certain minimum purchase obligations under this agreement and is required to pay the difference, if any, between the actual quantity purchased and the minimum purchase obligation. Chiron's minimum purchase obligation is effective once regulatory approval is obtained . Chiron can terminate this agreement in the fifth year with prior notice . Chiron's minimum purchase obligation under this agreement is expected to be approximately $36 .0 million over the next four years.

In April 2001, Chiron, Rhein Biotech N .V . (now part of Bema Biotech) and GreenCross Vaccine Corporation entered into a collaboration to research and develop certain pediatric combination vaccine products for sale outside of Europe and North America, The .coliaboration agreement requires capital commitments from Chiron, Bema Biotech and GreenCross Vaccine . Chiron's commitment is approximately 26 .4 million Euro ($30 .2 million at June 30, 2003) for the , expansion of Chiron's Italian manufacturing facilities, of which Chiron had-incurred costs of 4 .6 million Euro ($5 .4 million), as of June 3Q . 2003 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008 .

In February 2001, Chiron's Board of Directors approved a $235 .0 million capital expansion project, which includes the construction of a research and development facility (including a supporting central utility facility) and a parking structure in Emeryville, California . Chiron has committed to $37 .6 million in design and construction services, of which Chiron had incurred costs of $28 .4 million, as of June 30 ,

24 1 2003 . Chiron may cancel these commitments at any time . Related to the research and development facility, Chiron is evaluating various financing alternatives to fund this expansion . Construction was completed on the parking structure in December 2002 .

Chiron enters into indemnification provisions under its agreements with other companies in its ordinary course of business, typically with business partners, contractors, clinical sites, insurers and customers . Under these provisions Chiron generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of Chiron's activities . These indemnification provisions generally survive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Chiron could be required to make under these indemnification provisions is unlimited . The estimated fair value of the indemnity obligations of these agreements is minimal . Accordingly, Chiron has no liabilities recorded for these agreements as of June 30, 2003 . Chiron has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements .

Chiron is party to various claims, investigations and legal proceedings arising in the ordinary course of business . These claims, investigations and legal proceedings relate to intellectual property rights, contractual rights and obligations, employment matters, claims of product liability and other issues. While there is no assurance that an adverse determination of any of such matters could not have a material adverse impact in any future period, management does not believe based upon information known to it, that the final resolution of any of these matters will have a material adverse effect upon Chiron's consolidated financial position and results of operations or cash flows .

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

Note 16-Subsequent Events

On May 19, 2003, Chiron announced the commencement of an all cash offer to acquire all issued and to be issued share capital of Powderlect Pharmaceuticals pie for 550 pence per ordinary share . PowderJect, which is based in Oxford, United Kingdom, develops and commercializes vaccines . PowderJect's portfolio of vaccine products includes vaccines for influenza, yellow fever, travel diarrhea and cholera, tuberculosis, polio and tetanus. Powderject will be part of Chiron's vaccines segment. As of June 30, 2003, Chiron had purchased 3 .8 million shares of Powderlect for $33 .7 million, representing approximately 4.1% of the existing issued share capital of PowderJect as of that date . These shares were included in "Investments in equity securities and affiliated companies" as of June 30, 2003 . On July 8, 2003, Chiron's cash offer became unconditional . As of July 8, 2003, Chiron had acquired or agreed to acquire or had received valid acceptances of the offer in respect of, in aggregate, 83,069,483 PowderJect shares representing 90 .07% of the existing issued share capital of Powderlect . As part of the acquisition of PowderJect, Chiron will assume the debt of PowderJect including convertible notes with a face value o f 35.0 million British Pounds ($57.0 million at July 8, 2003) . As of August 11, 2003 ,

25 Chiron had acquired or agreed to acquire or had re ceived valid acceptances of the offer in respect of, in aggregate , 97,735,$00 PowderJect shares, representing 99 .14% of the issued share capital of Powderlect as of that date . Chiron has implemented the statuto ry procedures under the laws of the United Kingdom to acquire all remaining Powdetlect shares outstanding . Chiron expects to pay the acquisition consideration from its available cash and cash equivalents and thro ugh liquidation of ce rtain of its long- term investments in marketable debt securities.

On July 30, 2003, Chiron raised $450.0 million through an offering of convertible debentures, referred to as the "Offering", and an additional S50 .0 million from the exercise of an option, granted to the underwriters, to purchase additional convertible debentures in connection with the Offering. The convertible debentures bear a coupon rate of 1 .625% per annum and interest is payable semiannually . The debentures are convertible into shares of Chiron common stock and the terms include an initial conversion price of approximately $6$ .44 per share . The debentures may not be called for redemption by Chiron for five years. Holders of the debentures will have the option to require Chiron to purchase their debentures at par value in years five, 10, 15, 20 and 25 . Chiron may choose to pay the redemption purchase price in cash and / or shares of common stock . The debentures mature on August 1, 2033 .

26 Item 2. Management's Discussion and AnalyS of Financial Condition and Results of Operation s

Overvie w

this l0-Q contains forward-looking statements regarding our expectations, hopes or intentions regarding the future, including statements relating to sales growth, product development initiatives, new product marketing, acquisitions . competition, in - and out-licensing activities and expected cost savings that involve risks and uncertainties and are subject to change. . You should read the discussion below in conjunction with Part 1. Item 1 ., "Financial Statements . "of this 10-Q and Part 11, Items 7., 7A, and 8., "Management's Discussion and Analysis of Financial Condition and Results of Operations, " "Quantitative and Qualitative Disclosures About Markel Risk" and "Financial Statements and Supplementary Data. " respectively, of our Annual Report on Form 10-K for the year ended December 31, 2002. The forward-looking statements contained in this 10-Q reflect our current beliefs and expectations on the date of this J0-Q . Actual results, performance or outcomes may differ . from current expectations . Our actual performance may differ from current expectations due to many factors, including the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, stock price and interest-rate volatility, and marketing effectiveness . In particular, there can be no assurance that we will increase sales of existing products, successfully develop and receive approval to market new products, or achieve market acceptance for such new products. There can be no assurance that our out-licensing activity will generate significant revenue, nor that our in-licensing activities willfully protect us from claims of infringement by third parties . In addition, we may engage in business opportunities, the successful completion of which is subject to certain risks, including stockholder and regulatory approvals and the integration of operations . We have discussed the important factors, which we believe could cause actual results to differ from what is expressed in the forward-looking statements, under the caption "Factors That May AJfect Future Results" in this 10-Q . Consistent . with SEC Regulation FD, we do no t undertake an obligation to update the forward-looking information contained in this 10-Q .

We are a global pharmaceutical company that participates in three healthcare markets : biopharmaceuticals, vaccines and blood testing . Our revenues consist of product sales, earnings of unconsolidated joint business, collaborative agreement revenues, royalty and license fee revenues and other revenues . The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious disease, using the development and acquisition of technologies related to therapeutic proteins and small molecules . The biopharmaceuticals segment also includes collaborations with Berlex Laboratories, Inc. and its parent company, Schering AG of Germany, related to Setaseron® . The vaccines segment consists of a meningococcal vaccine, flu vaccines, travel vaccines, which include rabies and tick-borne encephalitis vaccines and pediatric vaccines. We sell these vaccines primarily in Germany, Italy, the United Kingdom and other international markets . Our vaccines segment is also involved in the development of other novel vaccines and vaccination technology . The blood testing segment consists ofan alliance with Gen-Probe incorporated and our one-half interest in the pretax operating earnings of our joint business contractual arrangement with Oriho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection . Our joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provide supplemental tests and microplate and chemiluntinescent instrument systems to automate test performance and data collection . We view certain other revenues and expenses as not belonging to any one segment . Asa result, we have aggregated these items into an "Other" segment . .

27 Critical Accounting Policies and The Use of Estimates

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

Our blood testing segment consists of our one-half interest in the pretax operating earnings of our joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provide supplemental tests and microptate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the first quarter 2003, we had accounted for revenues from non-U.S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter . More current information of non-U .S . affiliate sales of our joint business contractual arrangement became available in the first quarter 2003, and as a result, we are able to recognize revenues from non-U .S . affiliate sales on a one-month lag . The effect of this change, net of tax, was an increase to net income by $3 .2 million for earnings of unconsolidated joint business for the six months ended June 30, 2003 .

We recognize a portion of revenue for product sales of Betaseront8 upon shipment to our marketing partner . and the remainder based on a contractual percentage of sales by our marketing partner. We also earn royalties on our marketing partner's European sales of Betaferon® in those cases where we do not supply the product . Prior to the first quarter 2002, we had accounted for revenues from non-U .S . product sales on a one-quarter lag and royalties as a percentage of forecast received from our marketing partner, with an adjustment of the estimate to actual in the subsequent quarter . More current information of non-U .S . Betaseron® sales became available in 2002, and as a result, we were able to recognize revenues from Betaseron® product sales and Betaferon® royalties on a current basis beginning in the first quarter 2002 . The effect of this change, net of tax, was an increase in net income for the six months ended June 30, 2002 by $3 .1 million for product sales and X2.8 million for royalties .

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements :

Purchased in-process research and development-We allocate the purchase price of acquisitions based on the fair value of the assets acquired and liabilities assumed. To assist in determining the value of the in-process research and development and certain other intangibles, a third party valuation is typically obtained as of the acquisition date . For previous acquisitions, the income approach has been used to value in-process research and development . The income approach is based on the premise that the value of a security or asset is the present value of the future earning capacity that is available for distribution to the subject investors in the security or asset . We performed a discounted cash flow analysis, utilizing anticipated revenues, expenses and net cash flow forecasts related to the technology . Given the high risk associated with the development of new drugs, we probability adjust the revenue and expense forecasts to reflect the risk of advancement through the regulatory approval process based on the stage of development

in the regulatory process . Such a valuation requires significant estimates and assumptions . We believe the fair value assigned to the in-process research and development is based on reasonable assumptions. However, these assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur . Additionally, estimates for the purchase price allocation may change as subsequent information becomes available . For the Matrix Pharmaceutical acquisition, we allocated a portion of the purchase price to purchased in-process research and development and wrote off $54.8 million in the first quarter 2002 . We do not anticipate that there will be any alternative future use for the in-process research and development that were written off We allocated a portion of the purchase price to a liability for asset disposal and lease cancellation for the San Diego, California facility closed during the third quarter 2002 . In the fourth quarter 2002, we found an assignee for the manufacturing facility lease and revised the allocation of the purchase price resulting in a $9 .6 million decrease to purchased in-process research and development (as the residual amount allocated to in -process research and development was less than the estimated fair value of the in-process research and development) .

Investments-We invest in marketable debt and equity securities . The prices of some of our marketable securities are subject to considerable volatility . We record an impairment charge when we believe that an investment in a marketable security has experienced a decline in fair value, as measured by quoted market prices, that is other-than-temporary . We believe that an investment in a marketable security is impaired if its quoted market price has been below its carrying value for each trading day in a six-month period, at which point we write down the investment. In addition, in determining whether impairment of a marketable equity security is considered to be other-than-temporary, we consider all available factors in the evaluation. These factors may include, but are not limited to, (i) whether the issuer of the securities is experiencing depressed and declining earnings in relation to competitors, erosion of market share, and deteriorating financial position, (ii) whether the issuer is experiencing financial difficulties and its market is experiencing difficulties, (iii)-ongoing activity in our collaborations with the issuer, if any and (iv) the issuer's prospects for favorable clinical trial results, new product initiatives and new collaborative agreements. Decreases in the fair value of these securities may impact our profitability . To reduce this risk, we hedge a portion of our exposure through forward sales contracts .

Inventories-We maintain inventory reserves primarily for product failures, recalls and obsolescence . The manufacturing processes for many of our products are complex . Slight deviations anywhere in the manufacturing process may result in unacceptable changes in the products that may result in failures or recalls and, therefore, additional inventory reserves. Obsolete inventory, due to the expiration of shelf life, and the seasonal nature of some of our products, may result in additional product reserves . In estimating inventory obsolescence reserves, we analyze on a product-by-product basis (i) the shelf life and the expiration date, (ii) sales forecasts and (iii) inventory levels compared to forecasted usage obtained from the production planning department, Judgment is required in determining whether the forecasted sales and usage information is sufficiently reliable to enable us to estimate an inventory obsolescence reserve . In addition, we operate in a highly competitive environment, with rapidly changing technologies . New technology or changes in production processes may result in product obsolescence. As a result, we may be required to record additional inventory reserves . Product returns and rebates-In estimating returns, we analyze (i) historical returns and sales patterns, (ii) our experience with similar products, (iii) current inventory on hand at the distributors and in the distribution channel and the remaining shelf life of that inventory , (iv) current economic trends, (v) distributors practices, (vi) changes in demand, particularly due to the seasonality of certain of our products and (vii) introduction of new competing products .

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In arriving at the accrual for product returns we use one of the following four methodologies depending on the product : (i) we calculate the average actual returns percentage for the previous rolling twelve months on a product-by-product basis and apply it to gross sales on a product-by-product basis for the last twelve months to arrive at the reserve balance required at the balance sheet date. The change in the reserve balance is recognized as a charge against revenue for the period, (ii) we match the actual returns to the actual sale on a product-by-product basis to assess the historical trend for returns . Based on an analysis of the historical trend, the appropriate return percentage for the current period is then applied to current period sales to arrive at the product returns charge against revenue for the period, (iii) we calculate the average returns percentage for the previous rolling twelve months on a product-by-product basis and apply it to inventory on hand at the distributors on a product-by-product basis or (iv) for seasonal products we analyze our actual returns over the previous seasons to arrive at the average actual returns percentage, which is then applied to the current season's sales to arrive at the charge against revenue for the current period . In estimating rebates, we match the actual rebate to the actual sale on a product-by-product basis, to arrive at an actual rebate percentage . This actual rebate percentage is applied to current period sales to arrive at the rebates expense for the period . In addition, we consider allowable prices by Medicaid and Medicare . If actual product returns and rebates are greater than our estimates, additional product return and rebates accruals may be required,

Collaborative, royalty and license arrangements-We recognize up-front refundable fees as revenues upon the later of when they become nonrefundable or when performance obligations are completed . In situations where continuing performance obligations exist, we defer and amortize up-front nonrefundable fees ratably over the performance period, which is typically stipulated by the contract ; otherwise, we recognize them as revenues when collection is reasonably assured. In arrangements with multiple deliverables, there may be significant judgment in separating the different revenue generating activities and in determining whether each is a separate earnings process . - Milestones, if any, related to scientific or technical achievements are recognized in income when the milestone is accomplished . The terms of such arrangements may cause our operating results to vary considerably from period to period . We estimate royalty revenues based on previous period royalties received or on product sales forecast information provided by the third party licensee . In the subsequent quarter, we record an adjustment equal to the difference between those estimated royalty revenues recorded in the previous quarter and the contractual percentage of the third party's actual product sales for that period . We exercise, judgment in determining whether the forecast information provided by-licensees is sufficiently reliable for us to base our royalty revenue recognition thereon .

Income taxes-Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets . We record valuation allowances to reduce deferred tax assets to the amounts that are more likely than not to be realized, We have considered future'taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances . If we determined that we would be able to realize our deferred tax assets in the future in excess of our net deferred tax assets, adjustments to the deferred tax assets would increase income by reducing tax expense in the period that we made such determination. Likewise, if we determined that we would not be able to realize all or part of our net deferred tax assets in the future, adjustments to the deferred tax assets would decrease income by increasing tax expense in the period that we made such determination .

Litigation and other contingencies---We establish and maintain accruals for litigation and other contingencies when we believe a loss to be probable and reasonably estimable, as required by

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SFAS No . 5, "Accounting for Contingencies ." We base our accruals on information available internally within the company at the time of. such determination and after management has consulted with and obtained advice from external professional advisors. Judgment is required in both the determination of probability and as to whether such an exposure is reasonably estimable. Information may become available to us after that time, for which adjustments to accruals may be required . - -

Goodwill and intangible assets-The valuation in connection with the initial purchase price allocation and the ongoing evaluation for impairment ofgoodwill and intangible assets requires significant management estimates and judgment . The purchase price allocation process requires management estimates and judgrrtent as to expectations for various products and business strategies . If any of the significant, assumptions differ from the estimates and judgments used in the purchase price allocation, this could result in different . valuations for goodwill and intangible assets . Once it is established, we must test goodwill annually for impairment using a two-step process as required by SFAS No . 142 "Goodwill and Other Intangible Assets ." In addition, in certain circumstances, we must assess if goodwill should-be tested for impairment between annual tests . Intangible assets with definite useful lives must be tested for impairment in accordance with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets ." When we conduct our impairment tests for goodwill and intangibles, factors that are considered important in determining whether impairment might exist include significant continued under-performance compared to peers, significant changes in the underlying business and products of our reporting units, or other factors specific to each asset or reporting unit being evaluated . Any changes in key assumptions about the business and its prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material adverse effect on our consolidated results of operations . - -

The accounting policies of our reportable segments are the same as those described in Note 1, "The Company and Summary of Significant Accounting ' Policies," in the Notes to Condensed Consolidated Financial Statements above and in our Annual Report on Form 10-K for the year ended December 31, 2002 .

On July 1, 2002, we completed our acquisition of Pulmopharm GmbH, a distributor of TOB1® products in Germany and Austria by purchasing the remaining 80 .1 % ownership that we did not previously own. Previously, we owned 19.9% of Pulmopharm and accounted for the investment under the equity method . We accounted for the acquisition of this business under the purchase method of accounting and included Pulmopharm's operating results in our consolidated operating results beginning on 1 1002 . Pulmophatm is part of our biopharmaceuticals seg r

On February 20, 2002, we acquired Matrix Pharmaceutical, Inc ., a company that was developing tezacitabine, a drug to treat cancer . We accounted for the acquisition as an asset purchase and included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in our consolidated operating results beginning on March 1, 2002 . Matrix Pharmaceutical is part of our biopharmaceuticals segment .

Certain minor arithmetical variances between the following narrative and the Condensed Consolidated Financial Statements may arise due to rounding.

Results of Operations

Biopharmaceuticals

Product sales Biopharmaceutical product sales were $107 .3 million and $104 :0 million for the three months ended June 30, 2003 and 2002, respectively, and $209 .0 million and $194 .5 million for the

1 six months ended June 30, 2003 and 2002, n veiy . Biopharmaceutical product sales in 2003 and 2002 ed principally of BetaseronO, TOBI® and ProleukinO .

Beraseron® We manufacture interferon beta-1 b which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc . (collectively "Schering"), tinder the trade names Betaseron®w (in the U .S and other non-European markets) and Betaferon® (in Europe) . Bochringer Ingclheim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by Chiron, we recognize a portion of revenue for product sales upon shipment to Schering and the remainder based on a contractual percentage of sales by Schering, both of which we record as. product sales. For product manufactured by Boehringer ingelheim and marketed by Schering in Europe under the trade name Betaferon(b, we receive royalties calculated at the same percentage of sales less supply costs, which we record in royalty and license fee revenues . The amount we record as product sales, based on a percentage of sales by Schering, and Betaferon® royalties will decline by five percentage points pursuant to our contractual agreement with Schering . As a result, we estimate that the . percentage of sales on which our payments are based will decrease in the fourth quarter 2003, reducing our per unit revenue by approximately 18% (for sales of Chiron product) and approximately 34% (for royalties from sales of Boehringer Ingelheim product) . However, there are a number of mitigating considerations, including (i) the transitional supply agreement, (ii) the volume mix of Chiron product and Boehringer Ingelheim product and (iii) the launch of product upgrades with ease-of-use features that will somewhat offset this contractual change and impact the ultimate contribution of Betaseron® to Chiron's profit .

In the first quarter 2003, the U .S . Food and Drug Administration approved new labeling for Betaseron®, The labeling expands the indication for Betaseron® to treat all relapsing forms of multiple sclerosis to reduce the frequency of clinical exacerbations . Relapsing forms of multiple sclerosis include relapsing--remitting, the most common form, and secondary progressive multiple sclerosis with relapses .

Betaseron® product sales were $30 .5 million and $34 .2 million for the three months ended June 30, 2003 and 2002, respectively, and $59 .8 million and $56 .0 million for the six months ended June 30, 2003 and 2002, respectively . The decrease in Betaseron®' product sales in the second quarter 2003 as compared with the second quarter 2002 primarily related to Berlex Laboratories and Schering ordering patterns, as well as wholesaler ordering patterns in the second quarter 2002 . Wholesalers built inventory in the second quarter 2002, to support . the mid-2002 launch of our new room-temperature formulation, which positively influenced sales in that quarter, This impact was partially offset by (i) increased patient demand, (ii) price increases and (iii) the benefit of the movement in the Euro to U .S. Dollar exchange rate in the second quarter 2003 as compared with the second quarter 2002 .

The increase in Betaseron® product sales year-to-date 2003 as compared with year-to-date 2002 primarily related to (i) increased patient demand attributed to a favorable response in the market place to the new'room-temperature formulation and key marketing programs, (ii) an overall increase in the market for interferon beta-lb products for multiple sclerosis, (iii) price increases and (iv) the benefit of the movement in the Euro to U .S . Dollar exchange rate. These increases were partially offset by (i) incremental revenues recognized in the first quartet 2002 related to the effect of recording revenue based on more current information available from Schering and (ii) Berlex Laboratories and Schering ordering patterns as wholesalers built inventory to support the mid-2002 launch of our new room-temperature formulation . Prior to the first quarter 2002, we accounted for revenues from non-U .S . product sales based on information provided by Schering on a one--quarter lag. More current information of non-U .S . Betaseron® sales became available in 2002, and as a result, we were able to begin recognizing revenues from Betaseron® product sales on a current basis . This change resulted in incremental revenues recognized during the first quarter 2002 of$4.3 million . Inventory ordering patterns as well as foreign currency exchange rates may influence future Betaseron® sales .

32 TOBf® We sell TOBIO directly in the U .S . and certain international markets, We recognized TOBI& sales of $39 .0 million and $33 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $79 .7 million and $69 .4 million for the six months ended June 30, 2003 and 2002, respectively, Increased TOBE® sales in the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with yearto-date 2002, primarily related to (i) greater product penetration in various European countries, (ii) increased use and improved compliance in the U .S . by patients with cystic fibrosis, (iii) price increases and (iv) the benefit of the movement in the Euro to U .S. Dollar exchange rate . These increases were partially offset by wholesale ordering patterns . In addition, the first quarter 2003 was negatively impacted by a change in sales adjustments . We continue to pursue the use of TOBI® to treat other serious lung infections and to seek approval in other countries . Wholesale ordering patterns as well as reimbursement and government pressures , competition, foreign currency exchange rates and the level of rebates may influence future TOBI® sales . In December 2002, the U .S . Food and Drug Administration tentatively approved an abbreviated new drug application for an inhaled tobramycin for sale in the U .S. following expiration of the orphan drug status ofTOBI® in December 2004. We have a patent in the U .S . covering the formulation of TOBI® that extends until 2014 .

ProleukinO Sales ofProleukin® were $29.4 million and $27 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $55 .4 million and $51,6 million for the six months ended June 30, 2003 and 2002, respectively . Proleukin® product sales in the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, increased primarily as a result of (i) price increases, (ii) wholesaler ordering patterns and (iii) the benefit of the movement in the Euro to U.S. Dollar exchange rate. Wholesale ordering patterns, reimbursement pressures, government legislation and foreign currency exchange rates may influence future Proleukin® sales .

The balance of product sales recognized in our biopharmaceuticals segment consisted of various other products . which individually were not material .

We expect compeiitive pressures related to many of our biopharmaceutical products to continue into the future, primarily as .a result of the introduction of competing products into the market, as listed in Part 1, Item I ., "Business-Competition" of our Annual Report on Form 10-K for the year ended December 31, 2002 .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . . Our biopharmaceuticals segment recognized collaborative agreement revenues of $1 .1 million and $3 .5 million for the three months ended June 30, 2003 and 20.02, respectively, and $3 .3 million and $7 .1 million for the six months ended June 30, 2003 and 2002, respectively ,

Collaborative agreement revenues for the three months ended June 30, 2003, primarily consisted of our fourth quarter 2002 collaboration agreement and license agreement with GlaxoSmithKline plc related to certain of our MC-4R compound patents . Collaborative agreement revenues for the six months ended June 30, 2003, consisted of our fourth quarter 2002 collaboration agreement and license agreement with GlaxoSmith Kline plc and our first quarter 2001 collaboration agreement with Taisho Pharmaceutical Co ., .Ltd . to target macrolide mediated gene discovery . Collaborative agreement revenues for the three and six months ended June 30, 2002, primarily consisted of our second quarter 2000 agreement with S*BIO (discussed below) and our first quarter 2001 collaboration agreement with Taisho Pharmaceutical Co ., Ltd .

S*BIO In the second quarter 2000 , we invested in a Singapore-based venture , S*BIO Pte Ltd, to research and develop therapeutic , diagnostic , vaccine and antibody products . We also granted S*810 ce rtain rights to our gene expression and combinatorial chemistry technology . Under this a rrangement ,

33 .

j we received approximately $23 .7 million for technology transfer and research services . We recognized collaborative agreement revenues of $3 .0 million and $6 .1 million for the three and six months ended June 30, 2002, respectively, under this arrangement . The technology transfer period and related revenue recognition period ended in the third quarter 2002 .

The balance of collaborative agreement revenues recognized in our biopharmaceuticals segment consisted of various other agreements, which individually were not material .

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and the achievement of milestones . Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the future . In addition, the collaboration agreements typically .provide for certain milestone payments and various royalties on future product sales if the collaborative partners commercialize a product using our technology . However, we have no assurance that the collaborative partners will meet their development objectives or commercialize a product using our technology . Also, our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners . We have no assurance that new relationships will be established or that current collaborative agreement revenues will not decline.

Royalty and license fee revenues Our biopharmaceuticals segment earns royalties on third party sales of several products, including Betaferon® and recombinant insulin and glucagon products . Our biopharmaceuticals segment also earns license fees for technologies, such as hepatitis C virus-related patents, used by third parties to develop therapeutic products . The biopharmaceuticals segment recognized royalty and license fee revenues of $20 .8 million and $16 .4 million for the three months ended June 30, 2003 and 2002, respectively, and $38.6 million and $33 .7 million for the. six months ended June 30, 2003 and 2002, respectively .

Betaferon® We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Serlex Laboratories, Inc . (collectively "Schering"), under the trade names Betaseron® (in the U .S and other non-European markets) and letaferon® (in Europe) . Boehringer Ingelheim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by Boehringer ingelheim, .-we receive royalties calculated as a percentage ofsales less the amount paid or incurred by Schering for supply costs . As discussed in "Product sales---Betaseron®" above, under our contractual agreement with Schering, our royalty will decline by five percentage points. For the three months ended June 30, 2003 and 2002, we recognized $17 .2 million and $10 .6 million, respectively, and for the six months ended June 30, 2003 and 2002, we recognized $31 .2 million and $24.2 million, respectively, under this arrangement. Betaferon® royalties increased in the second quarter 2003 as compared with the second quarter 2002 primarily as the result of(i) a positive true-up of estimate to actual in the subsequent quarter, (ii) an increase in Chiron's effective royalty rate under an agreement with Schering and (iii) the benefit of the movement in the Euro to U .S. Dollar exchange rate . The increase in Chiron's effective royalty rate is due to a reduction of the allocated cost under a three-year limited cost sharing arrangement with Schering.

Betaferon® royalties increased year-to-date 2003 as compared with year-to-date 2002 primarily as the result of (i) positive true-ups in the first and - second quarters of 2003 of estimate to actual in the subsequent quarter, (ii) an increase in Chiron's effective royalty rate under an agreement with Schering, as discussed above, and (iii) the benefit of the movement in the Euro to U .S . Dollar exchange rate. These increases were offset by incremental revenues recognized during the first quarter 2002 of $3.9 million related to a change in our methodology of recognizing these royalties . Prior to 2002, we accounted for Betaferon® royalties as a percentage of forecast received from Schering, with an adjustment .of the estimate to actual in the subsequent quarter. More current information of European Betaseron® sales was available in 2002, and as a result, we were able to recognize Betaferon0 royaltie s

is . on a current basis beginning in the first quarter 2002 . Foreign currency exchange rates may influence future Betaferon® royalties .

Novo Nordisk We earn royalty revenues on insulin and glucagon product sales by Novo Nordisk AS . We recognized $1 .9 million and 51 .3 million for the three months ended June 30, 2003 and 2002, respectively, and $3.9 million and $3 .3 million for the six months ended June 30, 2003 and 2002, respectively, under this arrangement . Patents related to the production of insulin and glucagon expire beginning late 2003 and as a result, significant reductions in royalty revenue recognized under this arrangement are expected .

The balance of royalty and license fee revenues recognized in our biopharmaceuticals segment consisted of various other agreements, which individually were not material . The balance of royalty and license fee revenues for the three and six months ended June 30, 2003, primarily consisted of our fourth quarter 2002 agreement with GlaxoSmithKline-plc where we granted rights under certain of our MC-4R compound patents for which we recognized a portion of the. license fee in the second quarter 2003 . The balance of royalty and license fee revenues for the three months ended June 30, 2002, primarily consisted of our second quarter 2002 agreement with Merck & Co ., Inc : where we granted rights under certain of our hepatitis C virus-related patents for which we recognized a license fee in the second quarter 2002 . The balance of royalty and license fee revenues for the six months ended June 30, 2002 . consisted of our second quarter : 2002 agreement with Merck & Co ., Inc . and our first quarter 2002 agreement with Abbott Laboratories where we granted rights under certain of out hepatitis C virus-related patents for which we recognized a license fee in the first quarter 2002 .

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

Other revenues Our biopharmaceuticals segment recognized other revenues of $3 .2 million. and $2 .0 million for the three months ended June 30, 2003 and 2002, respectively, and $18 .8 million and $6 :7 million for the six months ended June 30, 2003 and .2002,.respectively .

Conlract ntahtfacttrring reveiiies Our biophariiiaceuticals segment recognized contract manufacturing revenues of $3 :0 million and $1 .9 million for the three months ended June 30, 2003 and 2002, respectively, and $3 .1 million and $6.3 million for the six months ended June 30 . 2003 and 2002, respectively . The fluctuation resulted from the level of activity and the timing of contract manufacturing activities ,

Biogen and Serono settlements A U .S. Court of Appeals partially reversed a District Cou rt ruling in connection with ce rt ain patents owned by Chiron and licensed exclusively to Schering AG's U . S . subsidiary, Berlex Laboratories . As a result of the ruling and prior agreements between Bingen and Berlex , Biogen was required to make a settlement payment to Schering . In accordance with an earlier contract between Chiron and Berlex , we recognized approximatel y $13 .0 million during the six months ended June 30, 2003, which represented our share of this set tl ement payment . In addition, there was a similar settlement between Berlex and Serono of which we recognized approximately $1 .4 million during the six months ended June 30, 2003 .

g~ l Depocyr® In the fourth quarter 2002, we sold U.S . sates and marketing rights for DepocytO to SkyePharma plc . For the six months ended June 30, 2003, we recognized 5 1 .0 million related to transition services provided to SkyePharma under the acquisition agreement .

The balance of other revenues recognized in our biopharmaceuticals segment . consisted of various other arrangements, which individually were not material ,

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

Gross profit . Biopharmaceutical gross profit as a percentage of net product sales was 71% and 72% for the three months ended June 30, 2003 and 2002, respectively, and 75% and 74% for the six months ended June 30, 2003 and 2002, respectively . The decrease in biopharmaceutical gross profit margins for the second quarter 2003 as compared with the second quarter 2002 primarily resulted from costs due to a reserve taken against certain manufactured components held in inventory. The increase in the biopharmaceuticat gross profit margins .year-to-date 2003 as compared with year-to-date 2002 primarily resulted from price increases and the benefit of the movement in the Euro to U.S . Dollar exchange rate, partially offset by costs due to a reserve taken against certain manufactured components held in inventory.

Biopharmaceutical gross profit percentages may fluctuate significantly in future periods due to production yields and as the biopharmaceutical product and customer mix changes.

Research and development Out biopharmaceuticals segment recognized research and development expenses of $57 .4 million and $61 .1 million for the three months ended June 30, 2003 and 2002, respectively, and $113 .7 million and $118 .6 million for the six months ended June 30, 2003 and 2002, respectively .

In the fourth quarter 2002, we reached an agreement in principle to transfer responsibility for the SILCAAT (referred to also as Proleukin® for HIV) trial, a Phase III study for recombinant human interleukin-2 (IL-2, aldeseleukin), to the investigators, as managed by a Scientific Committee comprised of researchers affiliated with the Hospital Henri Mondor in Paris, the National Institutes Allergy and Infectious Disease (N1AID), the University of Minnesota, and other research institutions. Responsibility for the SILCAAT study was transferred to NIAID and University of Minnesota effective February 14, 2003 . Our research and development expenses related to the SILCAAT trial are expected to decrease . in 2003 as a result of transferring responsibility for the trial . However, under the agreement, we are obligated to fund a maximum of $I8 .0million over the lifetime of the trial and to supply . clinical materials and certain other support services of which $3 .0 million has been paid through June 30, 2003 .

In April 2003, we acquired exclusive worldwide development and commercial rights from Novartis for aerosolized cyclosporine (ACsA), a therapy under evaluation for treatment of acute rejections in lung transplant recipients .

The decrease in research and development spending year-to-date 2003 as compared with year-to-date 2002 primarily related to the timing of various clinical trials, including (i) transfer of the responsibility of the SILCAAT trial, to the investigators in the fourth quarter 2002 (discussed above) an d (ii) termination of our trials for fibroblast growth factor (FGF), a compound for treatment of patients with peripheral arterial disease, HBV-MF59,an immunotherapy for patients with chronic hepatitis B infection, and PA-1806, a compound for gram negative infections in cystic fibrosis patients . These decreases .were partially offset by the investment in other development projects, including those activities related to the development of (i) tezacitabine,'obtained . as a part .of the acquisition of Matrix Pharmaceutical in the first quarter 2002, (ii) interleukin-2 in combination with various monoclonal antibodies and (iii) a dry . powder formulation of our inhaled TOBIO product for the treatment of pseudontonas aeruginosa in cystic fibrosis patients . In addition, we are required to make capital

36 improvements to our existing manufacturing facilities to support the supply of Betaferon® to Schering . In connection with this project, we are continuing to incur expenses relating to the development of new processes and the performance of test runs related to the installed equipment .

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

Selling , general, and administrative Our biopharmaceuticals segment recognized selling, general and administrative expenses of $28 .2 million and $23 .9 million for the three months ended June 30, 2003 and 2002, respectively, and $54 .4 million and $43 .9 million for the six months ended June 30, 2003 and 2002, respectively . The increase in selling, general and administrative expenses for the. second quarter 2003 as compared with the second quarter 2002, as well as year=to-date 2003 compared with year-to-date 2002, related to (i) sales. and marketing costs for various biopharmaceutical post-market approval commitments, (ii) support for continued market penetration of TOBW in Europe. (iii) costs following the acquisition of Pulmopharm in the third quarter 2002, (iv) additional costs associated with the enhancement . of current business processes and (v) the Euro to U .S . Dollar exchange rate fluctuation. .

Amortization expense Our biopharmaceuticals segment recognized amortization expense of $6 .2 million and $5 .9 million far the three months ended June 30, 2003 and 2002, respectively, and $12 .4 million and $1 1 .8 million for the six months ended June 30, 2003 and 2002, respectively, The increase in amortization expense in the three and six months ended June 30, 2003 as compared with the three and six months ended June 30, 2002 related to the distribution rights acquired in the acquisition of Pulmopharm in the third quarter 2002 .

Vaccines

Product sales We sell meningococcal, flu, travel and pediatric vaccines in Germany, Italy, the United Kingdom and other international markets. Vaccine product sales were $85 .6 million and $72 .7 million for the three months ended June 30, 2003 and 2002, respectively, and $154 .0 million and $130.6 million for the six months ended June 30, 2003 and 2002, respectively.

Menjugate1M our conjugate vaccine against meningococcal infection caused by the bacterium N . mevingitidis serogroup C, sales were $13.7 million and $9.9 million for the three months ended June 30, 2003 and 2002, respectively, and $21 .2 million and $15 .7 million for the six months ended June 30 ; 2003 and 2002, respectively . The increase in Menjugate''M sales in the second quarter 2003 as compared with the second quarter 2002 primarily related to an Australian tender in the state of New South Wales and the benefit of the movement in the Euro to U .S . Dollar exchange rate . The increase in MenjugateT^' sale s year-to-date 2003 as compared with year-to-date 2002 primarily related to the Australian tender, as discussed above, increased sales to the Italian market and the benefit of the movement in the Euro to U .S . Dollar exchange rate .

Sales of our flu vaccines were $3 .8 million and $1 .8 million for the three months ended June 30, 2003 and 2002, respectively, and S& I million an d $4.1 million for the six months ended June 30, 2003 and 2002, respectively . The increase in flu vaccine sales in the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily resulted from increased sales to The Netherlands and the benefit of the movement in the Euro to U .S . Dollar exchange rate .

Sales of our travel vaccines, comprised of tick-borne encephalitis and rabies vaccines, were $23 .1 million and $23 .4 million forthe three months ended June 30, 2003 and 2002, respectively, and $48 .8 million and $41 .8 million for the six months ended June 30, 2003 and 2002, respectively . The increase in travel vaccine sales year-to-date 2003 compared with year-to-date 2002, primarily related to increased tick-borne encephalitis vaccine sales in the German market, driven by the new adult and

37 pediatric formulations launched in the first quarter 2002, and the benefit of the movement in the Euro to U .S . Dollar exchange rate .

Sales of our pediatric vaccines were $45.0 million and $37 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $75 .9 million and $69 .0 million for the six months ended June 30, 2003 and 2002, respectively . The increase in pediatric vaccine sales for the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily was due to tender sales and the benefit of the movement in the Euro to U .S . Dollar exchange rate . These increases were partially offset by decreased sales of our polio vaccines .

Ce rt ain of our vaccine products, pa rt icularly our An vaccines , are seasonal and typically have higher sales in the third and fou rt h quarters of the year . In addition, we expect MenjugateT5" sales to continue to fl uctuate as public health authorities consider adoption of broad vaccination programs . We have initiated a Phase III trial in the U . S . for MenjugateT M. The study, which is being conducted in conjunction with the No rt hern Californ ia Kaiser Pennanente Vaccines Research Center, will expand the vaccine's safety database for a U . S. population relative to the safety profile of the current U .S .-licensed meningococcal polysaccharide vaccine Menomunc® (A, C, Y, W- 135). We are exploring oppo rt unities for additional MenjugateTM sales in other countries .

We expect competitive pressures related to many of our vaccine products to continue into the future, primarily as a result of the introduction of competing products into the market, including, but not limited to, new combination vaccines, as listed in Part 1, Item I ., "Business-Competition" of our Annual Report on Form IO-K for the year ended December 31, 2002 .

Royalty and license fee revenues Our vaccines segment earns royalties on third party sales of, and license fees on, several products . The vaccines segment recognized royalty and license .fee. revenues of $33 million and $2 .8 million for the three months ended June 30, 2003 and 2002, respectively, and $6.5 million and $5 .4 million for the six months ended June 30, 2003 and 2002, respectively .

GlaxoSmithKlrne An agreement with GlaxoSmithKline plc provides for royalties on sales of certain vaccine products . Under this agreement, we recognized $1 .6 million and $1 .7 million of such royalties for the three months ended June 30, 2003 and 2.002, respectively, and $3 .4 million and $3 .6 million of such royalties for the six months ended June 30, 2003 and 2002, respectively .

Other We recognized $1 .7 million and $1 .1 million for the three months ended June 30, 2003 and 2002, respectively, and $3 .1 million and $1 .8 million for the six months ended June 30, 2003 and 2002, respectively, of royalty revenues primarily on third party sales of hepatitis B virus vaccine products . . The increase in 2003 as compared with 2002 primarily resulted from increased availability of the pediatric formulation in Germany, partially offset by increased competition from multivalent hepatitis B virus vaccine products . Certain patents related to the production of hepatitis B vaccine products expire beginning in 2004, which will result in reductions in royalty revenues recognized under one arrangement,.

Other revenues Our vaccines segment recognized other revenues of $3 .2 million and $5,1 million for the three months ended June 30, 2003 and 2002, respectively, and $6 .0 million and $9 .1 million for the six months ended June 30, 2003 and 2002, respectively .

39 Grant and contract revenues Our vaccines segment other revenues included grant and contract revenues of $2 .5 million and $4 .0 million for the three months ended June 30, 2003 and 2002, respectively, and $4 .7 million and $7 .1 million for the six months ended June 30, 2003 and 2002, respectively . in the second quarter 2000, we entered into an agreement with the U .S . National Institutes of Health to advance our HIV vaccine program into human clinical trials . Under this arrangement, we could receive $23 .2 million over five years. Under supplemental arrangements, we may perform other work related to the National Institutes of Health's HIV vaccine program on a grant or contract-by-contract basis . A majority of the grant and contract revenues, $2 .3 million and $2 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $4 .1 million and $4.7 million for the six months ended June 30, 2003 and 2002, respectively, were recognized under these arrangements.

The balance of other revenues recognized in our vaccines segment consisted of various other arrangements , which individually were not material .

Other revenues recognized in our vaccines segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues. We have no assurance that we will be successful in obtaining additional revenues or that these revenues will not decline . .

Gross profit Vaccines gross profit as a percentage of net product sales was 56% and 61% for the three months ended June 30, 2003 and 2002, respectively, and 52% and 55% for the six months ended June 30, 2003 and 2002, respectively . The vaccine gross profit margin in the second quarter 2003 was negatively impacted by foreign exchange rates . In addition, vaccine gross profit margin year-to-date 2003 as compared with year-to-date 2002 was negatively impacted by an expected temporary shutdown of certain facilities, in the first quarter 2003, to ensure compliance with regulatory requirements .

Vaccines gross profit percentages may fluctuate significantly in future periods due to product and customer mix, seasonality and ordering patterns and production yields.

Research and development Our vaccines segment recognized research and development expenses of $26 .8 million and $17 .5 million for the three months ended June 30, 2003 and 2002, respectively, and $47 .4 million and $34 .6 million for the six months ended June 30, 2003 and 2002, respectively . The increase in research and development spending for the three months ended June 30, 2003 as compared with the three months ended June 20, 2002, as well as year-to-date 2003 compared with year--to--date 2002, primarily related to the. advancement of several programs in our meningococcal franchise .

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

Selling, general , and administrative Our vaccines segment recognized selling, general and administrative expenses of $24 .7 million and $19 .8 million for the three months ended June 30, 2003 and 2002, respectively, and $46.9 million and $39 .8 million for the six months ended June 30, 2003 and 2002, respectively . The increase in selling, general and administrative expenses in the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily resulted from additional costs associated with the enhancement of current business processes and headcount and the impact of the movement in the Euro to U .S . Dollar exchange rate . For the year-to-date comparison, these increases were partially offset by (i) a payment made in the first quarter 2002 to the German government in lieu of statutory price reductions on prescription drugs that are reimbursed under the German government's healthcare program that was expensed in the first quarter 2002 and (ii) increased sales and marketing costs associated with the 2002 launch of our newly formulated tick-borne encephalitis vaccine . -

Amortization , expense Our vaccines segment recognized amortization expense of $1 .5 million for each of the three months ended June 30, 2003 and 2002, and $2 .9 million for each of the six months ended June 30, 2003 and 2002 .

39 Blood testing

Product sales Our blood testing segment recognized product sales of $53 .1 million and $34 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $101 .6 million and $59 .8 million for the six months ended June 30 . 2003 and 2002, respectively .

Procleix® On February 27, 2002, the U .S . Food and Drug Administration approved the Procleix® HIV--11 HCV Assay . Under a collaboration agreement with Gen--Probe Incorporated, we market and sell the Procleix® HIV-1/ HCV Assay and the related instrument system . In addition to selling directly in the U .S ., we also sell in various European and Asia I Pacific markets, directly and through distributors . We recognize product revenues based on the details of each contract .

Worldwide product sales related to tests, instruments and the provision of services were $46 .0 million and $29.5 million for the three months ended June 30, 2003 and 2002, respectively, and $88 .1 million and $47.5 million for the six months ended June 30, 2003 and 2002, respectively . The three months ende d June 30, 2003 include a full quarter of commercial pricing for the Procleix® HIV-I/ HCV Assay in the U .S . following the U .S . Food and Drug Administration approval- in February 2002,-and the subsequent commercial pricing commencing May 1, 2002 . Also contributing to the increase in product sales in the second quarter 2003 as compared with the second quarter 2002 were market share gains in use U .S . and continued penetration into several markets abroad .

Subsequent to the first qua rter 2002, we signed new commercial contracts including those with existing America's Blood Centers customers . the American Red Cross, the U . S . military and the Association of Independent Blood Centers to provide the Procleix O. HIV- .ll HCV Assay, In addition, we experienced market share gains in the U .S . and increased sales to several markets abroad in 2003 as compared with 2002 . Slightly offsetting the increase in product sales related to tests, instruments and the provision of services in 2003 as compared with 2002, was a one-time positive adjustment recognized in the fi rst quarter 2002 under contracts with all our U . S . customers for increased donations exceeding contractual minimums .

In March 2003, the U .S . Food and Drug Administration accepted an investigational new drug (IND) for the West Nile virus assay . The new assay will run on the same instrumentation platform as the currently approved Procleix® HIV-IIHCV assay .

Ortho-Clinical Diagnostics Under the Ortho-Clinical Diagnostics, Inc. contract, we manufacture bulk reagents and antigens and confirmatory test kits for immunodiagnostic products. We recognized product sales under this contract of $7 .I million and $5.1 million for the three mouths ended June 30, 2003 and 2002, respectively, and $13 .5 million and $12 .3 million for the six months ended June 30, 2003 and 2002, respectively . The increase in the second quarter 2003 as compared with the second quarter 2002, primarily related to an increase in products manufactured for Ortho-Clinical Diagnostics . In addition, the timing of manufacturing services under the arrangement contributed to the increase in year-to--date 2003 sales as compared with year-to=date 2002`sales . Chiron also supplies bulk antigens for Ortho-Clinical Diagnostics to be included in products to be sold by Bayer under a June 2001 agreement among Chiron, Ortho--Clinical Diagnostics and Bayer Corporation (see also "Royalty and license fee revenues-Bayer" below) ,

We expect competitive pressures related to our blood testing products to continue into the future, primarily as a result of the introduction of competing products into the market, as listed in .Part I, Item 1 . "Business-Competition" of our Annual Report on Form 10-K for the year ended December i 1, 2002 .

Earnings of unconsolidated joint business Our share of earn ings from our j oint business contractual arrangement with Ortho-Clinical Diagnostics ; Inc : was $27 . 5 million- and $27 .4 million for the three months ended June 30, 2003 and 2002, respectively, and $54 . 0 .million and $46 .2 million fo r

40 the six months ended June 30, 2003 and 2002, respectively . The increase in year-to-date 2003 as compared with year-to-date 2002 primarily resulted from (i) a one-time benefit in the first quarter 2003 due to a change in estimate relating to revenues from Ortho-Clinical Diagnostics' non-U .S . affiliate sales, (ii) the timing of Ortho-Clinical Diagnostics' shipments to third parties and (iii) increased profitability of Ortho--Clinical Diagnostics' foreign affiliates . Prior to the first quarter 2003, we had accounted for revenues from non-U .S . affiliate sales on a one-quarter lag . More current information is now available to us and as such, we now recognize revenues from non-U .S . affiliate sales on a one-ntonth .Iag, consistent with the method of how we recognize revenues from Ortho-Clinical Diagnostics' sales for the U .S . portion of Ortho-Clinical Diagnostics' business .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Under the Ortho--Clinical Diagnostics, Inc . contract, we conduct research and development services related to immunodiagnostic products . Our blood testing segment recognized total collaborative agreement revenues of $2 .3 million and $2.8 million for the three months ended June 30, 2003 and 2002, respectively, and $4.2 million and $5 .4 million for the six months ended June 30, 2003 and 2002, respectively . The majority of collaborative agreement revenues recognized by our blood testing segment related to immunodiagnostic products. The fluctuations between. 2003 and 2002 primarily related to the timing . of research services .

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed . the status of projects under collaboration and the achievement of milestones. Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the future . Our ability to generate additional collaborative agreement revenues may depend, in part,_on our ability to initiate and maintain relationships with potential and current collaborative partners . We have no assurance that new relationships will be established or that current collaborative agreement revenues will not decline .

Royalty and license fee revenues Our blood testing segment earns royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing our hepatitis. C virus and HIV-related patents, for use in the blood screening and plasma fractionation markets. Our blood testing segment also earns license fees related toour hepatitis C virus and HIV-related patents for technologies used by third parties to develop products for use in the blood screening and plasma fractionation markets . The blood testing segment recognizedroyalty and license fee revenues of $23 .2 million and $12 .6 million for the three months ended June 30, 2003 and 2002, respectively, and $38 .8 million and $22 .8 million for the six months ended June 30, 2003 and 2002, respectively.

Baxter A.G. In June 2003, we entered into two license agreements with Baxter A.G . related to our hepatitis C virus and. HIV technology for use. in the . plasma frac tionation market for which we recognized a license fee in the second quarter 2003 . In addition, in the second quarter 2003, we recognized royalty revenues under one of these arrangements . -

F. Hoffmann-La Roche settlement In October 2000, we entered into three license agreements with F . Hoffmann-La Roche Limited and several of its affiliated companies related to thesettlement of certain litigation in the U .S . and certain other countries for the use of our hepatitis C virus and HIV intellectual property . Two agreements relate to in vitro diagnostic products . See "Other-Royalty and license fee revenues" below . The third agreement for blood screening was superseded in May 2001 by two new agreements, one for each. of hepatitis C virus and HIV. Revenues under these agreements were $14 .2 million and $11 .3 million for the three months ended June 30, 2003 and 2002, respectively, and $28 .6 million and $20 .2 million for the six months ended June 30, 2003 an d 2002, respectively . The increase in 2003 as compared with 2002 related to a contractual increase in the royalty rates and increased donations. Royalties will } continue under these new agreements through the lives of the hepatitis C virus and HIV-related patents covering F. Hoffmanm-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus--related patents begin to expire in 2015 for the U .S . and in 2008 for Europe . Currently, the applicable issued 141V-related patent in Europe expires in 2005 . An HIV-related patent was issued in the U .S . on March 13, 2003 . This patent will expire seventeen years from the date of issuance. As permitted under the terms of its licensing agreement, F. Hoffmann-La Roche has decided to institute arbitration proceedings in regard to the application of the U .S . patent . During any pending arbitration proceedings, F . Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due .

Bauer In June 200 ], Chiron and Ortho-Clinical Diagnostics, Inc . entered into an agreement with Bayer Corporation for the clinical diagnostic market . Under this agreement, Bayer manufactures and sells certain ofOrtho-Clinical Diagnostics' hepatitis C virus and HIV immunodiagnostic products for use on Bayer's instrument platforms, Bayer paid us a license fee of $45 .3 million, which we deferred (due to our continuing manufacturing obligations) and began recognizing as revenue in the third quarter 2001 . We will recognize the remaining amount ratably through 2010 .

Royalty and license fee revenues may fluctuate based on the nature of the related agreements and the timing of receipt of license fees . Results in any one period are not necessarily indicative of. results to be achieved in the future . In addition, our ability to generate additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies . We have no assurance that we will be able to do so or that future royalty and license fee revenues will not decline.

-Gross profit Blood testing gross profit as a percentage of net product sales was 46% and 41 % for the three months ended June 30, 2003 and 2002, respectively, and 44% and 39% for the six months ended June 30, 2003 and 2002 . respectively . The increase in blood testing gross profit margins in the second quarter 2003 as compared with the second quarter 2002, primarily related to an adjustment to cost of goods sold pursuant to our collaboration agreement with Gen-Probe Incorporated . In addition, the increase in blood testing gross profit margin year-to-date 2003 as compared with year-to-date 2002 related to (i) the increase in Procleix® HIV-I/ HCV product sales as a percentage of total blood testing product sales and (ii) the timing of manufacturing services under the Ortho-Clinical Diagnostics contract .

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

Research and development Our blood testing segment recogni2ed research and development expenses of $5 .6 million and $5 .2 million for the three months ended June 30, 2003 and 2002, respectively, and $10 .8 million and $9 .4 million for the six months ended June 30. 2003 and 2002, respectively . The increase in research and development spending in 2003 as compared with 2002 primarily related to the continued development of nucleic acid testing products .

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

Selling , general, and administrative Our blood testing segment recognized selling, general and administrative expenses of59.6 million and $8 .0 million for the three months ended June 30, 2003 and 2002, respectively, and $17 .4 million and $15 .2 million for the six months ended June 30, .2003 and 2002, respectively . The increased selling, general and administrative expenses in the second quarter 2003 as compared with the second quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, related to the expansion of our customer base for the Procleix® HIV-€/HCV Assay in the U .S ., Europe and other international markets and to the preparation and roll-out of the West Nile virus assay under IND testing . We expect continued growth in selling, general and administrative expenses related to nucleic acid testing technology and products as we expand our sales opportunities in new markets through anticipated additional nucleic acid testing adoption .

42 Other

Royalty and license fee revenues Our other segment earns royalties on third party sales of, and license fees on, several products : Our other. segment recognized royalty and license fee revenues of$19 .6 million and $13 .7 million for the three months ended June 30, 2003 and 2002, respectively, an d $36 .4 million and $28 .5 million for the six months ended June 30, 2003 and 2002, respectively . The majority of royalty and license fee revenues related to the use of our hepatitis C virus and HIV-related . patents by various third parties .

F. Ho1Jrnann-La Roche settlement In October 2000, we entered into three license agreements with F. Hoffmann--La Roche Limited related to the settlement of litigation in the U .S . and ce rt ain other countries for use of our hepatitis C virus and HIV nucleic acid testing intellectual property for use in clinical diagnostics.

Under the hepatitis C virus agreement, we received $85 .0 million, of which we recognized $40.0 million in the fourth quarter 2000 . We deferred the remaining $45 .0 million, which becomes nonrefundable ratably through 2005 . In the first quarter 2001 . we began recognizing portions of the $45 .0 million based upon the greater of(i) the scheduled quarterly minimum non-refundable amount or (ii) the actual earned credits as royalties on future sales related to F . Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products . The agreement also provides for royalties on future sales related to F. Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products, which commenced in the first quarter 2001 . Royalty revenues increased year-to-date 2003 as compared with year-to-date 2002, primarily as a result of increased sales recognized by F . Hoffmann-La Roche .

The HIV agreement provides for royalties on future sales related to F . Hoffmann--La Roche's use of our HIV-related patent . in its in vitro diagnostic products, which commenced in the first quarter 2001 when the European Patent Office Board of Technical Appeals upheld our HI V-related patent . Royalty revenues recognized under this agreement year-to-date 2003 were consistent with year-to-date 2002 .

Such royalties will continue through the lives of the hepatitis C virus and HIV-related patents covering F . l-loffmann-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents expire in 2015 for . the U .S . and in 2008-for Europe . Currently, the applicable issued- HIV-related patent in Europe expires in 2005 . An HIV-related patent directed to nucleic acid testing methods for HIV-€ was issued in the U .S . on March 13, 2003 . This patent will expire seventeen years from the date of issuance . The issuance of the patent triggered a milestone payment to Chiron of $10.0 million from F. Hoffmann-La Roche, which was received in April 2003 . As permitted under the terms of its licensing agreement, F . Hoffmann-La Roche has decided to institute arbitration proceedings in regard to the application of the U .S . patent. We have deferred recognition of this $10 .0 million milestone payment and interest as of June 30, 2003 . During any pending arbitration proceedings, F. Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due .

Bayer A cross-license agreement provides for royalties to us on HIV and hepatitis C virus products sold by Bayer, which increased year-to-date 2003 as compared with year--to-date 2002. - -

Abbott Laboratories A cross-license agreement provides for royalties to us on HIV and hepatitis C virus products sold by Abbott . We recognized royalty and license fee revenues. under this agreement in the second quarter 2003 .

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

43 Royalty and license fee revenues may fluctuate based on the nature of the related agreements, the timing of receipt of license fees and the expiration of patents . Results in any one period are not necessarily indicative of results to be achieved in the future . In addition, our ability to generate additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies . We have no assurance that we will be able to do to or that future royalty and license fee revenues will not decline .

Selling, general, and administrative Our other segment recognized selling, general and administrative expenses of$17 .2 million and $19 .4 million for the three months ended June, 2003 and 2002, respectively, and $34 .0 million and $35.0 million for the six months ended June, 2003 and 2002, respectively. The decrease in selling, general and administrative expenses in 2003 as compared with 2002 primarily resulted from lower litigation costs in the first and second quarters of 2003 related to our investment in and defense of our patents and technology, partially offset by increased consulting, severance and employee-related expenses .

Write-off of purchased in-process research and development The write-off of purchased in-process research and development was $54 .8 million for the six months ended June 30, 2002 . There was no write-off of purchased in -process research and development for the six months ended June 30, 2003 .

On February 20, 2002, we acquired Matrix Pharmaceutical, Inc . and accounted for the acquisition as an asset purchase . We allocated the purchase price based on the fair value of the assets acquired and liabilities assumed . We allocated a port ion of the purchase price to purchased in-process research and development and wrote off $54 .8 million in the first quarter 2002 . We allocated a portion of the purchase price to a liability for asset disposal and lease cancellation for the San Diego, Califo rnia facility closed during the third qua rter 2002, in the fou rt h quart er 2002 , we found an assignee for the manufacturing facility lease and revised the allocation of the purchase price resulting in a $9 .6 mil lion decrease to purchased in-process research and development . We do not anticipate that there will be any alte rnative future use for the in- process research and development that were written off . In valuing the purchased in-process research and development , we used probability-o f- success-adjusted cash flows and a 2O % discount rate. We assumed revenue from tezacitabine to commence after 2005 . As with all pharmaceutical products , the probability of commercial success for any research and development project is highly uncertain .

Restructuring and reorganization For the three and six months ended June 30, 2003, we recorded restructuring and reorganization charges o f $0 .5 million and $0.7 million, respectively: The charges consisted of termination and other .employee-related costs recognized in connection with the elimination of 7 positions in our Amsterdam manufacturing facility.

Interest expense We recognized interest expense of $2 .8 million and $3 .1 million for the three months ended June 30, 2003 and 2002, respectively, and $6 .3 million for each of the six months ended June 30, 2003 and 2002 . The decrease in the second quarter 2003 as compared with the second quarter 2002 primarily was'related to lower interest rates .

Interest and other income, net Interest and other income, net, primarily consisted of interest income'on .our cash and investment balances and other non-operating gains and losses . We recognized interest income of $6 .3 million and $9 .3 million for the three months ended June 30, 2003 and 2002, respectively, and $13 .3 million and $19 .1 million for the six months ended June 30, 2003 and 2002 . respectively . The decrease in interest income in 2003 as compared with 2002 primarily was due to lower average interest rates and lower average cash and investment balances .

We recognized gains of $4 .8 million and $7 .8 million for the three months ended June 30, 2003 and 2002, respectively, and $9 .4 and $14 .3 million for the six months ended June 30, 2003 and 2002, respectively, related to the sale of certain equity securities .

44 i i

We did not recognize any losses attributable to the other-than- icmporary impairment of equity securities for the three and six months ended June 30 . 2003 . For the three and six months ended June 30, 2002, we recognized losses attributable to the other-than-temporary impairment of certain equity securities o f $2 .8 million and $4 .6 million, respectively .

In the second quarter 2001, we recorded a charge of $l .5 million to write-down debt securities with a face value of $5 .0 million due to the decline in the credit rating of the issuer. On March 1, 2002, the issuer paid us $5 .1 million-the full principal plus interest . As a result, we recorded $ I .5 million in "Interest and other income, net," for the six months ended June 30, 2002 .

.On December 31, 1998, we completed the sale of our 30% interest in General Injectibles & Vaccines . inc ., a distribution business, to Henry Schein, Inc . and received 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 $2 .0 million for 2002 and $5.4 million for 2001 during the six months ended June 30, 2003 and 2002, respectively.

Income taxes The reported effective tax rate for 2003 is 25% of pretax income from continuing operations . The reported effective tax rate for the six months ended June 30, 2002 was 27% of pretax income from continuing operations, excluding the write-off of purchased in-process research and development related to the Matrix Pharmaceutical acquisition . The write-off of purchased in-process research and development in 2002 is not tax deductible . The 2003 effective tax rate is lower than the 2002 effective tax rate due to increased benefits associated with Chiron's research and development activities and tax planning initiatives . The effective tax rate may be affected in future periods by changes in management's estimates with respect to our deferred tax assets, acquisitions and other items affecting the overall tax rate.

The reported effective tax rate for 2003 of 25% excludes any anticipated impact associated with our July 2003 acquisition of PowderJect Pharmaceuticals plc . Powderiect operates primarily in the United Kingdom and Sweden, where the marginal tax rates are in excess of our current effective tax rate of 25% . Management is currently reviewing and is considering implementing tax strategies that mitigate these tax rate disparities .

Discontinued Operations . Ina strategic effort to focus on our core businesses of biopharmaceuticals, vaccines and blood testing, we completed the sale of Chiron Diagnostics and Chiron Vision in 1998 and 1997, respectively .

In the second quarter 2003, we reversed approximately $0 .5 million related to unutilized reserves for Chiron Diagnostics and Chiron Vision, which was recorded as a "Gain on disposal of discontinued operations" for the three months ended June' 30, 2003 .

In the first quarter 2003, Chiron and Bayer Corporation reached a settlement agreement relating to eerlain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, we made a payment to Bayer during the first quarter 2003 . We utilized an amount previously reserved for indemnity obligations, based upon the settlement agreement with Bayer . These amounts resulted in a net charge of $7 .6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of$1 .4 million which was recorded as a "Gain on disposal of discontinued operations" for the six' months ended June 30, 2003 .

In connection with the sale of Chiron Diagnostics and Chiron Vision, we recorded cumulative net deferred tax assets of $0 .2 million and $8.5 million at June 30, 2003 and December 31, 2002, respectively, principally attributable to the timing of the deduction of certain expenses associated with these sales . We also recorded corresponding valuation allowances of$0 .2 million and $8 .5 million at June 30, 2003 and December 31, 2002, respectively, to offset these deferred tax assets, as management

45 i

believes that it is more likely than not that the deferred tax assets to which the valuation allowance relates will not be realized . The future recognition of these deferred tax assets will be reported as a component of "Gain (loss) on disposal of discontinued operations . "

New Accounting Standards

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity ." This Statement establishes new standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity . It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) . This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 . The adoption of SFAS No . 150 is. not expected to have a material impact on our Consolidated Financial Statements .

In April 2003, the FASB issued SFAS No . 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities," which amends and clarifies the accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No . 133 . It requires, among other things, that contracts with comparable characteristics be accounted for similarly and clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows . SFAS No . 149 is effective generally for contracts entered. into and modified after June 30. 2003 . The adoption of SFAS No. 149 is not expected to have a material impact on our Consolidated Financial Statements .

. In November 2002, the FASB issued EITF Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables ." EITF Issue No. 00-2.1 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities . EITF Issue No : 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting . EITF Issue No. 00-21 provides guidance with respect ;to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting . EITF . Issue No, 00-2I also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions an d consideration that varies as a result of future actions of the customer or the company . Finally, EITF Issue No . 00-21 provides . guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting for an arrangement . The provisions of EITF Issue No. 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003 . The adoption of EITF Issue No . 00-21 is not expected to have a material impact on out Consolidated Financial Statements .

Liquidity and Capital Resources

Our capital requirements have generally been funded from operations , cash and investments on hand, debt borrowings and issuance of common stock . Our cash and investments in marketable debt securities, which totaled $1,266 .5 million at June 30 . 2003, are invested in a diversified portfolio of financial instruments , including money market instruments, corporate notes and bonds, government or government agency securities and other debt securities issued by financial institutions and other issuers

4 6

I with strong credit ratings . By policy, the amount of credit exposure to any one institution is limited . Investments are generally not collateralized and primarily mature within three years.

We believe that our cash, cash equivalents and short-term investments, together with funds provided by operations and leasing arrangements, will be sufficient to meet our foreseeable operating cash requirements including any cash utilized under our stock repurchase program . In addition, we believe we could access additional funds from the debt and, under certain circumstances . capital markets .

On May 19, 2003, we announced the commencement of an all cash offer to acquire all issued and to be issued share capital of PowderJect Pharmaceuticals plc for 550 pence per ordinary share. On July 8, 2003, our cash offer became unconditional . As part of the acquisition of PowderJect, we will assume the debt of PowderJect including convertible notes with a face value of 35- 0 million British Pounds ($57 .0 million at July 8, 2003). As of August 11, 2003, we had acquired or agreed to acquire or had received valid acceptances of the offer in respect of, in aggregate, 97,735,800 PowderJect shares, representing 99 .14% ofthe issued share capital of PowderJect as of that date.

On July 30, 2003, we raised $450 .0 million through an offering of convertible debentures, referred to as the "Offering ", and an additional $50 . 0 million from the exercise of an option, granted to the underwriters, to purchase additional convertible debentures in connection with the Offering . The convertible debentures bear a coupon rate of 1 .625% perannum and interest is payable semiannually . The debentures are convertible into shares of our common stock and the terms include an initial conversion price of approximately $68 .44 per share . The debentures may not be called for redemption by us for five years. Holders of the debentures will have the option to require us to purchase their debentures at par value in years five, 10, 15, 20 and 25 . We may choose to pay the redemption purchase price in cash and / or shares of common stock . The debentures mature on August 1, 2033 .

Sources and uses of cash We had cash and cash equivalents of$876 .0 million and $268.3 million at June 30, 2003 and 2002, respectively .

. Operating activities For the six months ended June 30, 2003, net cash provided by operating activities was $1 13 .2 million as compared with $82 .6 million for the six months ended June 30, 2002 . The increase incash provided by operating activities primarily was due to higher income from continuing operations before depreciationand amortization and other non-cash charges : The net cash provided by operating activities increased as a result of(i) higher royalty - payments received under the Roche royalty arrangements, (ii) $14 .4 million of cash received as a result of the Biogen and Serono settlements in connection with the McCormick patents (see "Biopharmaceuticals--Other revenues" above), (iii) higher royalty payments received under the Betaferon® royalty arrangement and (iv) larger increases in accounts receivable at June 30, 2002 as compared to June 30, 2003 . Partially offsetting these increases were .(i) larger increases in inventory at June 30, 2003 and (ii) payments in 2003 including a payment made to Bayer Corporation as a result of a settlement agreement relating to certain claims raised by Bayer in connection under the Stock Purchase Agreement dated September 17, 1998 and higher tax payments . We made approximately $29 .0 million in federal tax payments during the first half of 2003 as compared with approximately $17 .0 million in the first half of 2002.

At June 30, 2003, we had foreign net operating loss carryforwards of approximately $13 .2 million, of which approximately $3 .6 million begin expiring over the period 2008 to 2018 . The remaining foreign net operating loss carryforwards of $9 .6 million are available to offset future taxable income without limitation .

At June 30, 2003, we had unutilized federal net operating loss carryforwardsattributable to the acquisition of Matrix Pharmaceutical of approximately $56 .7 million, which are available to offset future domestic taxable income ratably through 2022 .

47 At June 30, 2003, we had $34.0 million of state net operating loss carryforwards, which expire between 2003 and 2022, and state net operating loss catryforwards attributable to the acquisition of Matrix Pharmaceutical, Inc . of approximately $28 .4 million, which are available to offset taxable income ratably through 2012 .

At June 30, 2003, we had $2 .2 million of federal business tax credit carryforwards attributed to the acquisition of PathoGenesis Corporation, which expire in 2012 . AtJune 30, 2003, we had $3 .6 million of federal business tax credit carryovers, which expire in 2007, and state business tax credit carryovers of $23 .0 million, which are available to offset future state tax liabilities without limitation .

We anticipate that research and development expenditures in 2003 will primarily be driven by (i) those activities under our December 2001 and June 2002 collaboration agreements with Nektar Therapeutics (formerly Inhale Therapeutic Systems, Inc .) related to, among other things, the development of a dry powder formulation of our inhaled TOB-l® product for the treatment of pseudomonds aeruginosa in cystic fibrosis patients and a dry powder inhaleabl e erythromyclamine product targeted for the treatment of acute exacerbations of chronic bronchitis, (ii) those activities related to the development of tezacitabirie, obtained as a part of the acquisition of Matrix Pharmaceutical in the first quarter 2002, (iii) those activities related to the development of interleukin .2 in combination with various monoclonal antibodies, (iv) expansion of our meningococcal franchise, (v) development of a flu cell culture system and (vi) research activities focused on identifying several novel vaccines and therapeutics for clinical development in the areas of oncology and infectious disease . In addition, we are required to make capital improvements to our existing manufacturing facilities to support the supply of Betaferon® toSchering . In connection with this project, we are continuing to incur expenses relating to the development of new processes and the performance of test runs related to installed equipment . Net cash from operating activities are expected to fund these research and development activities .

Investing activities . For the six months ended June 30, 2003 , net cash provided by investing activities consisted of proceeds from sales and maturities of investments in marketable debt securities of $917 . 8 million and proceeds from the sale of equity securities and interests in affiliates companies of $7 .4 million. . Cash provided by investing activities was offset by,purchases of investments in marketable debt securi ties of $277 .5 million, capitalexpenditures o f $52.4 million, purchases of equity securities and interests in affiliated companies of $36 .9 million, c as h paid for acquisitions, net of cash acquired of $ 1 .2 mi ll ion and other uses of cash of $0 . 8 million .

in April 2001, we entered into a collaboration with Rhein Biotech N .V. (now part of Berna Biotech) and GreenCross Vaccine Corporation to research and develop ce rt ain pediatric combination vaccine products for sale outside of Europe and North America. The collaboration agreement requires capital commitments from Chiron, Berna Biotech and GreenCross Vaccine . Our commitment is approximately 26 .4 million Euro ($ 30 .2 million at June 30, 2003) for the expansion of our Italian manufacturing facilities, of which we paid 4 .6 million Euro ($ 5 .4 million ), as of June 30, 2003 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008 . We currently are evaluating various financing alternatives to fund this expansion .

In February 2001, our Board of Directors approved a $235 .0 million capital expansion project, which includes the construction of a research and development facility (including a supporting central utility facility) and a parking structure in Emeryville, California. We had committed to $37.6 million in design and construction services, under which we had incurred costs of $28 .4 million, as of June 30, 2003 . We may cancel these remaining commitments at any time . .Related to the research and development facility, we are evaluating various financing alternatives to fund this expansion .

The purchases of equity securities and interests in affiliated companies consisted of a $33 .7 million payment to purchase 3 .8 million shares of PowderJect (discussed above) and equity contributions under several venture capital funds including a $1 .0 million capital contribution under a 2003 limited

48 partnership agreement, a $0.1 million capital contribution undera 2002 limited partnership agreement, a $0 .6 million capital contribution under a 2001 limited partnership agreement and a $1 .4 million capital contribution under a 2000 limited partnership agreement . We are obligated to pay $60.0 mil lion over ten years in equity contributions to these venture capital funds, of which $28 .7 million was paid through June 30, 2003 .

For the six months ended June 30, 2002, net cash used in investing activities consisted of purchases of investments in marketable debt securities of $320.7 million, net cash paid to acquire Matrix Pharmaceutical, Inc . of$54.9 million, capital expenditures of $54 .3 million, purchases of equity securities and interests in affiliated companies of $3 .1 million, other uses of cash of $0.9 million, and cash paid for acquisition costs related to the acquisition of PathoGenesis of $0 .4 million . Cash used in investing activities was offset by proceeds from sales and maturities of investments in marketable debt securities of $31 1 .1 million, proceeds from the sale of equity securities and interests in affiliated companies of $13 .4 and proceeds from the sale of assets of $0.2 million ,

Financing activities For the six months ended June 30, 2003 , net cash used in financing activities consisted of $68.1 million for the acquisition of treasury stock, $0:1 million for the net repayment of short-term borrowings and $0 .1 million for the repayment of debt . Cash used in financing activities was offset by $24 .5 million of proceeds from the reissuance of treasury stock (related to stock option exercises) and $2 .1 million of proceeds from put options.

Our Board of Directors has authorized the repurchase of our common stock on the open market. In December 2002, our Board of Directors approved an additional 5 .0 million share increase and authorized such repurchases through December 31, 2003 . As of June 30, 2003, we may repurchase up to an additional 3 .0 million shares of our common stock . - -

As of March 31, 2003, we had an outstanding put option contract with a third party, entitling the holder to sell to us 0 . 5 million shares at $36 .79 per share, In connection with the sale, we collected a $1 .4 million premium . The option expired unexercised on May 5, 2003 .

As of December 31, 2002, we had an outstanding put option contract with a third patty entitling the holder to sell to us 0 .5 million shares at S38 .11 per share . The option expired unexercised on January 29, 2003 .

For the six months ended June 30, 2002, net cash used in financing activities consisted of $45 .1 million for the acquisition of treasury stock and $0 .3 million . for the repayment of short-term borrowings . Cash used in financing activities was offset by $18 .0. million of proceeds from the reissuance of treasury stock (related to stock option exercises) and $2 .0 million of proceeds from put options.

We are currently evaluating a number of business development opportunities. To the extent that we are successful in reaching agreements with third parties, these transactions may involve selling a significant portion of our current investment portfolio, incurring additional debt or may cause us to issue Chiron shares .

49 Borrowing arrangements Under a revolving, committed, uncollateralized credit agreement with a major Financial institution, we can borrow up to $100 .0 million in the U .S . This credit facility is guaranteed by Novartis AG under a November 1994 Investment Agreement, provides various interest rate options and matures in February 2006 . There were no borrowings outstanding under this credit facility at June 30, 2003 and December 31, 2002 . In ' December 1999, Chiron and Novartis amended the November 1994 Investment Agreement to reduce the maximum amount of our obligations that Novartis would guarantee from $725 .0 million to $702 .5 million.

We also have various credit facilities available outside the U .S . There were no outstanding borrowings under these facilities at June 30, 2003 . Borrowings under these facilities totaled $0 .1 million at December 31, 2Q02 . One facility is maintained for our 51 %-owned Indian subsidiary, and allows for total borrowings of 200 million Indian Rupee-($43 million at June 30, 2003) . There were no outstanding borrowings under this facility at June 30. 2003 . At December 31, 2002, $0 .1 million was outstanding under this facility. Our Italian subsidiary also has various facilities, related to its receivables, which allow for total borrowings of 10 .9 million Euro ($12 .4 million at June 30, 2003) . There were no outstanding borrowings under these facilities at June 30, 2003 and December 31, 2002 ,

Capital Lease In July 2003 ; we entered into a new six-year lease to rent a research and development facility in Emeryville, California following the expiration of our existing lease . Effective July 1, 2003, we accounted for this new lease as a capital lease and, as a result, recorded the leased facility and the corresponding liability on our balance sheet . The amount recorded on our balance sheet for the leased facility is $157 .5 million . At the inception of the lease, the future minimum lease payments, exclusive of a residual value guarantee, are approximately $13 .7 million over the lease term. The interest payments represent variable-rate interest payments indexed to a three-month London interbank offered rate plus 40 basis points . The lease provides a $156 .0 million residual value guarantee from us to the lessors in the event of property value declines, Consequently, our maximum payment obligation is $156 .0 million upon termination of the lease on or before July 1, 2009 . On or before July 1, 2009, we can choose to either purchase the facility from the lessors or sell the facility to a third party . This option accelerates if we default on our lease payments or in the event of other defined events. As of'July 1, 2003, Novartis AG had guaranteed (under - provisions of the investment Agreement) payments on this lease commitment, including payment of the residual value guarantee . to a maximum o f $173.3 million . -

Factors that May Affect Future Result s

As a global pharmaceutical company, we are engaged in a rapidly evolving and often unpredictable business . The forward-looking statements contained in this l0-Q and in other periodic reports, press releases and other statements issued by us from time to time reflect our current beliefs and expectations concerning objectives, plans, strategies, future performance and other future events . The following discussion highlights some of the factors, many of which are beyond our control, which could cause actual results to differ . -

If otirfocus on the research and development of emerging technologies does not idtintaiely result in the creation o/'corumercial products, our business could he adversely affected.

We focus our research and development activities on areas in which we have particular strengths and on technologies that appear promising . These - technologies often are on the "cutting edge" of modem .science . As a result, the outcome of any research or development program is highly uncertain . Only a-very small fraction of these programs ultimately result in commercial products or even product candidates . Product candidates that initially appear promising often fail to yield successful products . In many cases, preclinical or clinical studies will show that a product candidate is not efficacious (that is, it lacks the intended therapeutic or prophylactic effect), or that it raises safety concerns or has other side effects, which outweigh the intended benefit . Success inpreciinical or early clinical trials (which

5 0

'i~ generally focus on safety issues) may not translate into success in large-scale clinical trials (which are designed to show efficacy), often for reasons that are not fully understood . Further, success in clinical trials will likely lead to increased investment, adversely affecting short-term profitability, to bring such products to market . And even after a product is approved and launched, general usage or post-marketing studies may identify safety or other previously unknown problems with the product which may result in regulatory approvals being suspended, limited to narrow indications or revoked, or which may otherwise prevent successful commercialization .

We collaborate with third parties to develop and commercialize new products, conflicts with or decisions by these third parties could harm our business .

-An important part of our business strategy depends upon collaborations with third parties, including research collaborations and joint efforts to develop and commercialize new products . As circumstances change, Chiron and our corporate partners may develop conflicting priorities or other .con f icts of interest, We may experience significant delays and incur significant expenses in resolving these conflicts and may not be able to resolve these matters on acceptable terms : Even without conflicts of interest, we may disagree with our corporate partners as to how best to realize the value associated with a current product or a product in development. In some cases, the corporate partner may have responsibility for formulating and implementing key strategic or operational plans . In addition, merger and acquisition activity within the pharmaceutical and biotechnology industries may affect our corporate partners, causing them to reprioritize their efforts related to research collaborations and other joint efforts with us . Decisions by corporate partners on key clinical, regulatory . marketing (including pricing), inventory management and other issues may prevent successful commercialization of the product or otherwise impact our profitability . if we fail to obtain or maintain the regulatory approvals we need to market our products . our business will suffer.

We must obtain and maintain regulatory approval in order to market most of our products . Generally, these approvals are on a product-by-product and country-by-country basis. In the case of therapeutic products, a separate approval is required for each therapeutic indication . See Part 1, Item 1 . "Business-Government Regulation" in our Annual Report on Form IO--K for the year ended December 31, 2002 . Product candidates that appear promising based on early, and even large-scale, clinical trials may not receive regulatory approval . The results of clinical trials often are susceptible to varying interpretations that may delay, limit or prevent approval or result in the need for post-marketing studies . In addition, regulations may be amended from time to time. Revised regulations may require us to reformulate products on a country or regional basis, obtain additional regulatory approvals, or accept additional risks that our products will not maintain market acceptance or be eligible for third party insurance coverage . Increased regulatory scrutiny and restrictions regarding marketing practices for products, including those products that are subject to government reimbursement, may impact the sales of such products . There is no guarantee that we will be able to satisfy these new regulatory requirements and may suffer a loss of revenue as a result .

Our products are complex and difficult to manufacture on a large-scale basis, which could cause us to delay product launches , experience shortages of prodders or prevent usf'om offering products on a volume basis.

51 manufacturing process, including quality control, labeling and packaging, may result in unacceptable changes in the products that may result in lot failures or product recalls, or liability to a third party to the extent we are contract manufacturing products in our facilities for such third party . Manufacturing processes which are used to produce the smaller quantities of material needed for research and development purposes may not be successfully scaled up to allow production of commercial quantities at reasonable cost or at all . All of these difficulties are compounded when dealing with novel biologic products that require novel manufacturing processes . Additionally, manufacturing is subject to extensive government regulation . Even minor changes in the manufacturing process require regulatory approval, which, in turn, may require further clinical studies . For some of our products we rely on others to supply raw materials and to manufacture those products according to regulatory requirements ,

In addition , any prolonged interruption in our operations or those of our pa rtners could result in our inabili ty to satisfy the product demands of our customers. A number of factors could cause interruptions , including equipment malfunctions or failures , interruptions due to labor actions, damage to a facility due to natural disasters , such as an ea rthquake, suspension of power supplied to these facilities arising out of regional power sho rtages or terrorist activities and armed con fl ict , including as a result of the disru ption of operations of our subsidiaries and our customers, suppliers, distributors , couriers, collaborative partners, - l icensees and clinical trial sites .

Our mishandling of hazardous materials could result in substantial costs and harm to our busines s

In connection with our research and manufacturing activities, we utilize some hazardous materials . Great care is taken to ensure we have appropriate procedures and permits in place for storing and handling such hazardous materials . We could be subject to loss of our permits, government fines or penalties and/or other adverse governmental action if such hazardous materials are stored, handled or released into the environment in violation of law or any permit . A substantial fine or penalty, the payment of significant environmental remediation costs or the loss of a permit or other authorization to operate or engage in our ordinary course of business could result in material , unanticipated expenses and the possible inability'to satisfy customer demand .

If any of our third party suppliers or manufacturers cannot adequately meet our needs, our business could be adversely affected.

We use raw materials and other supplies that generally are available from multiple commercial sources . Ce rtain manufacturing processes. however, use materials that are available from sole sources , or that are in short supply , or are difficult for the supplier to produce and certify in accordance with our specifications. From time to time, concerns are raised with respect to potential contamination of biological materials That are supplied to us . These concerns can fu rt her tighten market conditions for materials that may be in short supply or available from limited sources. Moreover, regulatory approvals to market our ' . products may be conditioned upon obtaining certain materials from specified sources, Our ability to substitute material from an altern ate source may be delayed pending regulato ry approval of such alternate source . Although we work to mitigate the risks associated with relying on sole suppliers, there is a possibility that material sho rtages could impact production .

We purchase bulk powdered tobramycin, the primary basic raw material in TOB€ . , from two of the principal worldwide suppliers of the drug . We anticipate that either one ofthese suppliers alone will be able to supply sufficient quantities to meet current needs; however, there can be rio assurance that t€ dse suppliers will be able to meet future demand in a timely and cost-effective manner . As a result, our operations could be adversely affected by an interruption or reduction in the supply of bulk powdered tobramycin .

52 We have entered into contracts with third s for the production and packaging ofTOBIO . Over time, an use alternative production and packaging sources. However, if the contracted third part ies become unable to produce or package sufficient quantities of TOBI® due to work stoppages or other factors, our operations could be disrupted until a lt ernative sources are secured .

in connection with the production of its flu vaccine product, PowderJect must purchase large quantities of chicken eggs . Currently, PowderJect purchases those eggs and incubation services from a single supplier and, pursuant to the contract with that supplier, Powderject is required to make specified minimum purchases from that supplier through 2007 . All of the chickens that produce those eggs are located in the United Kingdom . If Powderlect's supplier were to fail to supply eggs in sufficient quantities or quality, including as a result of any health or other issues related to the chickens, Powderiect's business would be materially adversely affected .

We are a key provider for the blood screening field of nucleic acid testing and immunodiagnostics . In nucleic acid testing, we rely on our collaborative . partner, Gen-Probe, to manufacture the Procleix® HIV-l/ HCV Assay . We currently source the related instrument system from . third party suppliers . Currently, Gen-Probe is the only manufacturer of nucleic acid testing products using Transcription-Mediated Amplification technology . in immunodiagnostics, under the Ortho-Clinical Diagnostics, Inc . contract, we manufacture bulk reagents and antigens and confirmatory test kits sold in the clinical diagnostics and blood screening fields. While we and our partners work to mitigate the risks associated with being a key provider, there can be no assurance that our partner, Gen-Probe, will be able to provide sufficient quantities of the Procleix® HIV-l/ HCV Assay or that we will be able to manufacture sufficient bulk reagents and antigens and confirmatory test kits for immunodiagnostic products . Our difficulties or delays or those of our partners' could cause a public health concern for the blood supply, as well as increase costs and cause loss of revenue or market share.

Ifwe cannot obtain necessary licenses to thirdpartypateuts, far the ntgriufacture or sale of Our products . we may have to witbdrax' fr•onr the market or delay the introduction of the affected product. .

Third parties, including competitors, have patents and patent applications in the U . S . and other significant markets that may be useful or necessary for the manufacture, use or sale of certain products and products in development by us and out corporate partners . It is likely that third parties will obtain these patents in the future. Ce rtain of these patents may be bro ad enough to prevent or delay us and our corporate partners from manufacturing or marketing products importan t to our current and future business. We cannot accurately predict the scope, validity and enforceability of these patents , if granted , the extent to which we may wish or need to obtain licenses to these patents, and the cost and availability of these licenses . If we do not or cannot obtain these licenses, products may be withdrawn from the market or delays could be encountered in market introduction while an attempt is made to design around these patents , or we could find that the development, manufacture or sale of such products is foreclosed . We could also incur substantial costs in licensing or challenging the validity and scope of these patents .

Because most of our products are based on technologies that are . unfamiliar to the healthcare communitty, they star not be accepted br healthcare providers and. putiems, which could harm our business.

We may experience .difficulties in launching new products , many of which are novel products based on technologies that are unfamiliar to the healthcare community. We have no assurance that healthcare providers and patients will accept such products . In addition, government agencies, as well as private organizations involved in healthcare , from time to time publish guidelines or recommendations to healthcare providers and patients . Such ,guidelines or recommendations can be very influential and may adversely affect the usage ofour products directly (for example, by recommending a decreased dosage of our product in conjunction with a concomitant therapy or a government entity withdrawing it' s

53 .

} recommendation to screen blood donations for certain viruses) or indirectly (for example, by recommending a competitive product over our product) .

If we are unable to avoid significant exposure to product liability claims, our business could be harme d

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

As we are a key provider for the blood screening fi eld of nucleic acid testing and immunodiagnostics, we may have product liability in addition to contract exposure, in the event that our difficulties or delays or those of our partners could cause a public health concern for the blood supply .

Ijwe are unable to successfully compete in the highly competitive healthcare industry, our business could be harmed.

We operate in a highly competitive environment, and the competition is expected to increase . Competitors include large pharmaceutical, chemical and blood testing companies, and biotechnology companies . Some of these competitors, particularly large pharmaceutical and blood testing companies, have greater resources than ours . Accordingly, even if we are successful in launching a product, we-may find that a competitive product dominates the market for any number of reasons, including : .

• the possibility that the competitor may have launched its product first ;

• the competitor may have greater access to certain raw materials ;

• the competitor may have more efficient manufacturing processes ;

• the competitor may adapt more quickly to technological change ;

• the competitor. may have greater marketing capabilities ; or

the competitive product may have therapeutic or other advantages. -

The technologies applied by our competitors and us are rapidly evolving, and new developments frequently result in price competition and produc t obsolescence . In addition, we may be impacted by competition from generic forms of our products or substitute products . Specific to one product, TOBI® ; a generic form of this product may be available from our competitors, which may cause loss of revenue or market share . In December 2002, the U.S . Food and Drug Administration tentatively . approved an abbreviated new drug application for an inhaled tobramycin for .sale in the U .S . following expiration of the orphan drug status ofTOB1® in December 2004. We have a patent in the U .S . covering the formulation of TOBI® that extends tint il 2014 . We have therefore f led a suit claiming that this new generic form of tobramycin violates our patent . If our patent is found invalid or if this new product is found not to infringe upon our patent, sales of T01310 could be adversely affected .

Our patents may not prevent competition or generate revenues .

54 important legal questions remain to be resolved as to the extent and scope of available patent protection for biotechnology products and processes in the U .S . and other important markets . We do not know how many of our pending patent applications will be granted, or the effective coverage of those that are granted . In the U .S . and other important markets, the issuance of a patent is neither conclusive as to its validity nor the enforceable scope of its claims. We have engaged in significant litigation to determine the scope and validity of certain of our patents and expect to continue to do so . An adverse outcome of litigation could result in the reduction or loss of royalty revenues . Engaging in patent litigation against one party may place significant royalty revenues received or to be received from other parties at risk. Even if we are successful in obtaining and defending patents, there can be no assurance that these patents will provide substantial protection . The length of time necessary to resolve patent litigation successfully may allow infringers to gain significant market advantage . Third parties may be able to design around the patents and develop competitive products that do not use the inventions covered by our patents . Many countries, including certain countries in Europe, have compulsory licensing laws under which a patent owner may be compelled to grant licenses to third parties (for example, the third party's product is needed to meet a threat to public health or safety in that country, or the patent owner has failed to "work" the invention in that country, or thethird party has patented improvements) . In addition, most countries limit the enforceability of patents against government agencies or government contractors . In these countries, the patent owner may be limited to monetary relief and may be unable to enjoin infringement, which could materially diminish the value ofthe patent . In addition, royalty revenues will decline as patents expire .

Sales of our products may be adversely affected by the availability and aniount oJ•reitttbtnsemeni in the user of our products front third parties, such as the government and insurance companies.

In the U .S . and other significant markets, sales of our products may be affected by the availability of reimbursement from the government or other third parties, such as insurance companies . It is difficult to predict the reimbursement status of newly approved, novel biotechnology products. and current reimbursement policies for existing products may change, In certain foreign markets, governments have issued regulations relating to the pricing and profitability of pharmaceutical companies . There have been proposals in the U .S . (at both the federal and state level) to implement such controls . Certain of our products could be subject to re--importation from other' countries . The growth of managed care in the U .S. also has placed pressure on the pricing of healthcare products . These pressures can be expected to continue.

If our efforts to integrate acquired or licensed businesses or technologies into our business are not success/id, our business could be harmed.

As part of our business strategy, we expect to continue to grow our business through in-licensing, collaborations or acquisitions of products or companies . For example, we are currently in the process of completing our acquisition of Powderfect, The failure to adequately address the financial, operational or legal risks raised by such transactions, including our acquisition of Powderiect, could harm our business . Financial aspects related to these transactions may alter our financial position, reported operating results or stock price, and include :

use of cash resources ;

potentially dilutive issuances of equity securities;

the incurrence of debt and contingent liabilities, impairment losses or restructuring charges ;

large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which niust be amortized over the appropriate life of the asset ; an d

amortization expenses related to other intangible assets .

5 5

Operational risks that could harm our existing operations or prevent realization of anticipated benefits from such transactions include :

difficulties in assimilating the operations , products, technology, information systems or personnel of the acquired company ;

diversion of management's attention from other business concerns;

inability to maintain uniform standards, controls, procedures and policies;

the assumption of known and unknown liabilities of the acquired company, including intellectual prope rt y claims ; and

subsequent loss of key personnel .of the acquired company.

Legal risks may include requirements to obtain the consent of our stockholders or a third party, or the approval of various regulatory authorities.

If such efforts to integrate acquired or licensed businesses or technologies into our business are not successful, out business could be harmed .

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

Many products in our current pipeline are in relatively early stages of research or development . Our ability to grow earnings in the near- to medium-term may depend, in part, on our ability to initiate and maintain other revenue generating relationships with third parties, such as licenses to certain of our technologies, and on our ability to identify and successfully acquire rights to later-stage products from third parties . We have no assurance that we will establish such other sources of revenue . Fluctuations in interest rates and, foreign cur, xchange rates could harm our business .

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

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

We have an alliance with Novartis AG, a life sciences company headquartered in Basel, Switzerland, Under a series of agreements between Chiron and Novartis, and as a result of subsequent stock issuances by Chiron, Novartis' ownership interest in Chiron was approximately 43% as of June 30, 2003 . The Governance Agreement between Chiron and Novartis contains provisions that require the approval of Novattis before we enter into certain corporate transactions . These transactions generally include significant debtor equity issuances, debt or equity repurchases, most mergers and acquisitions, the payment of cash dividends, amendments to Chiron's certificate of incorporation or by-laws, and other transactions that would adversely impact the rights of Novartis . or discriminate against Novartis, as a Chiron stockholder. In addition, a majority of the independent directors must approve any material transactions between Chiron and Novartis . These provisions may limit our ability to enter into transactions with third parties otherwise viewed as beneficial to Chiron . All of our shares owned by Novartis are eligible for sale in the public market subject to compliance with the applicable securities laws . We have agreed that, upon Novartis' request, we will file one or more registration statements under the Securities Act in order to permit Novartis to offer and sell shares of our common stock . Sales of a substantial number of shares of our common stock by Novartis in the public market could adversely affect the market price of our common stock . For more information on our relationship with

56 Novartis, see Note 9-"Related Party Transactions," in our Annual Report on Form 10-K for the year ended December 31, 200 2

Volatility of our stock price could negativelt impact our profitability .

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

fluctuations in earnings from period to period ;

• results of clinical trials conducted by us or by our competitors ;

•. announcements by us or our competitors regarding product development efforts, including the status of regulatory approval applications ;

the outcome of legal proceedings, including claims filed by us against third parties to enforce our patents and claims filed by third patties against us relating to patents held by the third parties ;

the launch of competing products ;

the resolution of (or failure to resolve) disputes with corporate partners ;

corporate restructuring by us ;

the sale of a substantial number of shares held by our existing stockholders ;

licensing activities by us ; and

the acquisition or sale by us of products, products in development or businesses .

In connection with our research and development collaborations , from time to time we may invest in equity securities of our corporate partners , The price of these securities also is subject 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 these securities may impact our profitability .

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

We pay taxes principally in the U .S ., Germany, Italy and The Netherlands . All of these jurisdictions have in the past and may in the future make changes to their corporate tax rates and other tax laws, which could increase our future tax provision . We have negotiated A number of rulings regarding income and other taxes that are subject to periodic review and renewal . If such rulings are not renewed or are substantially modified, income taxes payable in particula r jurisdictions could increase . While we believe that all, material tax liabilities are reflected properly in our balance sheet, we are presently under audit in several jurisdictions and may be subject to further audits in the future, and we have no assurance that we will prevail in all cases in the event the taxing authorities disagree with our interptetations of the tax law . In addition, we have assumed liabilities for all income taxes incurred prior to the sales of our former subsidiaries, Chiron Vision (subject to certain limitations) and Chiron Diagnostics . Future levels -of research and development spending, capital investment and export sales will impact our entitlement to related tax credits and benefits which have the effect of lowering our effective tax rate . ,

57 Volatility of earnings could negatively impact our business.

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

inventory management practi ce s , including wholesale ordering patterns ;

the level of pre-clinical and clinical trial-related activities ;

seasonality of certain vaccine products ;

the tender driven nature of certain vaccine products, in particular MenjugateTM ;

• the nature of our collaborative, royalty and license arrangements and other revenue sources ;

• foreign currency exchange rate fluctuations ; and

the level of product reserves due to various issues, including seasonality patterns, excess and obsolete inventory, and production yields .

Our results in any one quarter are not necessarily indicative of results to be expected for a full year .

Revisions to accounting standards, financial reporting and corporate governance requirements and tax ,lairs could result in changes to our standard practices and could require a signtf cant expenditure of time, attention and resources, especially by senior ntanagemenl .

We must follow accounting standards , financial reporting and corporate governance requirements and tax laws set by the governing bodies and lawmakers in the U . S. and other countries where we do business . From time to time, these governing bodies and lawmakers implement new and revised rules and taws . These new and revised accounting standards, financial reporting and corporate governance requirements and tax laws may require changes to our financial statements, the composition of our board of directors , the composition, the responsibility and manner of operation of various board - level committees, the information filed by us with the govern ing bodies and enforcement of tax laws against us . Implementing changes required by such new standards, requirements or laws likely will require a significant expenditure of time, attention and resources , especially by our senior management. It is impossible to predict the impact, if any, on Chiron of future changes to accounting standards , financial repo rt ing and corporate governance requirements and tax laws . In addition , it is possible that the application of ce rtain current accounting standards may change due to environniental factors , which may necessitate a change in our standard practice related to these accounting standards.

Item'3. Quantitative and Qualitative Disclosures About Market Ris k

Market risk management Our cash flow and earnings are subject to fluctuations due to changes in foreign currency exchange rates, interest rates, the fair value of equity securities held and our stock price . We attempt to limit our exposure to some or all of these market risks through the use of various financial instruments. There were no significant changes in our market risk exposures during the first half of 2003 . These activities are discussed in further detail in Part 11, Item 7A ., "Quantitative and Qualitative Disclosures About Market Risk" of our Annual Report on Form 10-K for the year ended .December 31, 2002.

Item 4 . Controls and Procedure s

58 or 15d-15(e) . Based on that evaluat hiron's management, including the CEO and CFO, conch . iat Chiron's disclosure controls and procedures were effective in timely alerting them to material information relating to Chiron required to be included in Chiron's periodic SEC filings .

(b) Changes in internal controls There have been no significant changes in Chiron's internal controls over financial reporting or in other factors that could significantly affect internal controls over financial reporting during the most recent fiscal quarter .

(c) Limitations on the effectiveness of controls It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met . In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events . Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions .

i t✓'

PART II

Item 1 . Legal Proceeding s

We are party to certain lawsuits and legal proceedings, which are described in Part 1 . Item 3 . "Legal Proceedings" of our Annual Report on Form 10-K for the year ended December 31, 2002 . The following is a description of material developments during the period covered by this Quarterly Report and should be read in conjunction with the Annual Report on Form 10-K for the year ended December 31, 2002 .

Average Wholesale Pricing

In December 2001, Citizens for Consumer Justice and 13 other named plaintiffs filed a class action lawsuit in the United States District Court for the District of Massachusetts against 29 biotechnology and pharmaceutical companies, including Chiron, in connection with setting average wholesale prices for various products, including DepoCytts, which are reimbursed by Medicare . Plaintiffs alleged that defendants violated federal antitrust and racketeering laws by devising and implementing a fraudulent pricing scheme against Medicare and Medicaid beneficiaries, and sought declaratory relief, as well as compensatory and punitive damages. In March 2002, Plaintiffs filed an amended complaint that eliminated the antitrust allegations and changed the subject drug from DepoCytt to Mitomycint, a generic oncology drug sold by the Cetus-Den Venue Therapeutics partnership, In September 2002, plaintiffs filed a Master Consolidated Class Action Complaint, which did not name Chiron as a defendant .

In February 2002, the State of Montana through its Attorney General filed .a complaint in the First Judicial District Court in Lewis and Clark County against 18 biotechnology and pharmaceutical companies, including Chiron,-in connection with setting average wholesale prices for various products, including DepoCyt®, that are reimbursed by Medicare and Medicaid. The Attorney General alleged that the Defendants violated Montana state and common laws on unfair trade practices and consumer protection, deceptive trade practices. Medicaid fraud, breach of contract and false claims, and seeks both compensatory and punitive damages.

In March 2002, the State of Nevada through its Attorney General filed a complaint in the Second Judicial District Court in Washoe County against 10 biotechnology and pharmaceutical companies, including Chiron, concerning setting average wholesale prices for various products, including DepoCyi®, that are reimbursed by Medicare and Medicaid . The Attorney General alleged that Defendants violated Nevada state and common laws on unfair and deceptive trade practices and consumer protection, Medicaid fraud, racketeering, and seeks both compensatory and punitive damages .

Between July and September 2002, three separate class action lawsuits were filed in two California Superior Courts against Chiron, Cetus Oncology, and numerous other biotechnology and pharmaceutical companies . Plaintiffs claims are based upon alleged violations of the California Business and Professions Codes, These matters seek compensatory and punitive damages, plus injunctive relief, against Chiron in connection with setting the average wholesale prices for various oncology drugs, including DepoCyttEE .

in .October 2002 and February 2003, the Montana, Nevada and California actions were coordinated and consolidated to the In re Pharmaceutical Industry Average Wholesale Price Litigation pre-trial proceedings. In August 2003, the States of Montana and Nevada both filed amended complaints, which did not name Chiron as a defendant .

In January 2003, the County of Suffolk filed a complaint in the United States District Court for the Eastern District of New York against 29 biotechnology and pharmaceutical companies, including Chiron, in connection . with setting average wholesale prices for various products, including TOB19 ,

60 which are reimbursed by Medicaid . Plaintiffs allege that defendants violated federal racketeering laws, federal and state laws on Medicaid fraud, and state laws on unfair trade practice, breach of contract, fraud and unjust enrichment by devising and implementing a fraudulent pricing scheme against Medicaid beneficiaries, and seeks declaratory relief, as well as compensatory and punitive damages . In August 2003, plaintiffs filed an Amended Complaint, which did not name Chiron as a defendant ,

Currently, the California actions are the only remaining matters pending in the in re Pharmaceutical Industry Average Wholesale Price Litigation pre-trial proceedings which name Chiron as a party defendant .

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

F. Hofmann-La Roche Ltd. and Roche Molecular Systems. Inc .-HI V

On March 11, 2003, the U .S . Patent and Trademark Office issued Chiron's U .S. Patent No. 6,531,276 (addressed to . Methods For Detecting Human Immunodeficiency Virus Nucleic Acid) (the 276 Patent") . Chiron has concluded that under an October 2000 HIV Probe License Agreement (the "Roche HIV Agreement") between Chiron, F. Hoffmann-La Roche Ltd. and Roche Molecular Systems (collectively, "Roche") . Roche is obligated to pay certain licensing fees and ongoing royalties for the sale of certain Roche HIV nucleic acid tests which infringe the '276 Patent . Roche disputes these obligations on a variety of grounds including non--infringement . Roche further contests the rate at which royalties must be paid if in fact its products are covered by the Roche HIV Agreement . In April 2003, the parties initiated alternative dispute resolution procedures (the "A :DR procedures"), mandated by the Roche HIV agreement, to address these'and, potentially other, disputes. The parties have been unable to resolve the matter, and in July 2003, Chiron initiated the final meet and confer process required under the ADR procedures . If this process fails to produce a resolution, the matter will be decided in a formal arbitration conducted under the rules of the CPR Institute for Dispute Resolution.

It is not known when nor on what basis this matter will be resolved .

F. Hoffmann-La Roche A .G.-HC V

Chiron initiated an action in July 2000 against Roche Diagnostics GmbH in the German Federal Court ("Landgericht") in Dusseldorf, asserting that Roche's manufacture and sale of hepatitis C virus immunoassay products infringe Chiron's German Patent Nos. DD 298 527, DD 298 524, DD 287 104, DD .297 446 (collectively, the "German patents") and Chiron's European Patent No . EP 0 450 931 (the "931 patent"). The Landgericht subsequently separated the matter into individual actions and then stayed oral hearings pending results of the nullity proceedings initiated by Roche in December 2000 in the German Federal Patent court ("Bundespatentgericht") against the same patents. In August 2002, the Bundespatentgericht upheld the validity of the German patents, but nullifiedthe German portion of the'931 patent . In November 2002, Chiron filed appeals in the Federal Supreme Court to the nullity decisions with respect to the '931 and '527 patents, and Roche likewise appealed the nullity decisions regarding the German patents . In July 2003, the Landgericht determined that Roche's HCV immunoassay kits containing a certain antigen infringe Chiron's'524 patent . Accordingly, the Landgericht granted Chiron the right to enjoin Roche from the import, use, possession and sale of such kits in Germany, and ordered Roche to provide information about its commercial activities related to such kits sinc e 1998 and to destroy any such kits in its possession in Germany. This judgment is subject to appeal . Furthermore, the Landgericht has stayed proceedings based on the'104,'527 and'931 patents pending the appeal ofthe Bundespatentgericht's judgment in the respective nullity suits .

} suit sought damages and injunctive relief . In April 1999, the Court granted Chiron's application and entered an injunction . In September 1999 . Roche appealed the decision to the Court of Appeals in Dusseldorf . Following withdrawal of certain claims from the'2€ 6 patent . Chiron rescinded the injunction and substituted the aforementioned'931 and German patents in the appellate proceeding . Oral hearings before the Court of Appeals on the German patents were held i n May 2003, and the Court is expected to render judgment in . September 2003 . Oral hearings on the'931 patent are stayed pending the appeal of the Bundespatentgericht's judgment in the '931 nullity suit .

It is not known when nor on what basis these matters will be resolved' .

German Red Cross Donation Service and Working Society of Physician s

In October 2001, the German Red Cross Donation Service and Working Society of Physicians brought.a complaint against Chiron and Roche before the Commission of the European Communities (the 'Commission") . These mailers generally alleged that Chiron and Roche have engaged in certain anticompetitive actions that violate Articles 81 and 82 of the Treaty Establishing the European Community (the "EC Treaty") in connection with HIV and hepatitis C virus nucleic acid tests in blood screening. The complainants sought a determination that Roche, pricing for its blood screening kits based upon the number of donations tested is unreasonable and should be prohibited through interim measures to be ordered by the Commission prior to final resolution of the action . Chiron filed its initial response with the Commission in January 2002 . In February 2002, the Sanquin Blood Services Foundation in The Netherlands also filed a complaint against Chiron and Roche before the Commission . The Sanquin complaint, filed in support of the German complaint, similarly alleged anticompetitive practices in violation of Articles 81 and 82 of the EC Treaty . The National Blood Authority of England also filed a related complaint with the Commission against Chiron and Roche in February 2002 . The National Blood Authority complaint focused exclusively on hepatitis C virus licensing . Chiron was also informed that blood banking entities from Finland and Luxembourg filed similar complaints with the Commission .

in July 2002, the Directorate General for Competition provided its provisional assessment concerning both the October 2000 hepatitis C virus and HIV nucleic acid testing licensing agreements for clinical .diagnostics and the May 2001 hepatitis C virus and HIV nucleic acid testing licensing agreements for blood screening between Chiron and Roche which had been notified to the European Commission in May 2001 and September 2001, respectively, and the complaints referenced above. The provisional assessment indicated that certain field of use restrictions and most favored nation license provisions appeared to give rise to competition restrictions incompatible with Article 8€(1) of the EC Treaty, and were unlikely to qualify for exemption under Article 81(3) of the EC Treaty . The provisional assessment did not indicate that the per donation pricing was incompatible with the EC Treaty .

In July 2003, the European Commission accepted a joint settlement proposal made by Chiron and Roche, thereby resolving all related complaints . As part of the settlement, Chiron and Roche agreed to modify certain terms of their agreements under which Roche has licensed Chiron's hepatitis C virus and HIV-l intellectual property for use in nucleic acid testing products in Europe . In resolving their inquiry, the European Commission concluded that the modified agreements satisfy the criteria for an individual exemption under Article 81(3) of the Treaty . Additionally, Chiron will extend a time-limited license offer to blood banks using "home brew" testing throughout Europe, allowing them to continue to use their own "in-house" technology to screen their own donations and the donations of other blood banks . As part of this offer, Chiron will provide relief from liability for past infringements to all blood banks that choose to take such a license . Laboratory Corporation ofkmerica Holdings

In April 2003, Chiron filed a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings ("LabCorp Holdings"), Laboratory Corporation of America ("LabCorp") and National Genetics Institute ("NGI") (collectively, the "Defendants"), seeking damages and an injunction against Defendants' manufacture, use and sale of the UltraQualT" HCV RT-PCR assay and HCV SUPERQUANTT"i assay for infringing Chiron's U .S . Patent No. 6,074,816 (the 816 patent") . The Defendants also filed a complaint in the United States District Court for the District of Delaware against Chiron seeking a declaratory judgment that Defendants infringe neither the'816 patent, nor U .S. Patent Nos . 5,712,088, 5,863,719, 6,074,816, and 5,714,596 (collectively, the "Chiron Hepatitis C virus-related patents"), and that the Chiron Hepatitis C virus-related patents are invalid . In August 2003, the Delaware Court granted Defendants' motion to enjoin Chiron from proceeding with the California action and compel Chiron to seek dismissal of that action . This decision is subject to appeal .

In August 2003, Chiron filed a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings, Laboratory Corporation of America and National Genetics Institute (collectively, the "Defendants"), seeking damages and an injunction against Defendants manufacture, use and sale of certain HIV assays for infringing Chiron's U .S . Patent No . 6,531,276 (the 276 patent")("Methods for Detecting Human Immunodeficiency Virus Nucleic Acid") .

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

Roxane Laboratories, Inc.

In June 2003, Chiron and Children's Hospital and Regional Medical Center (collectively, the "Plaintiffs"), filed a complaint in the United States District Court for the District of Delaware against Roxane Laboratories, Inc . ("Roxane") seeking damages and an injunction against Roxane's manufacture, use and sale or importation of an alleged generic version ofChiron's tobramycin solution for inhalation (TOBIF) described in Roxane's Abbreviated New Drug Application No . 65-105, for infringing Chiron's U .S. Patent No . 5,508,269 (the 269 patent")("Aminoglycoside Formulation for Aerosolization") . Plaintiffs also seek a judgment providing that the effective date of any U .S . Food and Drug Administration approval for Rbxane to make, use, sell or import said generic be no earlier than the date on which the '269 patent expires . In August 2003, Roxane filed a counterclaim seeking to invalidate the '269 patent, and a declaration of non-infringement.

It is not known when nor on what basis this matter will be resolved.

Sorin Biomedlca/Snia

In June 1994, Sorin Biomedica S .p .A . ("Sorin") filed a lawsuit with the Court of Milan, Italy against Chiron and Ortho Diagnostic Systems S .p .A . seeking a declaration of nullity and non-infringement of the Italian counterpart to Chiron's European Patent 0 318 216 (the "216 patent") claiming hepatitis C virus immunodiagnostic technology . Chiron denied Sorin's allegations and filed a counterclaim seeking a declaration of infringement . In February 1997, the Court enjoined Sorin from manufacturing or selling hepatitis C virus immunoassay kits in Italy . After Sorin made further objections, the Court ruled in October 1999 that certain '216 patent claims were valid and that Sorin's hepatitis C virus immunoassay infringed the '216 patent . In June 2000, the European Patent Office Technical Board Of Appeals upheld the validity of the '216 patent in an amended form which deleted claims that Chiron alleged to have been infringed by Sorin . In December 2000, Snia S,p .A ., Sorin's parent company, filed an appeal in the Court of Milan asking the Court to declare the Italian portion of the'216 patent null and void and to award Snia damages . In March 2001, Chiron denied Snia's allegations and asked the Court to dismiss the case . I n May 2002, the Court of Appeal of Milan

63 declared that Snia's claims were inadmissible and dismissed Snia's appeal. In July 2003 . Snia filed an appeal before the Supreme Court .

In January 2002, Chiron filed a complaint against Snia in the Court of Milan asserting that Snia's manufacture and sale of certain hepatitis C virus immunodiagnostics infringe the '931 patent. Chiron seeks a declaration of infringement based on the '931 patent, as well as damages . Trial is currently scheduled for December 1, 2004.

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

Sysmer Corporation

In March 2001, Chiron filed a complaint and petition for preliminary injunction with the Osaka District Court in Japan against Sysmex Corporation ("Sysmez") seeking damages and an injunction against Sysmex's manufacture and sale ofthe Ranream HCV it Ex kit for infringing Chiron's Japanese Patent No . 2733138 (the 138 patent") claiming hepatitis C virus immunodiagnostic technology . Sysmex denied the infringement allegations and filed two invalidation appeals with the Japanese Patent Office Board of Appeals against the '138 patent . In February 2003, the Japanese Patent Office Board of Appeals, ruiing .on one of the invalidation appeals, found that the'138 patent was invalid . In May 2003, Chiron filed an appeal of the invalidation judgment before the Tokyo High Court . Furthermore, the second invalidation appeal has been stayed pending Chiron's appeal to the Tokyo High Court .

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

Item 4 . Submission of Matters to a Vote of Security Holder s

(a) Chiron held its Annual Meeting of Stockholders on May 15, 2003 .

(b) Omitted pursuant to Instruction 3 to Item 4 of Form l0-Q .

(c) The two matters voted upon at the meeting were : (i) election of six directors to hold office for the terms indicated: and (ii) ratification of the appointment of Ernst & Young LLP as Chiron's independent auditors for the year ending December 31, 2003 . Two recently-appointed directors, Mr . J . Richard Fredericks and Mr. Howard H .-Pien, were nominated for election to hold office for a two-year term expiring in 2005 . The remaining four directors, Dr. Raymund Breu, Ms. Denise O'Leary, Mr. Sean Lance and Dr. Pieter Strijkert were currently serving as directors and were nominated for election to the Board for a three-year term expiring in 2006 .

(i) The following votes were cast for or were withheld with respect to each of the nominees for director:

DIRECTORS FOR WITHHEL D

Class of 200 5 J . Richard Fredericks 166,099,732 1,490,16 7 Howard H . Pien 165,301,325 2,288,57 4

Class of 200 6 Raymund Breu 160,906,114 6,683,78 5 Sean P . Lance 165,616,588 1,973,31 1 Denise M . O'Leary 164,553,029 3,036,870 Pieter J. Strijkert 161,432,1.40 6,157,75 9 All nominees were declared to have been elected as directors to hold their respective offices until the Annual Meeting of Stockholders in the years 2005 and 2006 as noted above. No abstentions or broker non-votes were cast for the election of directors .

64 The following directors shall continue in office after Chiron's Annual Meeting of Stockholders held on May 15, 2003 : Vaughn D . Bryson, Pierre E . Douaze and Edward E . Penhoet shall continue in office until the Annual Meeting of Stockholders in the year 2004 ; and Lewis W. Coleman, Paul L. Herding and William J . Rutter until the Annual Meeting of Stockholders in the year 2005 .

(ii) With respect to the proposal to ratify the appointment of Ernst & Young LLP as Chiron's independent auditors, 163,368,164 votes were cast for the proposal, 3,279,821 votes were cast against the proposal, and 941,914 votes abstained . No broker non-votes were cast in connection with the proposal . The selection of Ernst & Young LLP as the Chiron's independent auditors for the year ending December 31, 2003 was declared to have been ratified .

Item 6 . Exhibits and Reports on Form 8-K

(a) Exhibit s

Exhibit Number Exhibi t

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 l0-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-R . 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'sreport on Form l0-Q for the period ended June 30, 1996 .

3 .04 Bylaws of Chiron, as amended, incorporated by reference to Exhibit 3 .04 to Chiron's report on Form I 0-K for fiscal year 2000 .

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 I0-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 l0-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-t and A-2 to the Indenture filed as Exhibit 4.01 above), incorporated by reference to Exhibit 4.03 of Chiron's report on Form I0-Q for the period ended June 30, 2001 .

4 .04 Reserved.

10.004 Second Amendment between BNP Paribas Leasing Corporation , a Delaware corporation ( as successor in interest to BNP Leasing Corporation) ("BNPLC"), and Chiron, dated July 1, 2003 .

10.102 Amended and Restated Revolving Credit'Agreement, dated as of August 13, 2002 (the "Credit Agreement"), by and between Chiron and Bank of America, N .A . (the "Bank"), and exhibits thereto, incorporated by reference to Exhibit 10 .102 ofChiron's report on Form 10-Q for September 30, 2002.

65 10.212 Contract Manufacturing Agreement dated as of June 12, 2003 between Chiron S_r .l ., Cufron Behring GmbH & Co ., and SynCo Bio Partners B .V . (We have omitted certain information from the Agreement 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 .213 FDA Compliance Agreement dated as of June 12, 2003 between Chiron S .ri . Chiron Behring GmbH & Co and SynCo Bio Partners B .V . (We have omitted certain information from the Agreement 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 .321 Blood Screening HCV Probe License Agreement-European Union dated effective as of July 1, 2003, between Chiron, F . Hoffmann-La Roche Ltd ., and Roche Molecular Systems, Inc. (We have omitted certain information from the Agreement 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 .322 Blood Screening HIV Probe License Agreement-European Union dated effective as of July 1, 2003, between Chiron, F . Hoffmann-La Roche Ltd ., and Roche Molecular Systems, inc. (We have omitted certain information from the Agreement 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 .323 HCV Probe License and Option Agreement-European Union dated effective as of July 1, 2003, between Chiron, F . Hoffmann-La Roche Ltd ., and Roche Molecular Systems, inc. (We have omitted certain information from the Agreement 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 .324 1-1 IV Probe License and Option Agreement-European Union dated effective as of July 1, 2003, between Chiron, F . Hoffmann-La Roche Ltd ., and Roche Molecular Systems, Inc . (We have omitted certain information from the Agreement 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 .501 Chiron 1991 Stock Option Plan, as amended August 14, 1993, April It, 1994, February 24, 1995, March 8, 1996, February 28, 1997, August 7, 1998, August 20, 1999, February 25, 2000, September 21, 2000, February 16, 2001 and June 30 2003 .

10 .518 Nominating and Corporate Governance Committee Chatter.

10 .528 Amendment dated May 16, 2003 to Governance Agreement dated as of November 20, 1994, between Chiron and Novartis AG as successor-in-interest to Ciba-Gigy Limited .

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 .

66 31 .2 Certification of the Chiet 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 .

Management contract, compensatory plan or arrangement.

(b) Reports on Form 8- K

On April 23, 2003, Chiron filed a Current Report on Form 8-K, furnishing under Item 9, Chiron's preliminary results for its first quarter ended March 31, 2003, via a press release.

On May 19, 2003, Chiron filed .a Current Report on Form 8-K, reporting under Item 5, that its itidirect.wholly-owned subsidiary . Chiron UK-I Limited, had announced a cash tender offer to acquire all of the issued and to be issued share capital of PowderJect Pharmaceuticals plc for 550 pence per share subject to certain conditions . 67

1 CHIRON CORPORATIO N

June30,200 3

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, Chiron has duly caused this report to be signed on its behalf by the undersigne d thereunto duly authorized .

CHIRON CORPORATIO N

DATE : August 12, 2003 BY ; Isl HOWARD H . PIE N

Howard H . Pien President and Chief Executive Office r

DATE: August 12, 2003 BY ; Is! DAVID V . SMIT H

David V. Smit h Vice President, Finance and Acting Chief Financial Office r

68 EXHIBIT C Quigicj inks - Click here to rapidly navigate through this documen t

UNITED STATE S SECURITIES AND EXCHANGE COMMISSIO N Washington , D .C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2003

O R

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

For the transition period from t o

Commission File Number . 0-12798

CHIRON CORPORATIO N (Exact name of registrant as specified in its charter)

Delaware 94-2754624 (State or other jurisdiction of incorporation or organization ) (I.R.S. Employer Identification No.)

4560 Horton Street, Emeryvill e, California 94608 (Address of pri ncipal executive offices) (Zip code )

(510) 655-873 0 (Registrant's telephone number, including area code)

Not Applicabl e (Former name, former address and former fiscal year, if changed since last report )

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

Yes O No CI

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

Yes O No 0

Indicate the number of shares outstan ding of each of the issuer's classes of common stock , as of the latest practicable date.

Title of Class Outstanding at October 31, 2003 Common Stock, $ 0.01 par value 187,717,396

3 CHIRON CORPORATIO N TABLE OF CONTENTS

Page No.

PART T FINANCIAL INFORMATION,

ITEM 1 . Financial Statements (Unaudited )

Condensed Consolidated Balance Sheets at September.30, 2003 and December 31, 2002 3

Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and 2002 5

Condensed Consolidated Statements of Comprehensive Income for the three and vinemonths ended September 30, 2003 . and 2002 6

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and 2002 7

Notes to Condensed . Consolidated :Financial Statements g

ITEM 2 . Management' s Discussion and Analysis of Financial Condition and Results of Operations 33

ITEM 3 . Quantitative and Qualitative Disclosures About Market Risk 67

ITEM 4 . Controls and Procedures 67

PART 11 . OTHER INFORMATIO N

ITEM 1 . Legal Proceedings 6 8

ITEM 4. Submission of Matters to a Vote of Security Holders . 7 1

ITEM 6. Exhibits and Reports on Form 8-K 7 1

SIGNATURES 7A

2 Item 1 . Financial Statements

CHIRON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEET S

(Unaudited)

(In thousands, except share data)

Septearber 30, December 31, 2003 2002

ASSETS Current assets : Cash and cash equivalents $ 499,907 $ 247,950 Short-term investments in marketable debt securi ties 197,759 626,130

Total cash and short-term .investnients 647,666 874,080 Accounts receivable , net 427,749 278,625 Current portion of notes receivable 1,469 . 718 Inventori es , net of reserves 247,641 146,005 Current net deferred income tax assets 61;977 38,45 0 Derivative financial instruments 10,485 12,006 Other current assets 77,579 35 ;83 8

Total current assets 1,524,566 1,385,722

Noncurrent investments in ;.marketable debt securities 340,308 414,447

Property, plant, equipment and leasehold improvements, at cost : '.Land and buildings ' 360,281 168,144 Laboratory, production and office equipment 586,763 418,255 Leasehold improvements 109,680 . 93,463 Construction- in-progress 105,730 74,71 7

1,162,454 754,579 Less accumulated depreciation and amortization (520,136) (381,021 )

• Property , p]ant a quipmint and leeaseholda z;nprovements , net . 642,318 373,55 8

Purchased technologies , net 241,791 257,61 3 Goodwill. : t .'.. 709,765 239,746 Other intangible assets, net 477,247 147,08 9 Investments-in equity ;securities and affiliated-companies . '- 99,920 . -87,167 Noncurrent notes receivable 7,500 8,93 9 Noncurrent derivative financial instruments 10,177 9,007 Other noncurrent assets 38 ,821 37,05 6

$ . .4,092,413 $ 2,960,344

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

1 CHIRON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS ( Continued )

(Unaudited )

(In thousands, except share data)

September 30, December 31 , 2003 2002

LIABILITIES AND STOCKHOLDERS ' EQUITY Current liabilities : Accounts payable ; $ 92,319 59,02 2 Accrued compensation and related expenses 69,399 59,49 8 Short-term borrowings :: - 7 1 Current portion of unearned revenue 91,455 26,61 0 Income taxes payable 18,102 21,88 3 Other current liabilities 205,924 131,55 2

Total current liabilities 477,199 . 298,63 6

long-term debt 923,725 416,954 Capital lease 157,75 6 Noncurrent derivative financial instruments - 253 Noncurrent not deferred income tax liabilities : . 147,130 45,743 Noncurrent unearned revenue 49,696 62,580 Other noncurrentliabilities , 70,436 :35,81 3 Minority interest 6,633 5,355

Total liabilities 1,832,575 - 865,33 4

Commitments and contingencies

Put options 19,05 4

Stockholders' equity : Common stock : ., 1,917 1,91 7 Additional paid-in capital 2,494 ,733 2,445,20 8 - :Deferred stock .coinpensation ( 15,202) (11,349) . Accumulated defici t (155,994) (221,236 ) ,-Accumulated other:comprehensive income 122,257 54,861 Treasury stock , at cost (4,385,000 shares at September 30, 2003 and 4,830,000 shares at December 31, 2002) (187,873) (193,445)

To, wl stockholders ~equdy 2,259,838 2,075,95 6

$ 4,092,413 $ 2,960,34 4

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement . 4

0 CHIRON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands , except per share data )

Three Months Ended Nine Months Ended September 30, September 30,

2003 2002 2003 2002

Revenues : Product sales, net $ 432,674 S 272,190 S 897,222 $ 657,067 Revenues. from joint` business arrangement 26,058 32,356 79,985 78,548 Collaborative agreement revenues 7,816 4,977 15,554 17,786 Royalty and license fee revenues 66,237 48,047 186,537 138;41 9 Other revenues 7,688 10,911 32,482 28,13 6

Total revenues . 540,473 368,481 1,211,780 919,956

Operating expenses: Cost of sale s 174,380 97,432 357,389 239,82 3 Research and development 97,519 81,635 269,564 243,93 8 Selling, general and administrative 104,736 68,159 : . 257,485 . .202,022 Amortization expens e 19,821 7,504 35,135 22,32 8 Write-off of purchased in-process research and development 122,700 - 122,700 54;78 1 Rest ructuring and reorganization charge s 1,082 1,75 7 Other operating expenses 4,779 5,694 .7,573 . 11,17 6

Total operating expenses 525,017 260,424 1,051,603 774,068

income.fcom operations 15,456 108,057 160,177, 145,888

Interest expense (6,222) (3,210) (12,523) (9,498 ) Interest. and other income, net 5,239 8,696 .31,170 41,45 6 Minority interest (443) (477) (1,424) (1,360 )

Income :'frorn continuing . operations before income taxes 14,030 113,066 177,400 176,48 6

Provision for income taxe s 34,183 30,530 75,025 62,443

(Loss)income fro.. ontintiipg operations , (20,153) 82,536 102,375 114,04 3

Gain-(loss) from discontinued operations 1,174 (320) 3,138 (320)

Net (loss) income :, . 5 (18,979) $ 82,216 $ 105,513 $ . 113,72 3

; Basic (loss) earnings per stare : ..,'m(Loss) income from continuing operations $ (0 .11 ) $ 0.44 $ 0 .55 $ 0.6 0 rr~ww ~wrr~ .*rrr~~

Net (loss) incom e $ (0 .10) $ 0 .44 $ 0 .57 $ 0.6 0

Diluted (loss) earn ngs.per-share ; (Loss) income from continuing operations $ (0 .11) $ 0 .43 S . 0.54 $ 0 .5 9 r~ NNE" R

Net (loss) income $ (0.10) $ 0 .4 3 $ 0.55 $ 0.5 9 ~wrrr~ ~■ A~wrtr r

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

5 CHIRON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)

Three Months Ended Nine Months Ende d September 30, September 30,

2003 2002 2003 2002

Net'(loss) income $, - .( 18,979) $ 82,216 $ 105,513 $ 113,723

Other comprehensive income ( loss) :

Change in foreign cu rrency translation adjustment during the period , net of tax benefit (provision) of $295 for the three months ended . September 30, 2002 and (S6,154) for the nine months ended September 30, 2002 21,182 (6,926) 66,300 48,307

Unrealized gains (losses ) from investments : Net unrealized holding gains ( losses) arising during the pe riod, net of taz benefit (provision) of ($1,984) and $1,625. for the thre e months ended September 30,2003 .and 2002, respectively, and ($3,269) and $5,157 for the ninemonths ended September 30; 2003 and 2002, respectively 4,200 (2,610) 6,840 (8,233) Reclassification adjustment for net losses (gains) included in net income, net of tax (benefit) provision of ($37) for the thre e months ended September 30, 2002 and $ 3,626 and $3 ,550 for the nine months ended September 30, 2003 and 2002, respectively - 60 (5,744) (5,742)

Net unrealized gains (losses) from investments 4,200 (2,550) 1,096 (13,975)

Other comprehensive income (loss) 25,382 (9,476) 67,396 34,33 2

Comprehensive income I „ . $ 6,403 $ 72,740 $ 172,909 1 4$,05 5

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

A CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS O F CASH FLOW S

(Unaudited )

(In thousands)

Nine Montds. Ende d September 30 ,

2003 200 2

Netcash provided by operaung.activities •:'; S . 260,588 191,829

Cash flows from investing activities : Purchases of investments in marketable debt securities (622,650) (581,162 ) Proceeds from sales and maturities of investments in marketable debt securities 1,112,778 568,549 Proceeds from. notes.receivable 750 5,150 Capital expenditures (81,372) (74,111 ) Proceeds equityforward contracts .. . 5,98 9 Proceeds from sales of assets - 42 9 Purchases of equity . securities and interests in affiliated companies (4,270) (5,508) Proceeds from sale of equity securities and interests -in affiliated companies 12,545 18,86 9 Cash paid or acquistttans net:of c 3slt acquired (804,728) (58,176) Other, net (12,999) (3,954)

Net cash used in investing activities (399,946) (123,925)

Cash flows from financing activities :. ., .,Netrepaymentofshort term :borrowings (2,344) (630 ) Net repayment of debt and capital lease,' (62,341) - Paymentstoacquire treasury stock (132,675) (96,683 ) Proceeds from reissuance of treasury stock 85,995 21,96 8 Proceeds from .issuance of convertible-debentures-' 500,000 - Proceeds from issuance of debt 536 - Proceeds':fiom put,ppttons 2,144 3,71 3

Net cash provided by (used in) financing activities 391,315 (71,632)

Net increase (decrease} incash and =h equivalents 251,957 (3,728)

Cash and cash equivalents at beginning of the period 247,950 320,673

Cash aiui cash equivalents at end of the period $ 499,907 $ 316,945 ~ ~wwww~w

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

i CHIRON CORPORATIO N

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 200 3

(Unaudited )

Note I -The Company and Summary of Significant Accounting Policie s

Basis of Presentation

The- information presented in the condensed consolidated financial statements at September 30, 2003, and for the three and nine months ended September 30, 2003 and 2002, is unaudited but includes all normal recurring adjustments, which Chiron Corporation believes to be necessary for fair presentation of the periods presented .

The condensed consolidated balance sheet amounts at December 31, 2002, have been derived from audited financial statements . Historically, Chiron's operating results have varied considerably from period to period due to the nature of Chiron's collaborative, royalty and license arrangements and the seasonality of certain vaccine products. In addition, the mix of products sold and the introduction of new products will affect comparability from quarter to quarter . As a consequence, Chiron's interim results in any one quarter are not necessarily indicative of results to be expected for a full year . This information should be read in conjunction with Chiron's audited consolidated financial statements for the year ended December 31, 2002, which are included in the Annual Report on Form 10-K filed by Chiron with the Securities and Exchange Commission .

Principles of Consolidatio n

The condensed consolidated financial statements include the accounts of Chiron and its majority-owned subsidiaries . For consolidated majority-owned subsidiaries in which Chiron owns less than 100%, Chiron records minority interest in the condensed consolidated financial statements to account for the ownership interest of the minority owner . Investments in joint ventures, limited partnerships and interests in which Chiron has an equity interest of 50% or less, are accounted for using either the equity or cost method based on Chiron's ownership levels and the ability of Chiron to exert significant influence over the entity's operating, investing and financing decisions . All significant intercompany accounts and transactions have been eliminated in consolidation.

On July 8, 2003, Chiron acquired Powderiect Pharmaceuticals plc, a company based in Oxford, United Kingdom that develops and commercializes vaccines . Chiron accounted for the acquisition using the purchase method of accounting and included PowderJect Pharmaceuticals' operating results in its consolidated operating results beginning July 8, 2003 (see Note 5) . PowderJect Pharmaceuticals is part of Chiron's vaccines segment.

On July 1, 2002, Chiron completed its acquisition of Putmopharm GmbH, a distributor of TOBI® products in Germany and Austria by purchasing the remaining 80 .1% ownership that Chiron did not previously own . Previously, Chiron owned 19.9% of Pulmopharm and accounted for the investment under the equity method . Chiron accounted for the acquisition using the purchase method of accounting and included Pulmopharm's operating results in its consolidated operating results beginning on July 1, 2002 . Pulmopharm is part of Chiron's biopharmaceuticals segment (see Note 5) .

On February 20, 2002, Chiron acquired Matrix Pharmaceutical, Inc ., a company that was developing tezacitabine, a drug to, treat cancer. Chiron included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in its consolidated operating results beginning on March 1, 2002 (see Note 5) . Chiron is a limited partner of several venture capital funds . Chiron is obligated to pay $ 6 0.0 million over ten years in equity contributions to these venture capital funds, of which approximately $29 .8 million was paid through September 30, 2003 . Chiron accounts for these investments under the equity method of accounting .

Use ofEstimates and Reclassifications

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

Chiron's blood testing segment includes Chiron's one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, inc., a Johnson & Johnson company. Chiron accounts separately for research and development and manufacturing cost reimbursements and certain product sale revenues received from Ortho-Clinical Diagnostics but relating to the joint business contractual arrangement . Chiron's joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho--Ckinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retrovituses and provides supplemental tests and inicroplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the-first quarter 2003, Chiron had accounted for revenues relating to non-U .S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter. More current information of non-U .S, affiliate sales of the joint business contractual arrangement became available in the first quarter 2003, and as a result, .Chiron is able to recognize revenues relating to non-U .S . affiliate sales on a one-month lag. The effect of this change, net of tax, was an increase to net income by $3 .2 million for revenues from joint business arrangement for the nine months ended September 30, 2003 .

Chiron recognizes a portion of revenue for product sales of Hetaseron(D upon shipment to its marketing partner, and the remainder based on a contractual percentage of sales by its marketing partner. Chiron also earns royalties on the marketing partner's European sales of BetaferonO in those cases where Chiron does not supply the product. Prior to the first quarter 2002, Chiron had accounted for revenues from non-U .S. product sales on a one-quarter lag and royalties as a percentage of forecast received from its marketing partner, with an adjustment of the estimate to actual in the subsequent quarter. More current information of. non-U.S. l3etaseron® sales became available in 2002, and as a result, Chiron is able to recognize revenues from BetaseronO product sales and Betaferon® royalties on a current basis . The effect of this change, net of tax, was a decrease in net loss for the first quarter 2002 and an increase in net income for the nine months ended September 30, 2002 by $3 .1 million for product sales and $2 .8 million for royalties.

Chiron currently owns a facility in London, England for international operations . Chiron has definite plans to vacate this facility and move to a new facility . The existing facility is not available for immediate sale and is classified as held for use . Accordingly, the remaining estimated useful life of the existing facility has been revised . This has resulted in an additional $0.7 million of depreciation expense for the three months ended September 30, 2003 .

Chiron, prior to filing its financial statements on Form 10-Q, publicly releases an unaudited condensed balance sheet and statement of operations . Between the date of Chiron's earnings release and the filing-of Form 10-Q, reclassifications may be required . These reclassifications, when made, have no effect on income from continuing operations, net income or earnings per share. In the Condensed Consolidated Balance Sheet at September 30, 2003, cash and cash equivalents is reduced by $0.03 million due to the reclassification of short-term borrowings .

Revenue Recognition

"Revenues from joint business arrangement" represents Chiron's one-half share . in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc., a Johnson & Johnson company . The arrangement was established in 1989, based largely on the screening, using immunodiagnostie technology, of blood in blood banks and other similar settings for the presence of HIV and hepatitis viruses . Through this arrangement, Ortho-Clinical Diagnostics sells a full line of tests required to screen for hepatitis viruses and retroviiuses and provides supplemental tests and microplate-based instrument systems to automate test performance and data collection . In addition, Chiron and Ortho-Clinical Diagnostics jointly hold the immunodiagnostic rights to Chiron's hepatitis and retrovirus technology and receive royalties from the sales of hepatitis C virus and HIV tests by licensees .

Chiron manufactures viral antigens and supplemental hepatitis tests and sells these tests to Ortho-Clinical Diagnostics, while Ortho linical Diagnostics manufactures and sells assays and instrument systems . The revenue from the sale of these antigens and tests, from Chiron to Ortho-Clinical Diagnostics, are recorded in product sales, with the corresponding costs recorded in cost of sales . Reimbursements from Ortho-Clinical Diagnostics for research costs incurred by Chiron and the related research expenses are separately recorded . In addition to these product revenues and reimbursements, Chiron shares in the defined pre-tax operating earnings of the Ortho-Clinical Diagnostics joint business activity at a pre-determined percentage (50%), as defined in the agreement, rather than from an ownership interest in an entity. Chiron receives contractually defined profit sharing payments. from Ortho-Clinical Diagnostics on a quarterly basis .

Chiron's blood testing segment recognizes revenues related to nucleic acid testing product sales, which primarily consist of revenue derived from the sale and use of assays, revenue derived from the sale, lease or rental of equipment and revenue from providing field service for the instruments . Revenue is recorded based upon the reported results obtained from the customer from the use of

10 assays to screen donations or upon sale and delivery of the assays, depending on the underlying contract . In the case of equipment sales or [cases, revenue is recorded upon the sale and transfer of the title to the instrument or ratably over the life of the lease term, respectively. For the provision of service on the instruments, revenue is recognized ratably over the life of the service agreement .

Inventories

Inventories, net of reserves are stated at the lower of cost or market using the moving weighted-average cost method . Inventory that is obsolete (inventory that will no longer be used in the manufacturing process), expired, or in excess of forecasted usage is written down to its market value . Inventories, net of reserves consisted of the following (in thousands):

Septejuber30, December 31, % 2003 2002

Finished goo'.` $ 83, 80 $ 32,697 Work-in-process 104,952 77,232 Raw:matenals ;:, . .• , : : ; : . 59,509 . 36,0.7 6

$ 247,641 S 146,00 5

In connection with the acquisition of PowderJect Pharmaceuticals , on July 8, 2003 ( see Note 5), there was a step up in the value of inventory of $24 .4 million. For the three months ended September 30, 2003, $10.9 million of this step up was included in cost of sales. Approximately $13 .5 million of this step up remains in inventory at September 30, 2003 and will be charged to cost of sales as the related product is sold .

Impairment of Long-Lived Assets

Chiron evaluates the recoverability of long-lived assets when indicators of impairment are present . Impairment, if any, is based on the excess of the carrying value of such assets over their respective fair values, calculated based upon the projected discounted net cash flows associated with such assets .

Chiron had capitalized building design costs of $1 .6 million for a biologics pilot plant in Emeryville, California related to construction of a research and development facility for a capital expansion project (see Note 10) . Chiron has abandoned plans to construct this building and accordingly wrote off $1 .6 million of building design costs in the third quarter of 2003 .

Income Taxes

The reported effective tax rate for 2003 is 25% of pretax income from continuing operations, excluding the write-off of purchased in-process research and development related to the acquisition of PowderJect Pharmaceuticals (see Note 5)_ The effective tax rate may be affected in future periods by changes in Chiron's estimates with respect to the deferred tax assets, acquisitions and other items affecting the overall tax rate . Income tax expense for the nine months ended September 30, 2002, was based on an estimated annual effective tax rate on pretax income from continuing operations o f

11 approximately 27%, excluding the write-off of purchased in-process research and development related to the acquisition of Matrix Pharmaceutical, Inc . (see Note 5).

Put Options

Chiron has used written put options to reduce the effective costs of repurchasing its common stock . The put option contracts provide that Chiron, at its choice, can settle with cash or through physical delivery of shares and, accordingly, the fair value of such put option contracts (premiums received) is initially classified in equity. However, because either settlement choice could require Chiron to deliver cash if the put option is exercised, an amount equal to the cash redemption value of the put option contracts is classified as temporary equity until expiration of the option .

Stock-Based Compensatio n

Chiron measures compensation expense for its stock-based employee compensation plans using the intrinsic method prescribed by Accounting Principles Board Opinion No . 25, "Accounting for Stock Issued to Employees" and related Interpretations, including Financial Accounting Standards Board, referred to as FASB, Interpretation No . 44 "Accounting for Certain Transactions Involving Stock Compensation ." Compensation expense is based on the difference, if any, between the fair value of Chiron's common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant . This amount is recorded as "Deferred stock compensation" in the Condensed Consolidated Balance Sheets and amortized as a charge to operations over the . vesting period of the applicable options or share rights. Compensation expense is included primarily in "Selling, general and administrative" in the Condensed Consolidated Statements of Operations .

In accordance with Statement of Financial Accounting Standards, referred to as SFAS, No . 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure," Chiron has provided, below, the pro forma disclosures of the effect on net income and net income per share as if SFAS No . 123 had been applied

12 in measuring compensation expense for all periods presented. Due to rounding, quarterly amounts may not sum fully to yearly amounts .

Three Months Ended Nine Months Ended September 30, September 30,

2003 2002 2003 2002

(in thousands , except per share data )

Net (loss) income: As reported $ (18,979) S 82,216 $ 105,513 $ 113,723 Add-.Stock-based; employee compensation expense included in reporte d net(loss) income„net of related tax effects ,11091 757 3,743 2,268 Less : Total stock-based employee compensation expense determined unde r fair value based method for all awards, net of related tax effects 20,741 17,578 58,786 47,30 8

. Pro forma $ . : . (38,629) .• $ 65,395 . $ 50,470 $ 68,68 3 _ ~rrrrrr r .rr rrrrwr+rr ~ ~ Basic net (loss) income per share Asraported (0 .10) S .44 0.57 .0.60 Pro forma $ (0 .21) $ 0 .35 $ 0 .27 $ 0 .36 Diluted .nef(loss) incoine per share : As reported $ (0 .10) $ 0 .43 $ 0 .55 $ 0 .59 Pro forma :: : : ., $, .:. (0 .21) $ . 0. 27 . .$ 0 .36

Comprehensive Income

In 2003, the foreign currency translation component of comprehensive income was not adjusted for income taxes, as it relates to permanent investments in non-U.S . sdbsidiaries.-ln 2002, the foreign currency translation component of comprehensive income included the tax effects of certain profit repatriations from Chiron's German and Italian vaccines subsidiaries. Additionally in 2002, all other foreign profits, net of the German and Italian profit repatriations, were considered pennanently reinvested .

Treasury Stock

13 New Accounting Standards

In January 2003, the FASB issued Interpretation No . 46 (referred to as FIN No . 46), "Consolidation of Variable Interest Entities" which address the accounting f o r certain off-balance sheet lease financing. The recognition provisions of FIN No . 46 will be effective for Chiron at the end of the first reporting period ending after December 15, 2003 . The adoption of FIN No. 46 is not expected to have a material impact on the Consolidated Financial Statements .

Note 2--Earnings (Loss) Per Share

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

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

Three Months Ended Nine Months Ended September 30, September 3Q,

2003 2002 2003 2002

Income (loss) (Numerator) : (Loss) income from continuing operations $ (20,153) $ 82,536 $ 102,375 $ 114,043 Plus: Interest on convertible Liquid Yield Option Notes net of tax 1,78 7

(Loss) income from continuing operations, plus assumed issuances $ (20,153) S 84,323 S 102,375 S 114,04 3

Shares (Denominator.): Weighted--average common shares outstanding 186,685 188,493 186,658 189,17 5 Effoot.ofdilutive securities : Stock options and equivalents - 2,826 3,828 3,387 Put options - .2 3 '1 Convertible Liquid Yield Option Notes 5,228 - -

Weighted-average_cornmonshares-outstanding ; plus assumed issuances . 186,685 196,547 - 190,488 192,565

Basic (loss) earnings per share $ (0.11) $ 0.94 $ 0.55 $ 0.60

Diluted (foss) earnings per share $ . (0 .11 ) $ 0.43 $ 0.54 .$. . . < 0:59 rnr~~ wow ~~rrr ~~rr~

14 . The following table sets forth the computa- ins for b . asic and diluted ( loss) earn ings per share on net (loss).).,come (in thousands , except per share data) :

Three Months Ended Nine Months Ended September.30, September 30 ,

2003 2002 2003 200 2

Income (loss) (Numerator) : Net (loss) incom e $ (18,979) $ 82,216 $ 105,513 $ 113,72 3 Plus: Intere st on convertible Liquid Yield Option Notes, net of taxe s 1,78 7

Net (loss) income, plus assumed issuances $ (18,979) $ 84,003 $ 105,513 $ 113,723

5hares(1)enotninator) Weighted-average common shares outstanding 186,685 188,493 186,658 189,17 5 Effect of dilutive securities: Stock options and equivalents - 2,826 3,828 3,38 7 Put option s 2 3 .Convertible Liquid Yield Option Notes 5,228 - -

weighted-average common shares outstanding ; plus assumed issuance s 185,685 196,547 190,488 192,56 5

Basic ( loss) earn ings per share $ (0.10) $ 0.44 $ 0 .57 $ 0 .6 0 ~t~r t~~~ ~wtrrt ~~tw $ `. Diluted,(loss)'earnings ;per share . „ $ (0.10) $ . 0 :4 3 0.55 . 0 .59 t+wrtr tr .i s~wr~M t tr~ e. .NrtrM ~~

For the three months ended September 30,2003 and 2002, stock options to purchase 4 .2 million and 16 .5 million shares, respectively, and for the nine months ended September 30, 2003 and 2002, stock options to purchase 10 .7 million and 13 .9 million, respectively, with exercise prices greater than the average market prices of common stock, were excluded from the respective computations of diluted (loss) earnings per share as their inclusion would beantidilutive .

Also excluded from the computations of diluted (loss) earnings per share for each of the three and nine months ended September 30, 2003 were 5 .2 million shares of common stock issuable upon' conversion of the Liquid Yield Option Notes and 7 .3 million shares, of common stock issuable upon conversion of the Convertible Debentures as their inclusion would be antidilutive . For the nine months ended September 30, 2002, 5.2 million shares of common stock issuable upon conversion of the Liquid Yield Option Notes were excluded from the computation of diluted earnings per share as their inclusion would be antidilutive .

All potential common shares have been excluded from-the computation of diluted loss per share for the three months ended September 30, 2003, as their inclusion would be antidilutive due to the net loss . These potential common shares included stock options to purchase 23 .3 million shares of common stock, 5 .2 million shares of common stock issuable upon conversion of the Liquid Yield Option Notes and 7 .3 million shares issuable upon conversion of the Convertible Debentures .

15- Note 3-Put Options

In May 2003, Chiron entered into a contract with a third party to sell put options on Chiron stock, entitling the holder to sell to Chiron 0 .5 million shares at $43 .89 per share . The option expired June 30, 2003 . On June 30, 2003, Chiron's closing stock price was $43 .86 . The third party elected to exercise a portion of the options . As a result, Chiron repurchased 0.2 million shares . For the third quarter 2003, Chiron had no outstanding put option contracts .

In February 2003, Chiron entered into a contract with a third party to sell put options on Chiron stock, entitling the holder to sell to Chiron 0 .5 million shares at $36 .79 per share . The option expired unexercised on May 5, 2003 .

As of December 31, 2002, Chiron had an outstanding put option contract with a third party entitling the holder to sell to Chiron 0 .5 million shares at $38 .11 per share, The option expired unexercised on January 29, 2003 . This put option contract was initially classified as equity . However, because the settlement options available to Chiron could require Chiron to deliver cash if the put option was exercised by the counter-party, the cash redemption value, totaling $19 .1 million, was reclassified from "Additional paid-in capital" to "Put options" in temporary equity in the Condensed Consolidated Balance Sheet at December 31, 2002 . Upon expiration, the options were not exercised and the temporary equity of $19 .1 million was reclassified to permanent .equity in the first quarter 2003 .

Note 4-Discontinued Operation s

In a strategic effort to focus on its core businesses of biopharmaceuticals, vaccines and blood testing, Chiron completed the sale of Chiron Diagnostics and Chiron Vision in 1998 and 1997, respectively . Basic earnings per share from discontinued operations was $0 .01 and $0 .02 for the three and nine months ended September 3.0, 2003, respectively. Diluted earnings per share from discontinued operations was $0 .01 for each of the three and nine months ended September 30, 2003 . Discontinued operations had no impact on. basic and diluted earnings per share for the three and nine months ended September 30, 2002 .

The "Gain (loss) from discontinued operations" for the three and nine months ended September 30, 2003 and 2002, consisted of the following (in thousands) :

Three Months Ended Nine Months Ended September30, September30, .

2003 2002 2003 2002

Reversal of reserve s net charge) for indemnity obligations $ 1,833 $ - $ (5,222) $ - Employee settlemen t - (438) - (438) Income tax (provision), benefit , (659) 118 8,360 118

$ 1,174 $ (320) S 3,138 $ (320) trrrrrrr~ ~w w~t~r~~ i..r~

In the third quarter 2003, Chiron reversed approximately $1 .2 n iltion, .net of tax, related to unutilized reserves for Chiron Diagnostics, which was recorded asa "Gain from discontinued operatipns" for the three and nine months ended September 30, 2003 .

16 In the second quarter 2003, Chiron reversed approximately $0 .5 million related to unutilized reserves for Chiron Diagnostics and Chiron Vision, which was recorded as a "Gain from discontinued operations" for the nine months ended September 30, 2003 .

In the first quarter 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, Chiron was required to make a payment to Bayer during the first quarter 2003 . Chiron utilized an amount previously reserved for indemnity obligations, based upon the settlement agreement with Bayer. These amounts resulted in a net charge of $7 .6 million, offset by an income tax benefit of$9.0 million, resulting in a net gain of $ t .4 million, which was recorded as a "Gain from discontinued operations" for the nine months ended September 30, 2003 .

In the third quarter 2002, Chiron recognized a charge of $0 .4 million related to a settlement with a former employee arising out of the sale of Chiron Diagnostics- This amount was recorded as a "Loss from discontinued operations" for the three and nine months ended September 30, 2002 .

Income Taxes

In connection with the sale of Chiron Diagnostics and Chiron Vision, Chiron recorded cumulative net deferred tax assets of $0 .2 million and $8 .5 million at September 30, 2003 and December 31, 2002, respectively, principally attributable to the timing of the deduction of certain expenses associated with these sales . Chiron also recorded corresponding valuation allowances of $0 .2 million and $8 .5 million at September 30, 2003 and December 31, 2002, respectively, to offset these deferred tax assets, as management believes that it is more likely than not that the deferred tax assets to which the valuation allowance relates will not be realized : The future recognition of these deferred tax assets will be reported as a component of "Gain (loss) from discontinued operations. "

Note 5.-Acquisition s

Powderdect Pharmaceuticals plc On July 8, 2003, Chiron acquired PowderJect Pharmaceuticals, a company based in Oxford, United Kingdom that develops and commercializes vaccines. Chiron acquired all of the outstanding shares of common stock of Powderdect Pharmaceuticals for 550 pence per ordinary share, which, including-estimated acquisition costs, resulted in a total preliminary purchase price of approximately $945 .6 million . PowderJect Pharmaceuticals is part of Chiron's vaccines segment . PowderJect Pharmaceuticals' products, including vaccines for influenza, expand Chiron's portfolio of vaccine products .

Chiron accounted for the acquisition using the purch as e method of accounting and included Powder.Iect Pharmaceuticals ' operating results in its consolidated .operating results beginning J uly 8, 2003 . The components and initial allocation of the preliminary purchase price, based on their estimated fair values is summarized in the following table (in thousands). Chiron is in the process of finalizin g

17 certain estimates including those for lease exit costs, other exit activities and certain liabilities including a guarantee and therefore the initial allocation of the purchase price is subject to change.

Consideration and acquisition costs : Cash paid for common stock 1 831,02 6 Cash paid for options on common stock 59,153 Acquisition costs paid as of September 30, 2003 5,547 Acquisition.costs not yet paid as of September 30, 2003 49,920

Total preliminary purchase price $ 945,646

Allocation ofpreliminaty purchase price : Cash and cash equivalents $ 92,17 8 Short-tetrrt marketable securit 8,84 0 Accounts receivable, net 42,73 2 Inventories 68,375 Property, plant and equipment 70,19 9 Goodwill 451,823 Acquired intangible assets 335,500 Other assets 6,461 . Income taxes payable (17,741 ) Current liabilities :, {76,981) Net deferred tax liability (68 ;664) Long-terra liabilities (89;776) Write--ofof purchased in-process research and development 122,70 0

Total,pre.liminary :purchase price $ 945,64 6

Acquisition costs included involuntary termination costs of$16 .8 million, as well as other direct acquisition costs

Chiron allocated the preliminary purchase price based on the fair value of the assets acquired and liabilities assumed . A portion of the purchase price was allocated to purchased in-p ro cess research and development, which was written off entirely in . the third quarter 2003 because Chiron does not anticipate that there will be any alternative future use for the in-process research and development . The write-off of purchased in-process research and development represented the valuation of acquired, to-be-completed research projects . Purchased in-process research and development was determined using the income approach, which is based on the premise that the value of a security or as set is the present value of the future ea rning capacity that is available for distribution to the subject investors in the security or asset, In valuing the purchased in-process re search and development , Chiron used probability-of- success-adjusted cash flows and a 14% discount rate . Cash flows from projects including those rela ti ng to (i) viral infectious disease, ( ii) certain travel vaccines and (iii) vaccines for allergies were assumed to commence between 2004 and 2012 . Given the high risk associated with the development of new drugs,, Chiron probability adjusted the revenue and expense forecasts to re fl ect the risk of advancement through the regulato ry approval process based on the stage of development in th e

18 regulatory process. Such a valuation requires significant estimates and assumptions . Chiron believes that fair value assigned to purchased in-process research and development is bas ed on reasonable assumptions . However, these assumptions may he incomplete or inaccurate, and unanticipated events and circumstances may occur . To assist in determining the value of the purchased in-process research and development, a third-party valuation was obtained as of the acquisition date.

Acquired intangible assets included the fair value of distribution rights, a contract manufacturing agreement and developed product technologies . The distribution rights and the contract manufacturing agreement are being amortized on a straight-line basis over I to 4 years . The weighted average amortization period for these intangible assets is 2 years. Developed product technologies are being amortized using either the estimated sales method over 10 years or on a straight-line basis over 1 to I5 years . The weighted average amortization period for these intangible assets is I 1 years . The weighted average amortization period for total acquired intangible assets is 10 years .

Income taxes payable of $17 .7 million relates to current tax liabilities associated with PowderJect Pharmaceuticals at the date of acquisition . The net deferred tax liability of $68 .7 million is comprised of current and non-current deferred tax assets of $32 .0 million primarily related to net operating losses incurred from April 1, 2003 through the acquisition date and depreciation timing differences and a non-current deferred tax liability of $100.7 million related to acquired intangibles.

At the date of acquisition, PowderJect Pharmaceuticals had $150.0 million of tax loss carryforwards in the U.S., Sweden and the United Kingdom, which would give rise to a deferred tax asset of$46.0 million and $63 .0 million of other temporary differences in Sweden, which would give use to a deferred tax asset of$17 .6 million . A full valuation allowance has been established for these deferred tax assets, as it is more likely than not, at the date of acquisition, that all of these deferred tax assets will not be realized .

The following unaudited pro forma information presents the results of continuing operations and net income of Chiron and PowderJect Pharmaceuticals for the nine months ended September 30, 2003 and 2002 as if Chiron`s acquisition of PowderJect Pharmaceuticals had been consummated as of January 1, 2003 and 2002, respectively. The pro forma results exclude the nonrecurring charge for the write-off of purchased in-process research and development, which resulted directly from the transaction . The unaudited pro forma condensed combined financial information does not reflect any incremental direct costs, including any restructuring charges to be recorded in connection with the acquisition, or potential cost savings, which may result from the consolidation of certain operations of Chiron and PowderJect Pharmaceuticals . Accordingly, the unaudited pro forma financial information is presented for illustrative purposes and not necessarily indicative of the results of operations of the combined company that would have occurred had the acquisition occurred at the beginning of eac h

19 period presented, nor is it necessarily indicative of fbrure operating results . The unaudited pro forma information is as follows (in thousands, except per share data):

Nine Months Ended September 30,

2003 . 200

. $ ., 1,279;363 1,065,482 Total revenues = 7 Income from continuing operations S 188,985 S 92,941 Net income 192, .123 $ 92,621 Pro forma earnings per share from continuing operaliocc:: Basic_ $ 1 :01 $ 0.49 Diluted $ 0 .99 $ 0.48 Pro forma eammg s per p share net fro mmc'ome ; Basic $ i .03 $ 0 .49 Diluted $ 1 .01 $ 0 .4 8 Pulmopharm GmbH On July 1, 2002, Chiron completed its acquisition of Pulmopharm GmbH, a distributor of TOBI$ products in Germany and Austria by purchasing the remaining 80 .1% ownership that Chiron did not previously own . Previously, Chiron owned 19 .9% of Pulmophamt and accounted for the investment under the equity method. Chiron's acquisition of all of the-remaining.outstanding shares of common stock of Pulmopharm, including estimated acquisition costs, resulted in a total purchase price of approximately $3 .7 million . The acquisition resulted in the recognition of $3 .8 million of intangible assets relating to the distribution rights, $1 .2 million of goodwill, $0 .3 million of tangible assets and $1 .6 million of deferred tax liabilities on the acquisition date . In addition, on the acquisition date, the carrying value of the original investment in Pulmopharm, which totaled $0 .3 million, was reclassified to goodwill. Chiron accounted for the acquisition using the purchase method of accounting and included Pulmophanu's operating results in its consolidated operating results beginning on July 1, 2002 . Pulmopharm is part of Chiron's biopharmaceuticals segment .

.Matrix Phartuaceuticai, Inc. On February 20, 2002, Chiron acquired Matrix Pharmaceutical, Inc ., a company that was developing tezacitabine, a drug to treat cancer . Chiron acquired all of the outstanding shares of common stock of Matrix Pharmaceutical at $2 .21 per share, which, including acquisition costs, resulted in a total purchase price of approximately $67.0 million. Matrix Pharmaceutical is part of Chiron's biophamtaceuticals segment . Tezacitabine expanded Chiron's portfolio of cancer therapeutics .

Chiron accounted for the acquisition as an asset purchase and included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in its consolidated

1 operating results beginning on March 1, 2002 . The components and allocation of the purchase price, based on their fair values, consisted of the following (in thousands):

Consideration and acquisition costs: Cash paid for common stock $ 58,737 2,2 Cash paid for options on common stock 31 Acquisition costs 6,078

Total purchase p rice $ 67,046 ~nrrrur..rrr~

Allocation of purchase p rice : Cash and cash equivalents 17,337'S . Assets held for sale 2,300 Deferred tax assets 10,000 Other assets 1,469 Write-off of purchased .rn-process researchand development 45 181 Accounts payable ( 2,898 ) 1739 Reducti on of income taxes payable : Accrued liabilities (8,082)

Total purchaseprice ' $ 67,046

Acquisition costs included contractual severance and involuntary termination costs, as well as other direct acquisition costs . App roximately $5 .1 million . represented severance payments, assumed by Chiron, to eligible employees as def ined by their employment agreements.

Chiron allocated the purchase price based on the fair value of the assets acquiredand liabilities assumed . Once value was allocated to tangible assets, the residual amount (which was less than the estimated fair value of the in-process research an d development discussedbelow) was allocated to the identifiable intangible assets, including in-process research and development. Chiron allocated a po rt ion of the purchase price to purchased in-process research and development and wrote off $ 54 .8 million in the first quarter 2002. Chiron allocated a po rt ion of the purchase price to a liability for asset disposal and lease can cellation for the San Diego, Califo rnia facility closed:during the third qua rter 2002. In the .fourth quarter .2002, Chiron found an assignee for the manufacturing facility lease and revised the allocation of the purchase pri ce re sulting in a $9 . 6 million decrease to the liabilities relating to the expected exit of the facility . As a result , the revised aggregate fair value of the assets acquired and liabilities assumed, including purchas ed in-process research and development, exceeded the purchase p ri ce by $9 .6 million. Accordingly, this excess credit of $9.6 million was allocated to purchased in-process research and development, as an excess credit allocated to any other acquired asset would have resulted in the recording of assets below fair value and would have required a gain to be recognized as current assets were realized . Chiron does not anticipate that there will be any alternative future .use for the in-process research and development that was written off. The write-off of purchased in-process research and development represented the fair value, calculated using probability-of-success -adjusted cash flows and a 20% discount rate, at the acquisition date . Chiron assumed cash flows from

21 tezacitabine to commence after 2005 . As with all pharmaceutical products, the probability of commercial success tor any research and development project is highly uncertain.

As indicated in the above table, a portion of the purchase price was allocated to assets held for sale. In March 2002, Chiron sold the leasehold improvements and assigned the lease related to a facility located in Fremont, California . Chiron received an amount equivalent to the fair value of the assets at the date of acquisition.

Chiron paid $1 .0 million and $0 .2 million related to severance payments included in acquisition costs for PathoGenesis Corporation and Matrix Pharmaceutical, respectively, for the nine months ended September 30, 2003 . These payments are reflected in the Condensed Consolidated Statement of Cash Flows as a component of "Cash paid for acquisitions, net of cash acquired" for the nine months ended September 30, 2003 . In March 2002, Chiron paid $6.0 million related to a bank loan assumed during the purchase of Matrix Pharmaceutical . This payment is reflected on the Condensed Consolidated Statement of Cash Flows as a component of "Cash paid for acquisitions, net of cash acquired" for the nine months ended September 30, 2002 .

The. deferred tax assets primarily related to future utilization of net operating loss carryforwards . Chiron acquired federal and state net operating loss carryforwards and business credits attributed to Matrix Pharmaceutical of approximately $288 .7 million and $9 .5 million, respectively. The available utilization of such net operating loss and business tax credit carryforwards is limited in any one year to approximately $2 .7 million per annum over the next twenty years under provisions of the Internal Revenue Code . As such, a significant portion of Matrix Pharmaceutical's net operating loss carryforwards is expected to expire unutilized.

Note 6- Restructuring and Reorganizatio n

For the nine months ended September 30, 2003, Chiron recorded restructuring and reorganization charges of $1 .8 million . The charges, included in . "Restructuring and reorganization charges" in the condensed consolidated statement of operations, consisted of termination and other employee-related costs recognized in connection with the elimination of 15 positions in its Amsterdam manufacturing facility . Termination notice has been provided . Of the 15 positions for elimination, one was terminated as of September 30, 2003 . For the nine months ended September 30, 2002, Chiron had no restructuring and reorganization adjustments related to these items .

1 i termination costs included wage continuation, advance notice pay and medical and other benefits . Facility-related costs included losses on disposal of property, plant and equipment, lease payments and other related costs . For the nine months ended September 30, 2003 and 2002, Chiron had no restructuring and reorganization adjustments related to these items . Of the 371 positions for elimination, 367 were terminated as of September 30, 2003 .

Chiron expects to substantially settle the restructuring and reorganization accruals within one to six years of accruing the related charges . As of September 30, 2003, $1 .8 million was included in "Other current liabilities" in the Condensed Consolidated Balance Sheet . As of December 31, 2002 , $0 .2 million and $0.1 million were included in "Other current liabilities" and "Other noncurrent liabilities," respectively, in the Condensed Consolidated Balance Sheet .

The activity in accrued restructuring and reorganization for the nine months ended September 30, 2003 and 2002 is summarized as follows (in thousands) :

Amount of Amount Amount to Accrual at Total Utilized Be Utilize d December 31, Restructuring Through In Future 2002 Charge September 30,2003 Periods

Employee-related costs and Other .facility-related costs $ 334 . $ 1,757 $ . (316) $-' ; 1 ;775 mom X w .r~rtrrrarrrrr

Amount of Amount Amount to Accrualat Total Utilized Be Utilized December 3l, Restructuring Through In Future 2001 Charge September 30, 2002 Periods

Etnpl6yee-related costs an d Other facility-°related costs 693.: $ _ . $ (298) $ 395 atwawww~rrr

1 Note 7-Intangible Asset s

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

September 30, 2003 December 31, 2002

Gross Gros s Carrying Accumulated Net Carrying Carrying Accumulated Net Carrying Value Amortization Value Value Amortization Value

Purchased technologies $ 332,054 $ 90,263 S 241,79 1 $ 331,94 1 $ 74,328 $ 257,61 3 ~a~i ~ ~.~ ~rrrrr

Patents S 115,638 S 59,128 $ 56,510 $ 106,723 $ 52,136 $ 54,58 7 Trademarks ' .' 57;663 18,540 39,123 53,394 14,928 38,46 6 Licenses and technology ri ghts(1) 46,573 23,117 23,456 35,243 16,063 19,18 0 Developed product technologies(2) ., - 324,924 10,805 314,119 - - Customer relationships 26,655 8,854 17,801 24,082 7,054 17,02 8 Know how(3) 12,105 5,352 6,753 10,935 4,245 6,690 Databas es 7,100 1,420 5,680 7,100 1,065 6,03 5 Other . 26,229 12,424 13,805 15,274 10,171 5,10 3 -rrr.rW.-.-y--`

Total other intangible assets S 616,88 7 S 139 ,640 $ 477,24 7 S 252,75 1 $ 105,662 $ 147,089 era ~ttrr~tr ww~rat r~rr~

Total intangible assets subject' . . . . to amortization . . $ 948 ;941 $ 229,903 $ 719,03 8 S 584,692 $ 179,990 . $ 404,702 r rr~rr .r+rrr ~ ~ ~~

~1)

Intangible assets related to distribution rights and a contract manufacturing agreement with a gross ca rrying value of $9 .1 million and accumulated amortization of $1 .7 million acquired in the acquisition of Powderdect Pharmaceuticals during the third quarter 2003 ( see Note 5 ) were included in Licenses and technology rights at September 30, 2003 . The gross car ry ing value of these intangible assets has decreased approximately $0 .04 million due to exchange rate fluctuations between the acquisition date and September 30, 2003. 2) ( Intangible assets with a gross carrying value of $ 324,9 million and accumulated amortization of $10 .8 million acquired in the acquisition of PowderJect Pharmaceuticals du ri ng the third quarter 2003 (see Note 5) were included in Developed product technologies at September 30, 2003 . The gross carrying value of these intangible assets has decreased approximately $ 1 .46 million due to exchange rate fluctuations between the acquisition date and September 30, 2003 .

(3) Upon acquisition of a 100% interest in Chiron Behring by the second qua rt er 1998 , Chiron acquired a po rt folio of products that were created by Behring an d are currently being sold internationally . These products embody Chiron Behring's proprietary "know-how" consisting of unpatented technology an d trade secrets. Since the unpatented technology and trade secrets meet the separability criterion , Chiron has recognized them collectively .as a separate intangible asset apa rt from goodwill in accordance with SFAS No . 141 .

Aggregate amortization expense is as follows (in thousands) :

For the nine months ended September 30, 2003 (reported) $ 51,367 For the remaining three months in the year ended December 31, 2003 (estimated) 25,68 4

For the year ended December 31, 2003 (estimated) $ 77,05 1

For the year ended December 31, 2004 (estimated) $ 96,95 4 For the, year ended December 31, 2005 (estimated) $ 94,22 9 For the year ended December 31, 2006 (estimated) $ 99,91 6 For the year ended December 31, 2007 (estimated) $ 101,804 For the year ended December 31, 2008 (estimated) $ 95,374 The changes in the carrying value of goodwill (including assembled workforce) by reporting unit consisted of the following (in thousands) :

- Biopharmaceuticals Vaccines Total

Balance as of December 31, 2002 $ 199,225 $ 40,521 $ 239;746 Goodwill acquired (Note 5) - 451,823 451,823 ,Effect of exchange-rate changes 18,146 (8;196

Balance as of September 30, 2003 _ $ 199,225 $ 510,540 $ 709,765 Chiron performed its annual impairment test for goodwill as of June 30, 2 0 03 . Based on this analysis, Chiron has no indication of an impairment loss .

Note 8--Segment Informatio n

Chiron is organized based on the products and services that it offers . Under this organizational structure, there are three reportable segments : (i) biopharmaceuticals, (ii) vaccines and (iii) blood testing. The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases, using the development and acquisition of technologies related to therapeutic proteins and small molecules . The vaccines segment consists principally of adult and pediatric vaccines for viral and bacterial infections . Chiron sells these vaccines in the U .S ., Germany, Italy, the United Kingdom and other international markets . The vaccines segment is also involved in the development of novel vaccines and vaccination technology . The blood testing segment consists of an alliance with Gen-Probe Incorporated and Chiron's one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Chiron's alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection . Chiron's joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron 's joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect

2 5

i'~ hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection .

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

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

For the three and nine months ended September 30, 2002, expenses of approximately $0 .4 million and $1 .2 million, respectively, previously allocated to the biopharmaceuticals segment, have been allocated to the vaccines segment to conform with the current period presentation .

The accounting policies of Chiron's reportable segments are the same as those described in Note I-The Company and Summary of Significant Accounting Policies above and in Chiron's Annual Report on Form 10-K for the year ended December 31, 2002 . Chiron evaluates the performance of its segments . based on each segment's income (loss) from continuing operations, excluding certain special items, such as restructuring and reorganization charges and the write--off of purchased in-process research and development, which are shown as reconciling items in the table below.

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

Three Months Ended Nine Months Ended September36, September 30 ,

2003 2002 2003 200 2

Revenues ' . Biopharmaceuticals : Product sales,: net Betaseron® $ 29,010 $ 28,533 $ 88,788 $ 84,59 3 TOBW 43,022 38,971 122,740 108,30 8 Proleukin® 29,859. 32,088 85,223 83,693 Other 8,166 6,319 22,258 23,81 8

Total product sales, net 110,057 105,911 319,009 300,41 2 Collaborative agre ement revenues 1,364 3,270 . 4,645 .10,28 5 Royalty and license fee revenues 23,523 12,494 62,098 46,23 1 .Otherrevenues 5,009 6,378 23,794 . 13,022.

Total biopharmaceuticals revenues 139,953 128,053 409,546 369,95 0

26 Vaccines: Product sales, net : Influenza vaccines 183,250 66,907 191,286 71,047 MenjugateTM 10,642 6,193 31,876 21,81 9 Travel vaccines 11,229 16,621 59,981 58,51 2 Pediatric and othe r vaccines 57,598 . 35,771 133,537 104,71 4

Total-product sales, net 262319' . 125,492 416,680 256,092 Collaborative agreement revenues 4,349 111 4,516 444 Royalty-'and license fee revenues 3,023 3,721 9,550 9,155 Other revenues 2,679 .4,289 8,688 13,38 7

Total vaccines . revenues . 272,770 133,613 439,434 279,07 8

Blood testing : Product sales, net: Procleix® 53,663 35,961 141,767 83,424 Ortho-Clinical Diagnostics .6,235 4,826 19,766 17,139

Total product sales, net 59,898 40,787 161,533 100,56 3 Revenues from joint business' arrangement - 26,058 . 32,356 79,985 78,54 8 Collaborative agreement revenues 2,103 1,596 6,393 7,05 7 Royalty and . license : fee revenues 20,57 6 ." . 14,232 59,372 36,99 4 'Other revenues - - - 4 1

Total bloodteshng revenues 108,635 88,971 307,283 223,203

Other: Royalty:and.license fee , : .revenues 19,115 17,'600 55,517 . 46,03 9 Other revenues - 244 --- . 1,68 6

Total other revenues 19,115 1 :7,844 55,517 47,72 5

Total revenues $ 540,473 $ 368,481 5 1,211,780 $ 919,95 6 rr . r ..rrrrrrrr+rrr ..rr. .~r~rrrw .wr y... .r.rr.Mrr.~...~w

27 Income (loss) from continuing operations Biopharmaceuticals S 16,745 $ 7,796 $ 50,716 $ 20,775 Vaccines . . 69,848 39,942 ; 65,340 :48,920 Blood testing 56,994 54,549 169,997 127,662 Other (4,349) :; .. ._ 5,770 . . . (1,419) 3,31 2

Segment income from operations 139,238 108,057 284,634 200,66 9 operating-expense reconciling items : ..._., . ; .

W rite-off o f purchased in-process research and development (122,700) - (122,700) (54,781 ) Restructuring and reorganizatio n charges ( 1,082) '. - (1,757) -

Income from operations 15,456 108,057 160,177 145,88 8 Interest expense -(6,222) (3,210) . (12,523) (9,498 ) Interest and othe r income, net 5,239 8,696 31,170 41,45 6 Minority interest . .(443) . (477) (1,424) (1,360) ter.. Income from continuing operations before income taxes $ 14,030 $ 113,066 $ 177,400 $ 176,486 rrrrrrrrrrrr~a ~w~w~ ~

Note 9-Debt Obligation s

On July 30, 2003, Chiron issued $500 :0 million aggregate principal amount of convertible debentures, which mature on August 1, 2033 . The convertible debentures accrue interest ata rate of 1 .625% per year and interest is payable on February I and August 1 commencing February 1, 2004 . The debentures are senior, unsecured obligations of Chiron and rank equal in right of payment with all of Chiron's existing and future unsecured andunsubordinated indebtedness .

The holders of the debentures may convert their debentures into shares of Chiron common stock when certain Chiron common stock price targets have been met at certain times, if the debentures have been called for redemption, if the credit rating assigned to Chiron's long-term senior debt is below specified levels or upon the occurrence and continuance of specified corporate transactions : For each $1,000 principal amount of debentures surrendered for conversion, the holder will receive 14 .6113 shares of Chiron common stock. This is equivalent to an initial conversion price of approximately $68.44 per share of common stock.. Upon conversion, holders will not receive any cash payment for accrued interest . Instead, accrued interest will be deemed paid by the common stock received by holders on conversion.

The holders of the debentures may require Chiron to repurchase the debentures on August 1, 2008, August 1, 2013, August 1, 2018, August 1, 2023 and August 1, 2028. The repurchase price will be

28 equal to the p rincipal and accrued and unpaid interest. Chiron may choose to pay the repurchase price in cash or Chiron common stock or any combination of the two.

On or after August 5, 2008, Chiron may redeem for cash all or part of the debentures at a redemption price of principal plus accrued and unpaid interest .

If Chiron undergoes certain change in control transactions, the holder of the debentures have the option to require Chiron to repurchase all or part of the debentures not previously called for redemption . The repurchase price will be equal to the principal and accrued and unpaid interest, Chiron may choose to pay the repurchase price in cash or Chiron common stock or any combination of the two .

Bond issuance costs amounted to approximately $10 .7 million and are being amortized to interest expense on a straight-line basis, which approximated the effective interest method, over five years, which represents the period from the issue date to the earliest redemption date . Bond issuance costs are recorded in "Other intangible assets, net" in the . Condensed Consolidated Balance Sheets . -

Note 10-Commitments and Contingencies

Effective June 2003, Chiron and SynCo Rio Partners B .V., a related party, executed a seven and a half-year contract manufacturing agreement . Under this agreement, SynCo agreed to provide services related to the production of certain of Chiron's vaccine products for the European and U .S . markets . Chiron has a firm binding order for products to be delivered by SynCo in 2004, 2005 and 2006 under this agreement . Chiron's minimum purchase obligation under this agreement, subject to adjustment depending on the quantities . purchased by Chiron in years 2007 through 2010, inflation and movement in the Euro to U .S . Dollar exchange rate, is expected to be approximately $34 .0 million over the term of the agreement .

Simultaneously in June 2003, Chiron and SynCo Die Partners B.V . executed an FDA compliance agreement : Under this agreement, Chiron will fund certain costs required to bring SynCo's Amsterdam manufacturing facility into compliance to support approval by the U .S . Food and Drug Administration to manufacture certain vaccine products for the U .S . market. Chiron's funding commitment under this agreement is expected to be approximately $10 .0 million through the first quarter 2005, of which Chiron had paid 3 .2 million Euro ($3 .7 million) as of September 30, 2003 .

in July 2003, Chiron entered into a new six-year lease to rent a research and development facility in Emeryville, California following the expiration of the existing operating lease. Effective July 1, 2003, Chiron accounted for this new lease as a capital lease and, as a result, recorded the leased facility and the corresponding liability on its balance sheet . The amount recorded on thebalance sheet for the . leased facility is .$157.5 million. The amount of the leased facility less the expected value of the facility at the end of the lease term is being amortized on a straight-line basis over the lease term . Chiron expects the value of the -facility at the end of the lease term will be approximately $151 .6 million . At the inception of the lease, the future minimum lease payments, exclusive of a residual value guarantee, are approximately $15 .7 million over the lease term . The interest payments represent variable-rate interest payments indexed to a three-month London interbank offered rate' plus 40 basis points . The

29 lease provides a $156 .0 million residual value guarantee from Chiron to the lessors in the event of property value declines . Consequently, Chiron's maximum payment obligation is $156 .0 million upon termination of the lease on or before July 1, 2009 .On or before July 1, 2009, Chiron can choose to either purchase the facility from the lessors or sell the facility to a third party . This option accelerates if Chiron defaults on its lease payments or in the event of other defined events . As of July 1, 2003, Novartis AG had guaranteed (under provisions of the Investment Agreement) payments on this lease commitment, including payment of the residual value guarantee, to a maximum of $ 173 .3 million.

In July 2003, Chiron acquired Powderlect Pharmaceuticals, plc (See Note 5). Associated with this acquisition, Chiron assumed operating leases for manufacturing facilities, office space, laboratory and office and manufacturing equipment . The future minimum lease payments for these leases are $0 .5 million for the fourth quarter 2003, $1 .9 million for 2004, $1 .7 million for 2005, $1 .6 million for 2006, $1 .5 million for 2007 and $13 million after 2007 . Also, associated with this acquisition, Chiron has guaranteed a $7 .0 million loan for research and development purposes .

In August 2003, Chiron entered into a $2 .5 million revolving credit agreement with Nektar Therapeutics to support the financing of equipment, facility improvements and other capital expenditures related to the manufacture of clinical supplies in support of a program to develop a dry powder formulation of TOBI®. Each advance made under this revolving line of credit matures on the sixth anniversary of the initial advance . As of September 30, 2003, Nektar Therapeutics has not drawn from the revolving line of credit .

In September 2003 ; Chiron entered into a 10-year lease agreement with a commencement date of December 5, 2003 for an administrative facility in Emeryville, California. The total minimum lease payments over the term of the lease are approximately $10 .0 million . This lease will be accounted for as an operating lease .

. In October 2003, Chiron entered into a 15-year lease extension . with a commencement date of January 1, 2005 for a production facility in Marburg, Germany- The additional minimum lease payments over the term of the lease extension are approximately $7 .9 million . This lease extension will be accounted for as an operating lease .

Chiron is limited partner of several venture capital funds, as discussed in Note 1-"The Company and Summary of Significant Accounting Policies ." In the second quarter 2003, Chiron became a limited partner of two additional venture capital funds . Chiron is obligated to pay $15 .0 million over ten years in equity contributions to these two new venture capital funds, of which $1 .3 million was paid through September 30, 2003 .

In April 2003, Chiron entered into a 15-year lease to re nt an office building in Uxbridge, United Kingdom . The total minimum lease .payments over the - term. of the lease are approximately 918 million British Pounds ($16 :6 million at September 30, 2003). After 10 years, Chiron has the option to terminate or continue the lease, with one-year prior notice. This lease is accounted for as an operating lease .

There were no amounts drawn against any outstanding letters of credit at September 30, 2003 . Effective -April 1, 2003, the amount of insurance-- related letters of credit has increased by $4 .8 million .

30 i

Effective February 2003, Chiron and Baxter Pharmaceutical Solutions LLC executed an eight-year manufacturing and supply agreement . Under this agreement, Baxter agreed to perform certain manufacturing procedures and supply Chiron with a key component for a certain biophannaceutical product . Chiron has certain minimum purchase obligations under this agreement and is required to pay the difference, if any, between the actual quantity purchased and the minimum purchase obligation. Chiron's minimum purchase obligation is effective once regulatory approval is obtained . Chiron can terminate this agreement in the fifth year with prior notice . Chiron's minimum purchase obligation under this agreement is expected to be approximately $36 .0 million over four years from regulatory approval .

In April 2001, Chiron, Rhein Biotech N .V . (now part of Berna Biotech) and GreenCross Vaccine Corporation entered into a collaboration to research and develop certain pediatric combination vaccine products for sale outside of Europe and North America . The collaboration agreement requires capital commitments from Chiron, Bema Biotech and GreenCross Vaccine . Chiron's commitment is approximately 26 .4 million Euro ($30.6 million at September 30, 2003) for the expansion of Chiron's Italian manufacturing facilities, of which Chiron had incurred costs of 7 .9 million Euro ($8 .9 million), as of September 30, 2003 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008 .

In February 2001, Chirons Board of Directors approved a $235 .0 million capital expansion project, which includes the construction o€a research and development facility (including a supporting central utility facility) and a parking structure in Emeryville, California . Chiron has committed to $37 .6 million in design and construction services, of which Chiron had incurred costs of $28 .5 million, as of September 30, 2003 . Chiron may cancel these commitments at any time . Related to the research and development facility, Chiron is evaluating various financing alternatives to fund this expansion . Construction was completed on the parking structure in December 2002.

Chiron enters into indemni fi cation provisions under its agreements with other companies in its ordinary course ofbusiness , typically with business partners, contractors , clinical sites, insurers: and customers . Under these provisions Chiron generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of Chiron's activities . These indemnification provisions generally su rv ive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Chiron could be required to make under these indemnification provisions is unlimited . The estimated fair value of the indemnity obligations of these agreements is minimal . Accordingly, Chiron has no liabilities recorded for these agreements as of September 30, 2003 . Chiron has not incurred mate rial costs to defend lawsuits or settle claims related to these indemnification agreements :` "

Chiron is party to various claims, investigations and legal proceedings arising in the ordinary course of business . These claims, investigations and legal proceedings relate to intellectual property rights, contractual rights and obligations, employment matters, claims of product liability and other issues . While there is no assurance that an adverse determination of any of such matters could not have a material adverse impact in any future period, management does not believe, based upon information

31 known to it, that the final resolution of any of these matters will have a material adverse effect upon Chiron's consolidated financial position and results of operations or cash flows .

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

Note 11-Subsequent Events

In October 2003, Chiron entered into a license agreement with Cubist Pharmaceuticals, Inc . for the development and commercialization of Cubist's antibiotic daptomycin for injection in Western and Eastern Europe, Australia, New Zealand, India and certain Central American, South American and Middle Eastern countries . In exchange for these development and commercialization rights, Chiron has agreed to pay Cubist up to $50 .0 million . This $50.0 million includes $18.0 million, which was paid by Chiron up front in the fourth quarter 2003, $10 .0 million of which was used to purchase restricted Cubist common stock-at a 50 percent premium over market price, and up to $32 .0 million of additional payments to Cubist upon the achievement of certain regulatory and sales milestones . Chiron will also pay Cubist a tiered royalty on daptomycin for injection made by Chiron . Chiron expects to record a portion of the up front payment as research and development expense.

In November 2003, Chiron's Board of Directors approved $51 .0 million in expenditures for a 25-year lease for buildings, which is part of a $97.0 million project for a new flu vaccines manufacturing facility in Liverpool, England. The new manufacturing facility will replace existing flu vaccines manufacturing facilities in Liverpool, England.

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

Overvie w

This 10-Q contains forward-looking statements regarding our expectations, hopes or intentions regarding the future, including statements relating to sales growth, product development initiatives, new product marketing, acquisitions, competition, in- and out-licensing activities and expected cost savings that involve risks and uncertainties and are subject to change. You should read the discussion below in conjunction with Part I, Item .] ., "Financial Statements," of this 10-Q and Part If, Items 7., 7A . and 8., "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures About Market Risk" and "Financial Statements and Supplementary Data . "respectively, of our Annual Report on Form 10-Kfor the year ended December 31, 2002. The forward-looking statements contained in this 10-Q reflect our current beliefs and expectations on the date of this 10-Q. Actual results, performance or outcomes may differ from current expectations. Our actual performance may differ from current expectations due to many factors, including the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, stock price and interest-rate volatility, and marketing effectiveness . In particular, there can be no assurance that we will increase sates ofexisting products. successfully develop and receive approval to market new products, or achieve market acceptance for such new products . There can he no assurance that our out-licensing activity will generate significant revenue, nor that our in-licensing activities willfully protect us from claims of infringement by third parties . In addition, we may engage in business opportunities, the successful completion ofwhich is subject to certain risks, including stockholder and regulatory approvals and the integration of operations. We have. discussed the important factors, which we believe could cause actual results to differ from what is expressed in the forward-looking statements, under the caption "Factors That May Affect Future Results" in this 10-Q . Consistent with SEC Regulation FD, we do not undertake an obligation to update theforward-'looking information contained in this IO-Q.

We are a global pharmaceutical company that participates in three healthcare markets : biopharmaceuticals, vaccines and blood testing. Our revenues consist of product sales, revenues from joifit business arrangement, collaborative agreement revenues, royalty and license fee revenues and other revenues . The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious disease, using the development and acquisition of technologies related to therapeutic proteins and small molecules . The biopharmaceuticals segment also includes collaborations with Berlex Laboratories, Inc_ and its patent company, Schering AG of Germany, related to Betaseront . The vaccines segment consists of a meningococcal vaccine, flu vaccines, including Fluvirini, a product we obtained as part of our third quarter 2003 acquisition of PowderJect Pharmaceuticals (discussed below), travel vaccines, which include rabies and tick-borne encephalitis vaccines and two products we obtained as part of our third quarter 2003 acquisition of PowderJect Pharmaceuticals, Arilvax® and Dukoral®, and pediatric and other vaccines . We sell these vaccines primarily in the U .S., Germany, Italy, the United Kingdom and other international markets. Our vaccines segment is also involved in the development of other novel vaccines and vaccination technology . The blood testing segment consists of an alliance with Gen-Probe Incorporated and our one-half share in the pretax. operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection. Our joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through our.joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of imtnunodiagnostic tests to detect hepatitis viruses and retroviruses and provide supplemental tests and microplate . and chemiluminescent instrument systems to automate test performance and data collection . We view certain other revenues and expenses as not belonging to any one segment . As a result, we have aggregated these items into an "Other" segment .

33 Critical Accounting Policies and The Use of Estimates

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

Our blood testing segment includes our one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our joint business arrangement with Ortho-Clinical Diagnostics is operated under .a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of inununodiagnostic tests to detect hepatitis viruses and retroviruses and .provide supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the first quarter 2003, we had accounted for revenues relating to non-U .S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter. More current information of non-U .S. affiliate sales of our joint business contractual arrangement became available in the first quarter 2003, and as a result, we are able to recognize revenues relating to non-U.S . affiliate sales on a one-month lag. The effect of this change, net of tax, was an increase to net income by $3 .2 million for revenues from joint business arrangement for the nine months ended September 30, 2003 .

We recognize a portion of revenue for product sales of Betaseron® upon shipment to our marketing partner, and the remainder based on a contractual percentage of sales by our marketing partner. We also earn royalties on our marketing partner's European sales of Betaferon® in those cases where we do not supply the product. Prior to the first quarter. 2002, we had accounted for revenues from non-U.S . product sales on a one-quarter lag and royalties as a percentage of forecast received from our marketing partner, with an adjustment of the estimate to actual in the subsequent quarter . More current information of non-U .S . Betaseron® sales became available in 2002, and as a result, we were able to recognize revenues from Betaseron® product sales and Betaferon® royalties on a current basis beginning in the first quarter 2002. The effect of this change, net of tax, was an increase in net income for the nine months ended September 30, 2002 by $3 .1 million .for product sales and $2.8 million for royalties .

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements:

Purchased in-process research and development-We allocate the purchase price of acquisitions based on the fair value of the assets acquired and liabilities assumed ; To assist in determining the value of the in-process research and development and certain other .intangibles, a third party valuation is typically obtained as of the acquisition date . For previous acquisitions , the income approach has been used to value in-process research and development . The income approach is based on the premise that the value of a security or asset is the present value of the future earn ing capacity that is available for distribution to the subject investors in the secu rity or asset . We performed a discounted cash flow analysis, utilizing anticipated revenues , expenses and net cash flow forecasts related to the technology . Given the high risk associated with the development ofnew drugs , we probability adjust the revenue and expense forecasts to reflect th e

risk of advancement through the regulatory approval process based on the stage of development in the regulatory process . Such a valuation requires significant estimates and assumptions . We believe the fair value assigned to the in-process research and development is based on . reasonable assumptions . However, these assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur. Additionally, estimates for the purchase price allocation may change as subsequent information becomes available. For the Powderiect Pharmaceuticals acquisition, we allocated a portion of the purchase price to purchased in-process research and development and wrote off $122 .7 million in the third quarter 2003 . For the Matrix Pharmaceutical acquisition, we allocated a portion of the purchase price to purchased in-process research and development and wrote off $54 .8 million in the first quarter 2002 . We do not anticipate that there will be any alternative future use for the purchased in-process research and development . For the Matrix Pharmaceutical acquisition, we also allocated a portion of the purchase price to a liability for asset disposal and lease cancellation for the San Diego, California facility closed during the third quarter 2002 . In the fourth quarter 2002, we found an assignee for the manufacturing facility lease and revised the allocation of the purchase price resulting in a $9 .6 million decrease to purchased in-process research and development (as the residual amount allocated to in-process research and development was less than the estimated fair value of the in-process research and development).

Investments-We invest in marketable debt and equity securities . The prices of some of our marketable securities are subject to considerable volatility, We record an impairment charge when we believe that an investment in a marketable security has experienced a decline in fair value, as measured by quoted market prices, that is other-than-temporary. We believe that an investment in a marketable security is impaired if its quoted market price has been below its carrying value for each trading day in a six-month period, at which point we write down the investment. In addition, in determining whether impairment of a marketable equity security is considered to be other-than-temporary, we consider all available factors in the evaluation . These factors may include, but are not limited to, (i) whether the issuer of the securities is experiencing depressed and declining earnings in relation to competitors, erosion of market share, and deteriorating financial position, (ii) whether the issuer is experiencing financial difficulties and its market is experiencing difficulties , (iii) ongoing activity in our collaborations with the issuer, if any and (iv) the issuer's prospects for favorable clinical trial results, new product initiatives and new collaborative agreements. Decreases in the fair value of these securities may impact our profitability. To reduce this risk, we hedge a portion of our exposure through forward sales contracts.

Inventories-We maintain inventory reserves primarily for product failures, recalls and obsolescence . The manufacturing processes for many of our products are complex. Slight deviations anywhere in the manufacturing process may result in unacceptable changes in the . products that may result in failures or recalls and, therefore, additional inventory reserves . Obsolete inventory,-due to the expiration of shelf life, and the seasonal nature of some of our products, may result in additional product reserves . In estimating inventory obsolescence reserves, we analyze ona product-by-product basis (i) the shelf life and the expiration date, (ii) sales forecasts and (iii) inventory levels compared to fbrecastedatsage.obtained from the production planning department . Judgment is required in determining whether the forecasted sales and usage information is sufficiently reliable to enable us to estimate an inventory obsolescence reserve . In addition, we operate in a highly cornpt:. .ee environment, with rapidly changing technologies . New te,___.,logy or changes in production processes may result in product obsolescence . As a result, we may be required to record additional inventory reserves.

Product returns and rebates-In estimating returns, we analyze (i) historical returns and sales patterns, (ii) our experience with similar products, (iii) current inventory on hand at the

3 5

distributors and in the distribution channel and the remaining shelf life of that inventory, (iv) current economic trends, (v) distributors practices, (vi) changes in demand, particularly due to the seasonality of certain of our products and (vii) introduction of new competing products . In arriving at the accrual for product returns we use one of the following four methodologies depending-on the .product : (i) we calculate the average actual returns percentage for the previous rolling twelve months on a product-by-product basis and apply it to gross sales on a product-by-product basis for the last twelve months to arrive at the reserve balance required at the balance sheet date . The change in the reserve balance is recognized as a charge against revenue for the period, (ii) we match the actual returns to the actual sale on a product-by-product basis to assess the historical trend for returns . Based on an analysis of the historical trend, the appropriate return percentage for the current period is then applied to current period sales to arrive at the product returns charge against revenue for the period, (iii) we calculate the average returns percentage for the previous rolling twelve months on a product-by-product basis and apply it to inventory on hand at the distributors on a product-by-product basis or (iv) for seasonal products we analyze our actual returns over the previous seasons to arrive at the average actual returns percentage, which is then applied to the current seasons sales to arrive at the charge against revenue for the current period . In estimating rebates, we match the actual rebate to the actual sale on a product-by-product basis, to arrive at an actual rebate percentage . This actual rebate percentage is applied to current period sales to arrive at the rebates expense for the period . In addition, we consider allowable prices by Medicaid and Medicare . If actual product returns and rebates are greater than our estimates, additional product return and rebates accruals may be required .

Collaborative, royalty and license arrangements-We recognize up-front refundable fees as revenues upon the later of when they become nonrefundable or when performance obligations are completed . In situations where continuing performance obligations exist, we defer and amortize up-front nonrefundable fees ratably over the performance period, which is typically stipulated by the contract ; otherwise, we recognize them as revenues when collection is reasonably assured . In arrangements with multiple deliverables, there may be significant judgment in separating the different revenue generating activities and in determining whether each is a separate earnings process . Milestones, if any, related to scientific or technical achievements are recognized in income when the milestone is accomplished . The terms of such arrangements may cause our operating results to vary considerably from period to period. We estimate royalty revenues based on previous period royalties received or on product sales forecast information provided by the third party licensee . In the subsequent quarter, we record an adjustment equal to the difference between those estimated royalty revenues recorded in the previous quarter and the contractual percentage of the third party's actual product sales for that period . We exercise judgment in determining whether the forecast information provided by licensees is sufficiently reliable for us to base our royalty revenue recognition thereon .

Income taxes-Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax assets . We record valuation allowances to reduce deferred tax assets to the amounts that are more likely than not to be realized . We have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for valuation allowances . If we determined that we would be able to realize our deferred tax assets in the future in excess of our net deferred tax assets, adjustments to the deferred tax assets would increase income by reducing tax expense in the period that we made such determination, Likewise, if we determined that we would not be able to realize all or part of our net deferred tax assets in the future, adjustments to the deferred tax assets would decrease income by increasing tax expense in the period that we made such determination .

3 6

Litigation and other contingencies-We establish and maintain accruals for litigation and other contingencies when we believe a loss to be probable and reasonably estimable, as required by SFAS No. 5, "Accounting for Contingencies ." We base our accruals on information available internally within the company at the time of such determination and after management has consulted with and obtained advice from external professional advisors . Judgment is required in both the determination of probability and as to whether such an exposure is reasonably estimable . Information may become available to us after that time, for which adjustments to accruals may be required .

Goodwill and intangible assets-The valuation in connection with the initial purchase price allocation and the ongoing evaluation for impairment of goodwill and intangible assets requires significant management estimates and judgment . The purchase price allocation process requires management estimates and judgment as to expectations for various products and business strategies . If any of the significant assumptions differ from the estimates and judgments used in the purchase price allocation, this could result in different valuations for goodwill and intangible assets . Once it is established, we must test goodwill annually for impairment using a two-step process as required by SFAS No . 142 "Goodwill and Other Intangible Assets ." In addition, in certain circumstances, we must assess if goodwill should be tested for impairment between annual tests . Intangible assets with definite useful lives must be tested for impairment in accordance with SFAS No. 144 "Accounting for the Impairment or Disposal of Long-Lived Assets." When we conduct our impairment tests for goodwill and intangibles, factors that are considered important in determining whether impairment might exist include significant continued under-performance compared to peers, significant changes in the underlying business and products of our reporting units, or other factors specific to each asset or reporting unit being evaluated . Any changes in key assumptions about the business and its prospects, or changes in market conditions or other externalities, could result in an impairment charge and such a charge could have a material adverse effect on our consolidated results of operations .

The accounting policies of our reportable segments are the same as those described in Note 1, "The Company and Summary of Significant Accounting Policies," in the Notes to Condensed Consolidated Financial Statements above and in our Annual Report on form 10-K for the year ended .December 31, 2002 .

On July 8, 2003, we acquired PowderJect Pharmaceuticals plc, a company based in Oxford, United Kingdom that develops and commercializes vaccines . We accounted for the acquisition of this business under the purchase method of accounting and included Powderlect Pharmaceuticals' operating results in our consolidated operating results beginning Jul ; 8, 2003 . Powderlect Pharmaceuticals is part of our vaccines segment . On July 1, 2002, we completed our acquisru, of Pulmopharm GmbH, a distributor of TOBI® products in uermany and Austria by purchasing the remaining 80 .1% ownership that we did not previously own . Previously, we owned 19 .9% of Pulmopharm and accounted for the investment under the equity method . We accounted for the acquisition of this business under the purchase method of accounting and included Pulmopharm's operating results in our consolidated operating results beginning on July 1, 2002 . Pultnapharm is part of our biopharmaceuticals segment .

On February 20, 2002, we acquired Matrix Pharmaceutical, Inc ., a company that was developing tezacitabine, a drug to treat'cancer . We accounted for the acquisition as an asset purchase and included Matrix Pharmaceutical's operating results, including the seven business days from February 20 to 28, 2002, in our consolidated operating results beginning on March 1, 2002 . Matrix Pharmaceutical is part of out biopharmaceuticals segment.

Certain minor arithmetical variances between the following narrative and the Condensed Consolidated Financial Statements may arise due to rounding.

37 Results of Operation s

Biopharmaceuticals

Product sales Biopharmaceutical product sales were $110.1 million and $105 .9 million for the three months ended September 30, 2003 and 2002, respectively, and $319.0 million and $300.4 million . for the nine months ended September 30, 2003 and 2002, respectively . Biopharmaceutical product sales in 2003 and 2002 consisted principally of Betaseron®, TOBIM and Proleukin® .

-Betaseron® We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc . (collectively "Schering"), under the trade names Betaseron® (in the U .S and other non-European markets) and Betaferon® (in Europe). Boehringer ingelheim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by Chiron, we recognize a portion of revenue for product sales upon shipment to Schering and the remainder based on a contractual percentage of sales by Schering, both of which we record as product sales . For product manufactured by Hoehringer Ingelheim and marketed by Schering in Europe under the trade name Betaferon®, we receive royalties calculated at the same percentage of sales less supply costs, which we record in royalty and license fee revenues . The amount we record as product sales, based on a percentage of sales by Schering, and Betaferon® royalties will decline by five percentage points pursuant to our contractual agreement with Schering . As a result, we estimate that the percentage of sales on which our payments are based will decrease in the fourth quarter 2003, reducing our per unit revenue by approximately 18% (for sales of Chiron product) and approximately 34% (for royalties from sales of Boehringer Ingelheim product) . However, there are a number of mitigating considerations, including (i) the transitional supply agreement, discussed in "Royalty and license fee revenues-Betaferon®" below (ii) the volume mix of Chiron product and Boehringer Ingelheim product and (iii) the launch of product upgrades with ease-of-use features . We believe these considerations will somewhat offset this contractual change and impact the ultimate contribution of Betaserone to Chiron's profit .

In October 2003, the U.S . Food and Drug Administration approved a new pre-filled diluent syringe for Betaseron® . The pre-filled diluent syringe will enhance the delivery mode and shorten preparation, helping to simplify injections of Betaseron® . In the first quarter 2003, the U .S . Food and Drug Administration approved new labeling for Betaseron® . The labeling expands the indication for Betaseron(b to treat all relapsing forms of multiple sclerosis to reduce the frequency of clinical exacerbations . Relapsing forms of multiple sclerosis include relapsing-remitting, the most common form, and secondary progressive multiple sclerosis with relapses .

Betaseron® product sales were $29 .0 million and $28 .5 million for the three months ended September 30, 2003 and 2002, respectively, and $88 .8 million and $84.6 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in Betaseron® product sales in the third quarter 2003 as compared with the third quarter 2002 primarily related to (i) increased patient demand, (ii) the benefit of the movement in foreign exchange rates and (iii) price increases . These increases were partially offset by fluctuations in Berlex Laboratories and Schering ordering patterns as they decreased inventories of the current materials in anticipation of the launch of our pre-filled diluent syringe materials, discussed above .

38 levels, in anticipation of the launch of our pre-filled diluent syringe materials, discussed above, negatively impacted sales in 2003 . Also partially offsetting the increases in Betaseron( product sales year-to-date 2003 as compared with year-to-date 2002, were incremental revenues recognized in the first quarter 2002 related to the effect of recording revenue based on more current information available from Schering . Prior to the first quarter 2002, we accounted for revenues from non-U .S . product sales based on information provided by Schering on a one-quarter lag_ More current information of non-U .S . Betaseron® sales became available in 2002, and as a result, we were able to begin recognizing revenues from Betaseron® product sales on a current basis . This change resulted in incremental revenues recognized during the first quarter 2002 of $4 .3 million . Inventory ordering patterns as well as foreign currency exchange rates may influence future Betaseron®.sales .

TOBIOD We sell TOBI® directly in the U.S. and certain international markets . We recognized TOBI® sales of $43 .0 million and $39.0 million for the three months ended September 30, 2003 and 2002, respectively, and $122 .7 million and $108.3 million for the nine months ended September 30, 2003 and 2002, respectively. Increased TOBI® sales in the third quarter 2003 as compared with the third quarter 2002 primarily related to (i) greater product penetration in various European countries, (ii) price increases and (iii) the benefit of the movement in the Euro to U .S . Dollar exchange rate . The increase was partially offset by wholesaler ordering patterns. in addition to the above factors, year-to-date 2003 TOM sales were also positively impacted by increased use and improved compliance in the U .S, by patients with cystic fibrosis when compared with year--to-date 2002 TOBIO sales : The increase in TOBI® sales year-to-date 2003 compared with year-to-date 2002 was partially offset by wholesaler ordering patterns and a change in sales adjustments .

We continue to pursue the use ofTOBI® to treat other serious lung infections and to seek approval in other countries . Wholesaler ordering patterns as well . as reimbursement and government pressures, competition, foreign currency exchange. rates and the level of rebates may influence future TOBI® sales . In December 2002, the U.S. Food and Drug Administration tentatively approved an abbreviated new drug application for an inhaled tobramycin for sale in the U.S . fol lowing expiration of the orphan drug status of TOBI® in December 2004 . Subsequently, the application was withdrawn and under terms of a settlement agreement reached in October 2003, approval will not be sought to market this generic product until the 2014 expiration of our patent in the U .S . covering the formulation of TOBI® .

Profeukin® Sales of Proleukin® were $29 .9 million and $32.1 million for the three months ended September 30, 2003 and 2002, respectively, and $85 .2 million and $83 .7 million for the nine months ended September 30, 2003 and 2002, respectively . Decreased Proleukin® product sales in the third quarter 2003 as compared with the third quarter 2002 primarily related to wholesaler ordering patterns . The decrease was partially offset by price increases and the benefit of the movement in the Euro to U .S . Dollar exchange rate.

The increase in Proleukin® product sales year-to-date 2003 as compared with year-to-date 2002 primarily .related to price increases and the benefit of the movement in the Euro to U .S . Dollar exchange rate. These . increases were partially offset by wholesaler ordering patterns . Wholesaler ordering patterns, reimbursement pressures, government legislation and foreign currency exchange rates may influence future Proleukin® sales .

The balance of product sales recognized in our biopharmaceuticals segment consisted of various other products, which individually were not material .

We expect competitive pressures related to many of our biopharmaceutical products to continue into the future, primarily as a result of the introduction of competing products into the market, as listed in Part 1, Item 1 ., "Business-Competition" of our Annual Report on Form 10-K for the year ended December 31, . 2002.

39 Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones. Our biopharmaceuticals segment recognized collaborative agreement revenues of $1 .4 million and $3 .3 million for the three months ended September 30, 2003 and 2002, respectively, and $4 .6 million and $10.3 million for the nine months ended September 30, 2003 and 2002, respectively .

Collaborative agreement revenues for the three months ended September 30, 2003, primarily consisted of our fourth quarter 2002 collaboration agreement and license agreement with GlaxoSmithKline plc related to certain of our MC-4R compound patents . Collaborative agreement revenues for the nine months ended September 30, 2003, consisted of our fourth quarter 2002 collaboration agreement and license agreement with GlaxoSmithKline plc and our first quarter 2001 collaboration agreement with Taisho Pharmaceutical Co ., Ltd . to target macrolide mediated gene discovery . Collaborative agreement revenues for the three and nine months ended September 30, 2002, primarily consisted of our second quarter 2000 agreement with S*BIO, discussed below, and our-first quarter 2001 collaboration agreement with Taisho Pharmaceutical Co., Ltd :

S*BIO In the second quarter 2000, we invested in a Singapore-based venture, S*131O Pte Ltd, to research and develop therapeutic ; diagnostic, vaccine and antibody products . We also granted S*BIO certain rights to our gene expression and combinatorial chemistry technology . Under this arrangement, we received approximately $23 .7 million for technology transfer and research services. We recognized collaborative agreement revenues of $2 .$ million and $8 .9 million for the three and nine months ended September 30, 2002; respectively, under this arrangement. The technology transfer period .and related revenue recognition period ended in the third quarter 2002 .

The balance of collaborative agreement revenues recognized in our biopharmaceuticals segment consisted of various other agreements, which individually were not material.

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and the achievement of milestones. Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the futura. In addition, the collaboration agreements typically provide for certain milestone payments and various royalties on future product sales if the collaborative partners commercialize. a product using our technology. However, we have no assurance that the collaborative partners will .meet their development objectives or commercialize a product using our technology. Also, our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners . We have no assurance that new relationships will be established or that current collaborative agreement revenues will not decline .

Royalty and license fee revenues Our biopharmaceuticals segment cams royalties on third party sales of several products, including BctaferonO and recombinant insulin and glucagon products. Our biopharmaceuticals segment also cams license fees for technologies, such as hepatitis C virus-related patents, used by third parties to develop therapeutic products . The biopharmaceuticals segment recognized royalty and license fee revenues of $23 .5 million and $12 .5 million for the three months ended September 30, 2003 and 2002, respectively, and $62 .1 million and $46 .2 million for the. nine months ended September 30, 2003 and 2002, respectively.

Betaferon® We manufacture interferon beta-lb which is marketed by Schering AG audits affiliates, including Berlex Laboratories, .Inc . (collectively "Schering"), under the trade names Betaseron® (in the U .S and other non-European markets) and Betaferon® (in Europe) . Boehringer ingelheim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by Boehringer Ingelheim, we receive royalties calculated as a percentage of sales less the amount paid or incurred by Schering for supply costs . As discussed in "Product sales-Hetaseron®" above, under our

40 contractual agreement with Schering, our royalty will decline in the fourth quarter 2003 by five percentage points

For the three months ended September 30, 2003 and 2002, we recognized Betaferon® royalties of S 16 .0 million and $9 .6 million, respectively, and for the nine months ended September 30, 2003 and 2002, we recognized $47 .2 million and $33 .8 million, respectively, under this arrangement, Betaferon® royalties increased in the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily as the result of (i) a positive impact of the difference between the adjustment of estimate to actual in both periods, (ii) an increase in Chiron's effective royalty rate under an agreement with Schering, (iii) increased patient demand as discussed in "Product sales-Betaseron®" above and (iv) the benefit of the movement in the Euro to U.S . Dollar exchange rate. The increase in Chiron's effective royalty rate is due to a reduction of the allocated cost under a three-year limited cost sharing arrangement under the transitional supply agreement with Schering . The increases year-to-date 2003 as compared with year-to-date 2002 were partially offset by incremental revenues recognized during the first quarter 2002 of $3 .9 million related to a change in our methodology of recognizing these royalties . Prior to 2002, we accounted for Betaferon® royalties as a percentage of forecast received from Schering, with an adjustment of the estimate to actual in the subsequent quarter. More current information of European Betaseron® sales was available in 2002, and as a result, we were able to recognize Betaferon® royalties on a current basis beginning in the first quarter 2002 . Foreign currency exchange rates may influence future Betaferon® royalties.

Novo Nordisk We earn royalty revenues on insulin and glucagon product sales by Novo Nordisk AS . We recognized $2 .3. million and $2 .5 million for the three months ended September 30, 2003 and 2002, respectively, and $6 .2 million and $5 .8 million for the nine months ended September 30, 2003 and 2002, respectively, under this arrangement. Patents related to the production of insulin and glucagon expire beginning late 2003 and as a result, significant reductions in royalty revenue recognized under this arrangement are expected.

The balance of royalty and license fee revenues recognized in our biopharmaceuticals segment consisted of various other agreements, which individually were not material. The balance of royalty and license fee revenues for the three and nine months ended September 30, 2003, primarily consisted of our third quarter 2003 agreement with Gilead Sciences, Inc . where we granted rights under certain of our hepatitis' C virus-related patents for which we recognized a license fee in the third quarter 2003 and our fourth quarter 2002 agreement with GlaxoSmithKline plc where we granted rights under certain of our MC-4R compound patents for which we recognized portions of the license fee in the second and third quarters of 2003 : The balance of royalty and license fee revenues for the nine months ended September 30, 2002, primarily consisted of our second quarter 2002 agreement with Merck & Co ., Inc . where we granted rights under certain of our hepatitis C virus-related patents for which we recognized a license fee in the second quarter 2002 and our first quarter 2002 agreement with Abbott Laboratories where we granted rights under certain of our hepatitis C virus-related patents for which we recognized a license fee in the first quarter 2002 .

In November 2003, we granted a license to Rigel Pharmaceuticals Inc . for the research, development and commercialization of small molecule therapeutics against certain hepatitis C virus drug targets .

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

41 market and capitalize on our technologies . We have no assurance that we will be able to do so or that future royalty and license fee revenues will not decline .

Other revenues Our biopharmaceuticals segment recognized other revenues of $5 .0 million and $6.4 million for the three months ended September 30, i 2003 and 2002, respectively, and $23.8 million and $13 .0 million for the nine months ended September 30, 2003 and 2002, respectively .

Contract manufacturing revenues Our biopharmaceuticals segment recognized contract manufacturing revenues of $4 .7 million and $6 .3 million for the three months ended September 30, 2003 and 2002, respectively, and $7 .8 million and $12 .6 million for the nine months ended September 30, 2003 and 2002, respectively. The decrease resulted from the level of activity and the timing of contract manufacturing activities .

Biogen and Serono settlements A U .S . Court of Appeals partially reversed a District Court ruling in connection with certain patents owned by Chiron and licensed exclusively to Schernng AG's U .S . subsidiary, Berlex Laboratories. As a result of the ruling and prior agreements between Biogen and. Berlex, Biogen was required to make a settlement payment to Schering. In accordance with an earlier contract between Chiron and Berlex, we recognized approximately $13 .0 million during the nine months ended September 30, 2003, which represented our share of this settlement payment . In addition, there was a similar settlement between Berlex and Serono of which we recognized approximately $1 .4 million during the nine months ended September 30, 2003 .

Depocyt@ In the fourth quarter 2002, we sold U .S . sales and marketing rights for Depocyt® to SkyePharma plc . For the nine months ended September 30, 2003, we recognized $1 .0 million related to transition services provided to SkyePharma under the acquisition agreement .

The balance of other revenues recognized in our biopharmaceuticals segment consisted of various other arrangements, which individually were not material .

Other revenues recognized in our biopharmaceuticals segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues. We cannot guarantee that we will be successful in obtaining additional revenues or that these revenues -will not decline .

Gross prof t Biopharmaceutical gross profit as a percentage of net product sales was 74% and 77% for the three months ended September 30, 2003 and 2002, respectively, and 75% for each of the nine months ended September 30, 2003 and 2002 . The decrease in biopharrnaceutical gross profit margins for the third quarter 2003 as compared with the third quarter 2002 was primarily the result of higher annual maintenance shutdown costs and product start-up costs for the recently approved pre-filled diluent syringe for B taseron® by the U.S . Food and Drug Administration.

Biopharmaceutical gross profit margins for the nine months ended September 30, 2003 benefited from price increases and the movement in the Euro to U.S . Dollar exchange rate . However, the increase was offset by costs due to a reserve taken against certain manufactured components held in inventory, higher annual maintenance shutdown costs and product start-up costs for the recently approved pre-filled diluent syringe for Betaseron® by the U .S . Food and Drug Administration .

Biopharmaceutical gross profit percentages may fluctuate signi ficantly in future periods due to production yields and as the biopharmaceutical product and customer mix changes.

Research and development Our biopharmaceuticals segment recognized research and development expenses of $56 .1 million and $60 . l "million for the three months ended September 30, 2003 and 2002, respectively, and $169 .8 million and $178 . 7 million for the nine months ended September 30, -2003 an d 2002, respectively . 42 . The decrease in research and development spending in the third quarter 2003 as . compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primari ly related to the timing of various clinical trials, including (i) transfer of the responsibility of the SILCAAT trial, to the investigators in the fourth quarter 2002 , discussed below, and (ii) termination of our trials for HBV-MF54, an immunotherapy for patients with chronic hepatitis 13 infection, and PA-1806, a compound for gram negative infections in cystic fibrosis patients. These decreases were partially offset by the investment in other development projects, including those activities re lated to the development of (i) tezacitabine , obtained as a part of the acquisition of Matrix Pharmaceutical in the first quarter 2002 , (ii) interleukin- 2 in combination with various monoclonal antibodies , (iii) a d ry powder formulation of our inhaled. TOBIO product for the treatment of pseudomonas aeruginosa in cystic fibrosis patients an d (iv) tifacogin, as discussed below . In addition, we are require d to make capital improvements to our existing manufacturing facilities to suppo rt the supply of Betaferon® to Schering . In connection with this project, we are continuing to incur expenses relating to the development of new processes and the performan ce of test runs related to the installed equipment .

In the fourth quarter 2002, we reached an agreement in principle to transfer responsibility for the SILCAAT (referred to also as Proleukin® for HIV) trial, a Phase Ili-study for recombinant human interleukin-2 (IL-2, aldeseleukin), to the investigators, as managed by a Scientific Committee comprised of researchers affiliated with the Hospital Henri Mondor in Paris, the National Institutes Allergy and Infectious Disease (NIAID), the University of Minnesota, and other research institutions . Responsibility for the SILCAAT study was transferred to NIAID and University of Minnesota effective February 14, 2003, Out research and development expenses related to the SILCAAT trial are expected to decrease in 2003 as a result of transferring responsibility for the trial . However, under the agreement, we are obligated to fund a maximum of $18 .0 million over the lifetime of the trial and to supply clinical materials and certain other support services of which $6 .0 million has been paid through September 30, 2003 .

In October 2003, we entered into a license agreement with Cubist Pharmaceuticals, Inc . for the development and commercialization of Cubist's antibiotic daptomycin for injection in Western and Eastern Europe, Australia ; New Zealand, India and certain Central American, South American and Middle Eastern countries . In exchange for these development and commercialization rights, we have agreed to pay Cubist up to $50 .0 million . This $50 ..0 million includes $18 .0 million, which was paid by Chiron up front in the fourth quarter 2003, $10 .0 million of which was used to purchase restricted Cubist common stock at a 50 . percent premium over market price and up to $32 .0 million of additional payments .to Cubist upon the achievement of certain;regulatory and sales milestones. We will also pay Cubist a tiered royalty. on daptomycin for injection made by Chiron . We expect to record a portion of the up front payment as research and development expense .

In October 2003, we acquired all .of Pfizer, Inc.'s, formerly Pharmacia Corp.'s, interest in tifacogin, in return for which Pfizer will receive royalties on sales of tifacogin . We are initiating plans for a Phase III trial for tifacogin in patients with severe community-acquired .pneumonia .

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

Selling, general , and administrative Our biopharmaceuticals segment recognized selling, general and administrative expenses of $28 .7 million and $24 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $83 .1 million and $68.7 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in selling, general and administrative expenses for the third quarter 2003 as compared with the third quarter 200 i) ongoing sales 2 related to (

43 and marketing programs to support TOBI4D in the U .S . and continued market penetration in Europe, (ii) continued investment in and defense of our patents and technology, (iii) sales and marketing costs for various biopharmaceutical post-market approval commitments, (iv) additional costs associated with the enhancement of current business processes and (v) the Euro to U .S . Dollar exchange rate fluctuation . In addition, the increase year-to-date 2003 as compared with year--to-date 2002 was impacted by increased costs following the acquisition of Pulmopharm in the third quarter 2002 .

Amortization expense Our biopharmaceuticals segment recognized amortization expense of $6 .2 million for each of the three months ended September 30, 2003 and 2002, and $18 .6 million and $18 .0 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in amortization expense year°to-date 2003 as compared with year-to-date 2002 related to the distribution rights acquired upon acquisition of Pulmopharm in the third quarter 2002 .

Yaccirres

Product sates We sell flu, meningococcal, travel, pediatric and other vaccines in the U .S ., Germany, Italy, the United Kingdom and other international markets . Vaccine product sales were $262 :7 million and $125 .5 million for the three months ended September 30, 2003 and 2002, respectively, and $416 .7 million and $256.1 million for the nine months ended September 30, 2003 and 2002, respectively.

Sales of our flu vaccines were $183 .3 million and $66.9 million for the three months ended September 30, 2003 and 2002, respectively, and S 191 .3 million and $71 .0 million for the nine months ended September 30, 2003 and 2002, respectively. Flu vaccines sales increased in the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily as a result of additional sales of flu vaccine products following our third quarter 2003 acquisition of Powderject Pharmaceuticals. PowderJect Pharmaceuticals flu vaccine sales. were $103.3. million in the third quarter 2003 . Excluding PowderJect Pharmaceuticals, sales of our remaining flu vaccines increased primarily as a result of the benefit of the movement in the Euro .to U.S . Dollar exchange rate and price and volume increases in Germany and Italy .

Menjugate''M, our conjugate vaccine against meningococcal infection caused by the bacterium N. meningitidis serogroup C, sales were $10 .6 million and $6 .2 million for the three months ended September 30, 2003 and 2002, respectively, and $31 .9 million and $21 .8 million for the nine months ended September 30, 2003 and 2002, respectively. The increase in MenjugateTM sales in the third quarter 2003 as compared with the third quarter 2002 primarily related to tender salesto Australia, Spain and .Franee and the benefit of the movement in the Euro.to U.S. Dollar exchange rate . The increase in ivtenjugateTm sales year-to-date 2003 as compared with year-to-date 2002 primarily related to the tender business, as discussed above, increased sales to the Italian market and the benefit of the movement in the Euro to U .S . Dollar exchange rate .

Sales of our travel vaccines, comprised of tick-borne encephalitis, rabies vaccines and two products we obtained as part of our third quarter 2003, acquisition ofPowderJect Pharmaceuticals, Arilvax® and Dukoral®, were $11 .2 million and $16 .6 million for the three months ended September. 30, 2003 and 2002, respectively, and $60 .0 million and $58 .5 million for the nine months ended September 30, 2003 and 2002, respectively- The decrease in travel vaccines sales in the third quarter 2003 as compared with the third quarter 2002 was primarily related to decreased tick-borne encephalitis vaccine sales in the German market. In the-third quarter 2002, we had end of season sales and additional sales of the then newly approved adult and pediatric formulations, launched in the first quarter 2002 . The decrease in travel vaccines sales in the third quarter 2003 as compared with the third quarter 2002 was partially offset by additional sales I of travel vaccine products following our third quarter 2003 acquisition of PowderJect Pharmaceuticals and the benefit of the movement in the Euro to U .S . Dollar exchange rate . The increase in tr avel. vaccines sales year-to-date 2003 .as compared with year-to-date 2002

44 primarily resulted from additional sales of travel vaccine products following our third quarter 2003 acquisition of PowderJect Pharmaceuticals and the benefit of the movement in the Euro to U.S . Dollar exchange rate partially offset by decreased tick-borne encephalitis vaccine sales, as discussed above .

Sales of our pediatric and other vaccines were $57 .6 million and $35 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $133 .5 million and $104 .7 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in pediatric and other vaccines sales for the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily was due to additional sales of other vaccine products following our third quarter 2003 acquisition of PowderJect Pharmaceuticals, the timing of tender sales and the benefit of the movement in the Euro to U.S. Dollar exchange rate.

Ce rtain of our vaccine products , particularly our flu vaccines , are seasonal and typically have higher sales in the third and fourth quarters of the year. In addition , we expect MenjugateTM sales to continue to fluctuate as public health authori ties consider adoption of broad vaccination programs . We have initiated a Phase III-trial in the U .S . for Menjugate;M. The study, which is being conducted in conjunction with the Northern Californ ia Kaiser Permanente Vaccines Research Center, will expand the vaccine 's safe ty database for a U.S . population relative to the safety profile of the current U .S .-licensed meningococcal polysaccharide vaccine Menomune® (A, C, Y, W-135) . We are exploring opportunities for additional MenjugateT M sales in other countries .

We expect competitive pressure s related to many of our vaccine products to continue into the future, primarily as a result of the introduction of competing products into the market, including, but not limited to, new combination vaccines, as listed in Part 1, Item I ., "Business-Competition" of our Annual Report on Form 10--K for the year ended December 31, 2002 .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve. specified milestones. Our vaccines segment recognized collaborative agreement revenues of $4 .3 million and $0 .1 million for the three months ended September 30, 2003 and 2002, respectively, and $4.5 million and $0 .4 million for the nine months ended September 30, 2003 and 2002, respectively . In the first quarter 2002, we entered into an agreement to supply a vaccine for meningococcal meningitis caused by the bacterium N . meningitidis serogroup B to the Ministry of Health in New Zealand. We recognized revenue under this arrangement in the third quarter 2003 . In addition, as a result of our third quarter 2003 acquisition of PowderJect Pharmaceuticals, we recognized revenue under a shared services agreement with Medlmmune, Inc .

The balance of collaborative agreement revenues recognized in our vaccines segment consisted of various other arrangements, which individually were not mate rial .

Collaborative agreement revenues tend to fluctuate based on the amount and timing of re search services performed, the status of projects under collaboration and the achievement of milestones . Due to the nature of our collaborative agreement revenues , results in any one pe ri od are not necessarily indicative of results to be achieved in the future. In addition, the collaboration agreements typically provide for ce rtain milestone payments and various royalties : on future product sales if the collaborative partners commercialize a product using our technology . However, we have no assurance that the collaborative partners will meet their development objectives or commercialize a product using our technology . Also, our ability to generate additional collaborative agreement . . revenues may depend, in part, on our abili ty to . initiate and maintain relationships with potential and current collaborative partners . We have no assurance that new relationships will be established or that current collaborative agreement re venues will not decline,

1 $3 .0 million and $3 .7 million for the three months ended September 30, 2003 and 2002, respectively, and $9 .6 million and $9.2 million for the nine months ended September 30, 2003 and 2002, respectively .

GlaxoSmithKline An agreement with GlaxoSmithKline plc provides for royalties on sales of certain vaccine products . Under this agreement, we recognized $1 .8 million and $1 .6 million of such royalties for the three months ended September 30, 2003 and 2002, respectively, and $5 .2 million of such royalties for each of the nine months ended September 30, 2003 and 2002 .

Other We recognized $1 .2 million and $2 .1 million for the three months ended September 30, 2003 and 2002, respectively, and $4 .3 million and $3 .9 million for the nine months ended September 30, 2003 and 2002, respectively, of royalty revenues primarily on third party sales of hepatitis B virus vaccine products. The decrease in the third quarter 2003 as compared with the third quarter 2002 primarily resulted from decreased sales. of hepatitis B virus vaccine products due to competition from multivalent hepatitis B virus vaccine products . The increase in year-to-date 2003 as compared with year-to-date 2002 primarily resulted from increased availability of the pediatric formulation in Germany, partially offset by .increased competition from multivalent hepatitis B virus vaccine products. Certain patents . related to the production of hepatitis B vaccine products expire beginning in 2004, which will result in reductions in royalty revenues recognized under one arrangement . -

Other revenues Our vaccines segment recognized other revenues of $2 .7 million and $4 .3 million for the three months ended September 30, 2003 and 2002, respectively, and $8.7 million and $13.4 million for the nine months ended September 30, 2003 and 2002 ; respectively .

Grant and contract revenues Our vaccines segment other revenues included grant and contract revenues of $2 .2 million and $3 .1 million for the three . months ended September 30, 2003 and 2002, respectively, and $6 .9 million and $10 .2 million for the nine months ended September 30, 2003 and 2002, respectively . In the second quarter 2000, we entered into an agreement with the U .S . National Institutes of Health to advance our HIV vaccine program into human clinical trials. Under this arrangement, we could receive $23 .2 million over five years. Under supplemental arrangements, we may perform other work related to the National Institutes of Health's HIV vaccine program on a grant or contract-by-contract basis . A majority of the grant and contract revenues, $1 .8 million and $2.6 million for the three months ended September 30, 2003 and 2002, respectively, and $5.9 million and $7 .3 million for the nine months ended September 30, 2003 and 2002, respectively, were recognized under these arrangements .

The balance of other revenues recognized in our vaccines segment consisted of various other arrangements, which individually were not material :

Other revenues recognized in our vaccines segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues . We have no assurance that we will be successful in obtaining additional revenues or that these revenues will not decline .

Gross profit Vaccines gross profit as a percentage of net product sales was 58°/a and 60% for the three months ended September 30,2003 and 2002, respectively, and 56% and 57% for the nine months ended September 30, 2003 and 2002, respectively. The vaccine gross profit margin in the third quarter 2003 was negatively impacted by the Euro to U.S. Dollar exchange rate fluctuation and the mix of vaccine products . In addition, vaccine gross profit margin year-to-date 2003 as compared with

46 year-to-date 2002 was negatively impacted by an expected temporary shutdown of certain facilities, in the first quarter 2003, to ensure compliance with . . regulatory requirements . In connection with the acquisition of PowderJect Pharmaceuticals on July 8, 2003, there was a step up in the value of inventory of$24 .4 million . Included in cost of sales in the third quarter 2003 was $10 .9 million of this step up . Excluding this step up, vaccine gross profit as a percentage of net product sales for the three months ended September 30, 2003 would have been 62% . Approximately $13 .5 million of this step up remains in inventory at September 30, 2003 and will be charged to cost of sales as the related product is sold .

Vaccines gross profit percentages may fluctuate significantly in future periods due to product and customer mix, seasonality and ordering patterns and production yields.

Research and development Our vaccines segment recognized research and development expenses of $35 .3 million and $1.7 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $82 .7 million and $52 .4 million for the nine months ended September 30, 2003 and 2002, respectively. The increase in research and development spending for the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 200 3 compared with year-to-date 2002, was driven by additional costs associated with programs obtained following our third quarter acquisition of PowderJect Pharmaceuticals . Excluding $7.2 million of add itional research and development expenses associated with 1'owderlect Pharmaceuticals, the increase in research and development spending resulted from the advancement of several programs in our meningococcal franchise and flu cell culture .

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

Selling, general, and administrative Our vaccines segment recognized selling, general and administrative expenses of$43 .4 million and $23 .4 million for the three months ended September 30, 2003 and 2002, respectively, and $90 .3 million and $63 .2 million for the nine months ended September 30, 2003 and 2002, respectively . The' increase in selling, general and administrative expenses in the third quarter 2003 as compared with. the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, primarily related to additional expenses following our third quarter acquisition of PowderJect Pharmaceuticals . Excluding $19.4 million of additional selling, general and administrative expenses associated with PowderJect Pharmaceuticals, including integration costs of $5 .3 million, the remaining increase in selling, general and administrative resulted from additional costs associated with the enhancement of current business processes and headcount and the Euro toU .S . Dollar exchange rate fluctuation. For the year-to--date comparison, these increases were partially offset by (i) a payment made in the first quarter 2002 to the German government in lieu of statutory price reductions on prescription drugs that are reimbursed under the German government's healthcare program that was expensed in the first quarter 2002 and (ii) increased sales and marketing costs associated with the 2002 launch of our newly formulated tick-borne encephalitis vaccine .

Amortization expense Our vaccines segment recognized amortization expense of $13 .6 million and S1 .3 million for the three months ended September 30, 2003 and 2002, respectively, and $16 .5 million and $4.2 million for the nine .months ended September 30, 2003 and .2002, respectively . The increase in amortization expense for the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to--date 2002, related to the intangibles acquired following our acquisition of PowderJeci Pharmaceuticals in the third quarter 2003 .

47 Blood testing

Product sales Our blood testing segment recognized product sales of $59 .9 million and $40 .8 million for the three months ceded September 30, 2003 and 2002, respectively, and $161 .5 million and $100 .6 million for the nine months ended September 30, 2003 and 2002, respectively .

Procleix® On February 27, 2002, the U .S . Food and Drug Administration approved the Procleix® HIV-11 HCV Assay . Under a collaboration agreement with Gen-Probe Incorporated, we market and sell the Procleix® HIV-11 HCV Assay and the related instrument system. In addition to selling directly in the U .S ., we also sell in various European and Asia / Pacific markets, directly and through distributors . We record revenue based upon the reported results obtained from the customer from the use of assays to screen donations or upon sale and delivery of the assays, depending on the underlying contract . In the case of equipment sales or leases, we record revenue upon-the sale and transfer of the title to the instrument or ratably over the life of the lease term, respectively . For the provision of service on the instruments, we recognize revenue ratably over the life of the service agreement .

Worldwide product sales related to tests, instruments and the provision of services were $53 .7 million and $36 .0 million for the three months ended September 30, 2003 and 2002, respectively, and $141 .8 million and $83 .4 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in product sales in the third quarter 2003 as compared with the third quarter 2002 primarily related to (i) the introduction of the West Nile virus assay on an investigational-use basis in the U.S . and (ii) market share gains in the U .S . and continued penetration into several markets abroad for the ProcleixO HIV-1/ HCV Assay . In March 2003, the U.S . Food and Drug Administration accepted an investigational new drug (IND) for the West Nile virus assay . The new assay runs on the same instrumentation platform as the currently approved Procleix® HIV-1/HCV assay .

The increase in product sales year-to-date 2003 as compared with year--to-date 2002 primarily related to commercial pricing in the U .S . commencing May 1 ; 2002 for the Procleix® HIV-l/ HCV Assay following the U .S . Food and Drug Administration approval in February 2002 . In addition, subsequent to the first quarter 2002, we signed new commercial contracts including those with existing America's Blood Centers customers, the American Red Cross, the U .S . military and the Association of Independent Blood Centers to provide the Procleix0 HIV-l/ HCV. Assay . Other factors contributing to the increase in 2003 were (i) the introduction of the West Nile virus assay on an investigational-use basis in the U .S ., as discussed above and (ii.) market share gains in the U .S . and increased sales to several markets abroad for the Procleix® HIV-l/ HCV Assay . Slightly offsetting the increase in product sales related to tests, instruments and the . provision of services in 2003 as compared with 2002, was a one-time positive adjustment recognized in the first quarter 2002 under contracts with all our U.S . customers for increased donations. exceeding contractual minimums.

Orlho-Clinical Diagnostics Under our joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., we manufacture bulk reagents,and antigens and confirmatory test kits for immunodiagnostic products . We recognized product sales under this arrangement of $6 .2 million and $4 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $19 .8 million and $17 .1 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in the third quarter 2003 as compared with the third quarter 2002, primarily related to an increase in products manufactured for . Ortho-Clinical Diagnostics . In addition, the timing of manufacturing services under the arrangement contributed to the increase of year-to-date 2003 sales as compared with year-to-date 2002 sales . Chiron also supplies bulk antigens for Ortho-Clinical Diagnostics to be included inproducts to be sold by Bayer under a June 2001 agreement among Chiron, Ortho-Clinical Diagnostics and Bayer Corporation (see also "Royalty and license fee revenues-Bayer" below) .

48 {

Item 1 . "Business-Competition" of our Annual Report on Form I O -K for the year ended December 31, 2002 .

Revenues from joint business arrangement Our share of revenues from our joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc . was $26 .1 million and $32.4 million for the three months ended September 30, 2003 and 2002, respectively, and $80 .0 million and $78 .5 million for the nine months ended September 30, 2003 and 2002, respectively . The decrease in revenues from joint business arrangement for the third quarter 2003 as compared with the third quarter 2002 primarily resulted from lower profits from Ortho-Clinical Diagnostics' U .S . operations. The increase in year-to-date 2003 as compared with year-to-date 2002 primarily resulted from (i) a one-time benefit in the first quarter 2003 due to a change in estimate relating to revenues from Ortho-Clinical Diagnostics' non-U . S . affiliate sales, (ii) the timing of Ortho--Clinical Diagnostics' shipments to third parties and (iii) increased profitability of Ortho-Clinical Diagnostics' foreign affiliates . Offsetting the increase were lower profits from Ortho-Clinical Diagnostics' U.S . operations in the third quarter 2003, as discussed above . Prior to the first quarter 2003, we had accounted for revenues relating to non-U .S. affiliate sales on a one-quarter lag . More current information is now available to us and as such, we now recognize revenues relating to non--U .S, affiliate sales on a one-month lag, consistent with the method of how we recognize revenues relating to Ortho-Clinical Diagnostics' sales for the U.S. portion of Ortho-Clinical Diagnostics' operations .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Under the Ortho-Clinical Diagnostics, Inc . joint business arrangement,-we conduct research and development services related to immunodiagnostic products. Our blood testing segment recognized total collaborative agreement revenues of $2 .1 million and $1 .6 million for the three months ended September 30, 2003 and 2002, respectively, and $6 .4 million and $7 .1 million for the nine months ended September 30, 2003 and 2002, respectively . The majority of collaborative agreement revenues recognized by our blood testing segment related to immunodiagnostic products .-The fluctuations between 2003 and 2002. p rimarily related to the timing of research services .

Royalty and license fee revenues Our blood testing segment earns royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing our hepatitis C virus and IV-related patents, for use in the blood screening and plasma fractionation markets . Our blood testing segment also earns license fees related to our hepatitis C virus and HIV-related patents for technologies used by third parties to develop products for use in the blood screening and plasma fractionation markets . The blood testing segment recognized royalty and license fee revenues of $20 .6 million and $14 .2 million for the three months ended September 30, 2003 and 2002, respectively, and $59 .4 million and $37 .0 million for the nine months ended September 30, 2003 and 2002, respectively.

Baxter R.G. In June 2003, we entered into two license agreements with Baxter A .G . related to our hepatitis C virus and HIV technology for use in the , plasma fractionation market for which we recognized a license fee in the second quarter 2003 . in addition, in the second and third quarters of 2003, we recognized royalty revenues under one of these agreements . -

49 F. Hoffmann-La Roche settlement In October 2000, we entered into three license agreements with F. Hoffmann-La Roche Limited and several of its affiliated companies related to the settlement of certain litigation in the U .S . and certain other countries for the use of our hepatitis C virus and HIV intellectual property. Two agreements relate to in vitro diagnostic products . See "Other-Royalty and license fee revenues" below . The third agreement for blood screening was superseded in May 2001 by two new agreements, one for each of hepatitis C virus and HIV. Revenues under these agreements were $18 .9 million and $13 .0 million for the three months ended September 30, 2003 and 2002, respectively, and $47.5 million and $33 .2 million for the nine months ended September 30, 2003 and 2002, respectively. The increase in 2003 as compared with 2002 related to (i) a $4 .0 million one-time payment estimated using an alternative methodology under an agreement with F . Hoffmann-La Roche relating to back royalties, (ii) a contractual increase in the royalty rates and (iii) increased donations . Royalties will continue under these new agreements through the lives of the hepatitis C virus and HIV-related patents covering F . Hoffmann-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents begin to expire in 2015 for the U .S . and in 2008 for. Europe . Currently, the applicable issued HIV-related patent in Europe expires in 2005 . An HIV-related patent was issued in the U .S. on March 13, 2003 . This patent will expire seventeen years from the date of issuance . As permitted under the terms of its licensing agreement, F . Hoffmann-La Roche has decided to institute arbitration proceedings in regard to the application of the U .S . patent. During any pending arbitration proceedings, E . Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due .

Bayer In June 2001, Chiron and Ortho-Clinical Diagnostics, Inc . entered into an agreement with Bayer Corporation for the clinical diagnostic market . Under this agreement, Bayer manufactures and sells certain of Ortho-Clinical Diagnostics' hepatitis C virus and HIV immunodiagnostic products for use on Bayees instrument platforms . Bayer paid us a license fee of $45 .3 million, which we deferred (due to our continuing manufacturing obligations) and began recognizing as revenue in the third quarter 2001 . We will recognize the remaining amount ratably through 2010 .

Royalty and license fee revenues may fluctuate based on the nature of the related agreements and the timing of receipt of license fees. Results in any. one period are not necessarily indicative of results to be achieved in the future . In addition, our ability to generate additional' royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies . We have no assurance that we will be able to do so or that future royalty and license fee revenues will not decline .

Gross profit Blood testing gross profit as a percentage of net product sales was 40% for the each of the three months ended September 30, 2003 and 2002, and 42% and 39% for the nine months ended September 30, 2003 and 2002, respectively . The increase in blood testing gross profit margin year-to-date 2003 as compared with year-to-date 2002 related to (i) increased profitability of the nucleic acid testing business due to a lower level of fixed costs over an increased volume of sales and (ii) the timing of manufacturing services under the Ortho-Clinical Diagnostics contract .

In November 2003, Chiron and Gen-Probe Incorporated agreed to amend their world-wide blood screening collaboration agreement in order to adopt permanent, fixed revenue shares for each party . Effective January 1, 2004, Gen-Probe's share will be set at 45 .75% of net revenues for assays which include a test for the hepatitis C virus . For commercial assays which do not test for the hepatitis C virus such as the prospective West Nile test, the agreement remains unchanged with each party retaining 50% of the net revenues after deduction of appropriate expenses .

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

5 0

1 Research and development Our blood testing segment recognized research an d development expenses of$5 .9 million and $3 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $16.7 million and S 13 . 2 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in research and development spending in 2003 as compared with 2002 primarily related to the continued development of nucleic acid testing products .

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

Selling, general , and administrative Our blood testing segment recognized selling, general and administrative expenses of $9 .7 million and $6.2 million for the three months ended September 30, 2003 and 2002, respectively, and $27.1 million and $21 .4 million for the nine months ended September 30 ; 2003 and 2002, respectively. The increased selling, general and administrative expenses in the third quarter 2003 as compared with the third quarter 2002, as well as year-to-date 2003 compared with year-to-date 2002, related to the expansion of our customer base for the Procleix® HIV- I/HCV Assay in the U .S ., Europe and other international markets and the preparation and roll-out of the West Nile vines assay under INI] testing . We expect continued growth in selling, general and administrative expenses related to nucleic acid testing technology and products as our sales opportunities expand in new markets through anticipated additional nucleic acid testing adoption .

Other

Royalty and license fee revenues Our other segment earns royalties on third party sales of, and license fees on, several products . Our other segment recognized royalty and license fee revenues of $19.! million and $17,6 million for the three months ended September 30, 2003 and 2002, respectively, and $55 .5 million and $46.0 million for the nine months ended September 30, 2003 and 2002, respectively . The majority .of royalty and license fee revenues related to the use of our hepatitis C virus and HIV-related patents by various third parties .

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

The HIV agreement provides for royalties on future sales related to F . Hoffmann-La Roche's use of our HIV-related patent in its . in vitro diagnostic . products, which commenced in the first quarter 2001 when the European Patent Office Board of Technical Appeals upheld our HIV---related patent . Royalty revenues recognized under this agreement year-to-date 2003 were consistent with year-to-date 2002 .

Such royalties will continue through the lives of the hepatitis C virus and HIV-related patents covering F . Hoffinann-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents expire in 2015 for the U.S . and in 2008 for Europe . Currently, the applicable issued HIV-related patent in Europe expires in 2005 . An HIV-related patent directed to nucleic acid testing methods for HIV-1 was issued in the U .S . on March 13, 2003 . This patent will expire seventeen years from the date of issuance . The issuance of the patent triggered a milestone payment to Chiron of $10 .0 million from F . Hoffinann-La Roche, which was received in April 2003 . As permitted under the terms of its licensing agreement, F . Hoffmann-La Roche has decided to institute arbitration proceedings in regard to the application of the US, patent . We have deferred recognition of this $10 .0 million milestone payment and interest as of Septembe r 1 30, 2003 . During any pending arbitration proceedings, F . Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due .

Bayer A cross-license agreement provides for royalties to us on HIV and hepatitis C virus products sold by Bayer, which increased year-to-date 2003 as compared with year-to-date 2002.

Abbott Laboratories A cross-license agreement provides for royalties to us on HIV and hepatitis C virus products sold by Abbott . We recognized royalty and license fee revenues under this agreement in the second quarter 2003 .

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

Selling, general , and administrative Our other segment recognized selling, genera! and administrative expenses of $22 .9 million and $13 .7 million for the three months ended September, 2003 and 2002, respectively, and $56 .9 million and $48.7 million for the nine months ended September, 2003 and 2002, respectively . The increase in selling, general and administrative expenses in the third quarter 2003 as compared with the third quarter 2002 primarily resulted from integration costs of $1 .7 million associated with our third quarter acquisition of PowderJect Pharmaceuticals, an impairment charge associated with long-lived assets, employee-related expenses and additional consulting costs . In addition, the increase year-to-date 2003 as compared with year-to-date 2002 was impacted by additional severance costs and was partially offset by lower litigation costs in the first and second quarters of 2003 related to our investment in and defense of our patents and technology.

Write-o ff of purchased i n-process research and development The write-off of purchased in-process research and development was $122 .7 million and $54 . 8 million for the nine months ended September 30, 2003 and 2002, respectively .

On July 8, 2003, we acquired PowderJect Pharmaceuticals and accounted for the acquisition using the purchase method of accounting . We allocated the purchase price based on the fair value of the assets acquired and liabilities assumed . We allocated a portion of the purchase price to purchased in-process research and development and wrote off $122.7 million in the third quarter 2003 . We do not anticipate that there will be any alternative future use for the in-process research and development. In valuing the purchased in-process research and development, we used probability-of-success-adjusted cash flows and a 14% discount rate . Cash flows from projects including those relating to (i) viral infectious disease, (ii) certain travel vaccines and (iii) vaccines for allergies were assumed to commence between 2004 and 2012 .

52 and development and wrote off $54.8 million in the first quarter 2002 . We allocated a portion of the purchase price to a liability for asset disposal and lease cancellation for the San Diego, California facility closed during the third quarter 2002 . In the fourth quarter 2002, we found an assignee for the manufacturing facility lease and revised the allocation of the purchase price resulting in a $9 :6 million decrease to purchased in-process research an d development. We do not anticipate that there will be any alternative future use for the in-process research and development . In valuing the purchased in-process research and development, we used probability-of-success-adjusted cash flows and a 20% discount rate . We assumed revenue from tezacitabine to commence after 2005 . As with all pharmaceutical products, the probability of commercial success for any research and development project is highly uncertain .

Restructuring and reorganization For the three and nine months ended September 30, 2003, we recorded restructuring and reorganization charges of $1 .1 million and$1 .8 million, respectively. The charges consisted of termination and other employee-related costs recognized in connection with the elimination of i5 positions in our Amsterdam manufacturing facility.

Interest expense We recognized interest expense of $6 .2 million and $3 .2 million for the three months ended September 30, 2003 and 2002, respectively, and $12 .5 million and $9.5 million for the nine months ended September 30, 2003 and 2002, respectively . The increase in the third quarter 2003 as compared with the third quarter 2002 primarily related to interest expense recognized on the $500.0 million convertible debentures that were issued on July 30, 2003, additional expense resulting from debt assumed following our third quarter acquisition of PowderJect Pharmaceuticals .

Interest and other income , net Interest and other income, net, primarily consisted of interest income on our cash and investment balances and other non-operating gains and losses. We recognized interest income of $5 .4 million and $8 .8 million for the three months ended September 30, 2003 and 2002, respectively, and $18 .7 million and $27.9 million for the nine months ended September 30, 2003 and 2002; respectively . The decrease in interest income in 2003 as compared with2002 primarily was due to lower average cash and investment balances following the acquisition ofPowderlect Pharmaceuticals and lower average interest rates.

We recognized gains of $9 .4 million and $14 .3 million for the nine months ended September 30, 2003 and 2002, respectively, related to the sale of certain equity securities . Thera were no gains related to the sale of equity securities during the three months ended September 30, 2003 and 2002 .

There were no losses attributable to the other-than-temporary impairment of equity securities for the three months ended September 30, 2003 and 2002, and the nine months ended September 30, 2003 . For the nine months ended September 30, 2002, we recognized losses attributable to the other-than-temporary impairment of certain equity securities of $4 .8 million.

In the second quarter 2001, we recorded a charge of $1 .5 million to write-down debt securities with a face value of $5 .0 million due to the decline in the credit rating of the issuer. On March 1, 2002, the issuer paid us $5.1 million-the Sill principal plus interest .. As a result, we recorded $1 .5 million in "interest and other income,'net," for the nine months ended September 30, 2002.

On December 31, 1998, we completed the sale of our 30% interest in General Injectibles & Vaccines , Inc., a distribution . business, to Henry Schein, Inc . and received 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 Hen ry Schein' s gross profit , through 2003 . We received $2.0 million for 2002 and $5.4 million for 2001 during the " IN nine months ended September 30, 2003 and 2002 , respectively .

Income taxes The reported effective tax rate for 2003 is 25% of pretax income from continuing operations, excluding the write-off of purchased in-process research and development related to the

,53

~~M Powderiect Pharmaceuticals acquisition . The reported effective tax rate for the nine months ended September 30, 2002 was 27% of pretax income from continuing operations, excluding the write-off of purchased in-process research and development related to the Matrix Pharmaceutical acquisition . The write-off of purchased in-process research and development in 2003 and 2002 is not tax deductible . The 2003 effective tax rate is lower than the 2002 effectiv e tax rate due to increased benefits associated with Chiron's research and development activities and tax planning initiatives . The effective tax rate may be affected in future periods by changes in management's estimates with respect to our deferred tax assets, acquisitions and other items affecting the overall tax rate .

Management believes the acquisition of PowderJect Pharmaceuticals may cause an increase in the future effective tax rate and is in the process of evaluating certain options that may mitigate any potential increase . Specifically, most of PowderJect Pharmaceutical's profits are earned in the United Kingdom, subject to a 30% marginal tax rate . Management is currently negotiating debt-to-equity levels with United Kingdom Inland Revenue that it expects will, more likely than not, maintain the reported effective tax rate of 25% through 2004 . There is no assurance that such debt . to-equity levels being negotiated with United Kingdom Inland Revenue will be accepted and accordingly, the reported effective tax rate of 25% for 2004 may change .

Discontinued Operations In a strategic effort to focus on our core businesses of biopharmaceuticals, vaccines and blood testing, we completed the sale of Chiron Diagnostics and Chiron Vision in 1998 and 1997, respectively .

In the second and third quarters 2003, we reversed approximately $1 .7 million related to unutilized reserves for Chiron Diagnostics and Chiron Vision, which was recorded as a "Gain from discontinued operations" for the nine months ended September 30, 2003 .

In the first quarter 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, we made a payment to Bayer during the first quarter 2003 . We utilized an amount previously reserved for indemnity obligations, based upon .the settlement agreement with Bayer . These amounts resulted in a. net charge of $7 .6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of $1 .4 million which was recorded as a "Gain . from discontinued operations". for the nine months ended September 30, 2003 .

In the third quarter 2002, we recognized a charge of $0.4 million related to a settlement with a former employee arising out of the sale of Chiron Diagnostics . This amount was recorded as a "Loss from discontinued operations" for the three and nine months ended September 30, 2002 .

In connection with the sale of Chiron Diagnostics and Chiron Vision, we recorded cumulative net deferred tax assets of $0 .2 mill ion and $8 .5 million at September 30, 2003 and December 31, 2002, respectively, principally attributable to the timing of the deduction of certain expenses associated with these sales . We also recorded corresponding valuation allowances of $0 .2 million and $8.5 million at September 30, 2003 and December 31, 2002, respectively, to offset these deferred tax assets, as management believes that it is more likely than not that the deferred tax assets to which the valuation allowance relates will not be realized, The future recognition of these deferred tax assets will be reported as a component of "Gain (loss) from discontinued operations . "

New Accounting Standard s

In January 2003, the FASB issued Interpretation No_ 46 (referred to as FIN No . 46), "Consolidation of Variable Interest Entities" which address the accounting for certain off-balance sheet lease financing. The recognition provisions of FIN No . 46 will be effective for us at the end of the firs t

54 repo rt ing pe ri od ending after December 15, 2003 . The adoption of FIN No. 46 is not expected to have a material impact on the Consolidated Financial S tatements.

Liquidity and Capital Resources r

Our capital requirements have generally been funded from operations, cash and investments on hand, debt borrowings and issuance of common stock . Our cash and investments in marketable debt securities, which totaled $1,038 .0 million at September 30, 2003, are invested in a diversified portfolio of financial instruments, including money market instruments, corporate notes and bonds, government or government agency securities and other debt securities issued by financial institutions and other issuers with strong credit ratings . By policy, the amount of credit exposure to any one institution is limited, Investments are generally not collateralized and primarily mature within three years .

We believe that our cash, cash equivalents and short-term investments, together with funds provided by operations and leasing arrangements, will be sufficient to meet our foreseeable operating cash requirements including any cash utilized under our stock repurchase program, In addition, we believe we could access additional funds from the debt and, under certain circumstances, capital markets .

Sources and uses of cash We had cash and cash equivalents of $499 . 9 million and $316 .9 million at September 30, 2003 and 2002, respectively .

Operating activities For the nine months ended September 30, 2003, net cash provided by operating activities was $260 .6 million as compared with $191 .8 million for the nine months ended September 30, 2002 . The increase in cash provided by operating activities primarily was due to higher income from continuing operations before depreciation and amortization and other non-cash charges . The net cash provided by operating activities increased primarily as a result of(i) higher royalty payments received under the Roche royalty arrangements, (ii) $14 .4 million of cash received as a result of the 13iogen and Semno settlements in connection with the McCormick patents (see "Biopharrnaceuticals----Other revenues" above), (iii) higher royalty paythents received under the Betaferon® royalty arrangement and (iv) larger increases in accounts payable and accrued liabilities at September 30, 2003 as compared to September 30, 2002 . Partially offsetting these increases were (i) payments in 2003 including a payment made to Bayer Corporation as a result of a settlement agreement relating to certain claims raised by Bayer in connection under the Stock Purchase Agreement dated September 17, 1998 and (ii) larger increases in inventory and accounts receivable at September 30, 2003 as compared to September 30, 2002 .

At September 30, 2003, we had foreign net operating loss carryforwards of approximately $13 .2 million, of which approximately $3 .6 million begin: expiring over the period 2008 to 2018 . The remaining foreign net operating loss carryforwards of $9 .6 million are available to offset future taxable income without limitation.

At September 30, 2003, we had tinutilized federal net operating loss canyforwards attributable to the acquisition of Matrix Pharmaceutical of approximately $51 .9 million, which are available to offset future domestic taxable income ratably through 2021 .

At September 30, 2003, we had $45.9 million of state net operating doss carryforwards, which expire between 2003 and 2021, and state net operating loss carryforwards.attributable to the acquisition of Matrix Pharmaceutical , Inc. of approximately $27.3 million, which are available to offset taxable income ratably through 2012 .

At September 30, 2003, we had $2 .2 million of federal business tax credit carryforwards attributed to the acquisition of PathoGenesis Corporation, which -expire in 2012.

55 At September 30, 2003, we had $45 .5 million of federal alternative minimum tax foreign tax credit carryovers, which expire in 2007, and state business tax credit carryovers of $23 .2 million, which are available to offset future state tax liabilities without limitation .

We anticipate that research and development expenditures in the, fourth quarter 2003 will primarily be driven by (i) those activities under our December 2001 and June 2002 collaboration agreements with Nektar Therapeutics (formerly Inhale Therapeutic Systems, Inc .) related to, among other things, the development of a dry powder formulation of our inhaled TOBIV product for the treatment of pseudomonas aeruginosa in cystic fibrosis patients and a dry powder inhaleable erytitromyclamine product targeted for the treatment of acute exacerbations of chronic bronchitis, (ii) those activities related to the development of tezacitabine, obtained as a part of the acquisition of Matrix Pharmaceutical in the first quarter 2002, (iii) those activities related to the development of interleukin-2 in combination with various monoclonal antibodies, (iv) expansion of our meningococcal franchise, (v) development of a flu cell culture system, (vi) research activities focused on identifying several novel vaccines and therapeutics for clinical development in the areas of oncology and infectious disease and (vii) those activities related to development with tifacogin in severe community-acquired pneumonia . In addition, we are required to. make capital improvements to our existing manufacturing facilities to support the supply of Betaferont$) to Schering . In connection with this project, we are continuing to incur expenses relating to the development of new processes and the performance of test runs related to installed equipment . Net cash from operating activities are expected to fund these research and development activities .

Investing activities For the nine months ended September 30, 2003, net cash used in investing activities consisted of cash paid for acquisitions, net of cash acquired of $804 .7 million, purchases of investments in marketable debt securities of $622 1 6 million, capital expenditures of $81 .4 million, purchases of equity securities and interests in affiliated companies of $4 .3 million, and other uses of cash of $13 .0 million. For the nine months ended September 30, 2003, cash paid for acquisitions, net of cash acquired, consisted of cash paid to acquire PowderJect Pharmaceuticals, net of cash acquired, of $803 .5 million and cash paid for acquisition costs related to the acquisitions of PathoGenesis Corporation and Matrix Pharmaceutical of $ 1 .0 million and $0 .2 million, respectively. Cash used in investing activities was offset by proceeds from sales and maturities of investments in marketable debt securities of $1,112.8 million, proceeds from the sale of, equity securities and interests in affiliates companies of $12.5 million and proceeds from notes receivable of $0 .8 million .

On July 8, 2003, we acquired PowderJect Pharmaceuticals, a company based in Oxford, United Kingdom that develops and commercializes vaccines . We acquired all of the outstanding shares of common stock of Powderiect Pharmaceuticals for 550 pence per ordinary share, which, including estimated acquisition costs, resulted in a total preliminary purchase price of approximately $945 .6 million. As part of the acquisition of PowderJect, we assumed the debt o f PowderJect including convertible notes with a face value of 35 .0 million British Pounds (fair value of $57 .0 million at July. 8, 2003) . We paid the convertible notes during the third quarter 2003 and the payment is included in "Net repayment of debt and capital lease" in the. Condensed Consolidated Statement of Cash Flows for the nine months ended September 30, 2003 .

In April 2001, we entered into a collaboration with Rhein Biotech N .V . (now part ofBema Biotech) and.GreenCross Vaccine Corporation to research and develop certain pediatric combination vaccine, products for sale outside of Europe and. North .America. The collaboration agreement requires capital commitments from Chiron, Berna Biotech and GreenCross Vaccine. Our commitment is approximately 26 .4 million Euro ($30 .6 million at September 30, 2003) for the expansion of our Italian manufacturing facilities, of which we paid 7 .9 million Euro ($8 .9 million), as of September 30, 2003 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008 . We currently are evaluating various financing alternatives to fund this expansion .

56 In February 2001, our Board of Directors approved a $235 .0 million capital expansion project, which ince, . ., s the construction of a research and development facility (including a supporting central utility facility) anda parking structure in Emeryville, California . We had committed to $37 .6 million in design and construction services, under which we had incurred costs of$28 .5 million, as of September 30, 2003 . We may cancel these remaining commitments at any time . Related to the research and development facility, we are evaluating various financing alternatives to fund this expansion .

The purchases of equity securities and interests in affiliated companies consisted of equity contributions under several venture capital funds including a $1 .3 million capital contribution under two 2003 limited partnership agreements, a $0 .1 million capital contribution under a 2002 limited partnership agreement, a $1 .4 million capital contribution under a 2001 limited partnership agreement and a $1 .5 million capital contribution under a 2000 limited partnership agreement . We are obligated to pay $60.0 million over ten years in equity contributions to these venture capital funds, of which $29 .8 million was paid through September 30, 2003 .

For the nine months ended September 30, 2002, net cash used in investing activities consisted of purchases of investments in marketable debt secu rities of $581 .2 million, capital expenditures of $74 . 1 million , net cash paid to acquire Matrix Pharmaceutical, Inc. of $55 .4 million, purchases of equity securities and interests in affiliated companies of $5 .5 million, cash paid to acqui re Pulmopltarm of $2 .4 million, cash paid for acquisition costs related to the acquisition of PathoGenesis of $0,4 million and other uses of cash of $4.0 million . Cash used in .investing activities was offset by proceeds from the sale and maturity of investments in marketable debt securities of $568 .5 million, proceeds from the sale of equity securities and interests in affiliated companies of $18 .9 million, proceeds from equity forward contracts of $6.0 million proceeds from notes receivable of $5.2 million and proceeds from sales of assets of $0 .4 million .

Financing activities For the nine months ended September 30, 2003, net cash provided by financing activities consisted of $500 .0 million of proceeds from the issuance of convertible debentures ( discussed below), $86:4 million of proceeds from the reissuance of treasury stock (related to stock option exercises) $2 .1 million of proceeds from put options and $0.5 million of proceeds from the issuance of debt. Cash provided by financing activities was offset by $132 .7 million for the acquisition of treasury stock, $62.3 million for the repayment of debt and capital lease and $ 2 .3 million for the net repayment of short-term borrowings .

As discussed in "Note 9-Debt Obligations," on July 30, 2003, we issued $500 .0 million aggregate principal amount of convertible debentures, which mature on August 1, 2033. The convertible debentures accrue interest at a rate of 1 .625% per year and interest is payable on February I and August 1, commencing February 1, 2004 .

Our Board of Directors has authorized the repurchase of our common stock on the open market . In December 2002, our Board of Directors approved an additional 5.0 million share increase and authorized such repurchases through December 31, 2003 . As of September 30, 2003, we may repurchase up to an additional 2.1 million shares of our common stock .

In January 2001, we initiated a put option program to reduce the effective costs of repurchasing our common stock . Under this program, we have entered into contracts with third parties to sell put options on Chiron stock, entitling the holders to sell to us a specified number of shares at a specified price on a specified date . In May 2003, we entered into a .contract with a third party to sell put options on Chiron stock, entitling the holder to . sell to us 0 .5 million shares at $43 .89 per share. In connection with the sale, we . collected a $0.7 million premium . The option expired June 30, 2003, On June 30, 2003, our closing stock price. was $43 .86 . The third party elected to exercise a portion of the options . As a result, we repurchased 0 .2 million shares. For the third quarter 2003, we had no outstanding put option contracts. 57 As of March 31, 2003, we had an outstanding put option contract with a third party, entitling the holder to sell to us 0 .5 million shares at $36 .79 per share . In connection with the sale, we collected a $1 .4 million premium . The option expired unexercised on May 5, 2003 ,

As of December 31, 2002, we had an outstanding put option contract with a third party entitling the holder to sell to us 0 .5 million shares at $38 .11 per share. The option expired unexercised on January 29, 2003 .

For the nine months ended September 30, 2002, net cash used in financing activities consisted of $96 .7 million for the acquisition of treasury stock and $0.6 million for the repayment of short-term borrowings . Cash used in financing activities was offset by $22 .0 million in proceeds from the reissuance of treasury stock (related to stock option exercises) and $3 .7 million in proceeds from put options .

Borrowing arrangements Under a revolving, committed, uncollateralized credit agreement with a major financial institution, we can borrow up to $100 .0 million in the U.S, This credit facility is guaranteed by Novartis AG under a November 1994 Investment Agreement, provides various interest rate options and . matures in February 2006 . There were no borrowings outstanding under this credit facility at September 30, 2003 and December 31, 2002 . In December 1999, Chiron and Novartis amended the November 1994 Investment Agreement to reduce the maximum amount of our obligations that Novartis would guarantee from $725.0 million to $702 .5 million.

We also have various credit facilities available outside the U .S . There were no outstanding borrowings under .these facilities at September 30, 2003 . Borrowings under these facilities totaled $0 .1 million at December 31, 2002 . One facility is maintained for our 51%-owned Indian subsidiary, and allows for total borrowings of 200 million Indian Rupee ($4.4 million at September 30, 2003). There were, no outstanding borrowings under this facility at September 30, 2003 . At December 31, 2002, $0 . 1 million was outstanding under this facility . Our Italian subsidiary also has various facilities, related to its receivables, which allow for total borrowings of 10.9 million Euro ($12 .6 million-at September 30, 2003) . There were no outstanding borrowings under these facilities at September 30, 2003 and December 31, 2002.

Capital Lease As discussed in "Note 10-Commitments and Contingencies," in July 2003, we entered into anew six-year lease to rent a research and development facility inErneryvilie, California following the expiration of the existing operating lease . Effective July 1, 2003, we accounted for this new lease as a capital lease and, as a result, recorded the leased facility and the corresponding liability on our balance sheet. The amount recorded on the-balance sheet for the leased facility is $157.5 million. The amount of the leased facility less the expected value of the facility at the end of the lease term is being amortized on a straight-line basis over the lease term . We expect the value of the facility at the end of the lease term to be approximately $151 .6 miliiom :At the inception of the lease, the future minimum lease payments, exclusive of a residual value guarantee, are approximately $15 .7 million over the lease term . The interest payments represent variable-rate interest payments indexed to a three-month London interbank offered rate plus 40 basis points . The lease provides a $156.0 million residual value guarantee from Chiron to the lessors in the event of property value declines . Consequently, our maximum payment obligation is $156 .0 million upon termination of the lease on or before July 1, 2009, On or before July 1, 2009, we can choose to either purchase the facility from the lessors or sell the facility to a third party . This option accelerates if we default on our lease payments or in the event of other defined events . As of July .1, 2003, Novartis AG had guaranteed (under provisions of the Investment Agreement) payments on this lease commitment, including payment of the residual value . guarantee, to a maximum of $1733 million.

ry Factors That May Affect Future Results

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

If our focus on the research and development of emerging technologies does not ultimately result in the creation of commercial products , our business could be adversely affected.

We focus our research and development activities on areas in which we have particular strengths and on technologies that appear promising . These technologies often are on the "cutting edge" of modem science . As a result, the outcome of any research or development program is highly uncertain . Only a very small fraction of these programs ultimately result in commercial products or even product candidates . Product candidates that initially appear promising often fail to yield successful products. In many cases, preclinical or clinical studies will show. that a product candidate is not efficacious (that is, it lacks the intended therapeutic or prophylactic effect), or that it raises safety concerns or has other side effects, which outweigh the intended benefit . Success in preclinical or early clinical trials (which generally focus on safety issues) may not translate into success in large-scale clinical trials (which are designed to show efficacy), often for reasons that are not fully understood. Further, success in clinical trials will likely lead to increased investment, adversely affecting short-term profitability, to bring such products to market . And even after a product is approved and launched, general usage or post-marketing studies may identify safety or other previously unknown problems with the product which may result in regulatory approvals being suspended, limited to narrow indications or revoked, or which may otherwise prevent successful commercialization .

We collaborate with third parties to develop and commercialize new products ; conflicts with or decisions by these third parties could harm our business .

An important part of our business strategy depends upon collaborations with third parties, including research collaborations andjoint efforts to develop an d commercialize new products . As circumstances change, Chiron and our corporate partners may develop conflicting priorities or other conflicts of interest . We may experience significant delays and incur significant expenses in resolving these conflicts and may not be able to resolve these matters on acceptable terms . Even without conflicts of interest, we may disagree with our corporate partners as to how best to . realize the value associated with a current product or a product in development . In-some cases, the corporate . partner may have responsibility for formulating and implementing key strategic or operational plans . In addition, merger and acquisition activity within the pharmaceutical and biotechnology industries may affect our corporate partners, causing them to reprioritize their efforts related to the research collaborations and other joint .efforts with us . Decisions by corporate partners on -key clinical, regulatory, marketing (including pricing), inventory management and other issues may prevent successful commercialization of the product or otherwise impact our profitability.

If wefall to obtain or.maintain the regulato ry approvals we. need to market our products, our business will suffer.

We must obtain and maintain regulatory approval in order-to market most of our products. Generally, these approvals are on a product-by--product and country-by-country basis . In the case of therapeutic products, 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 clinical trials often are susceptible to varying interpretations that may delay, limit or prevent approval or result in the need for post-marketing studies . In addition ,

F- regulations may be amended from time to time. Revised regulations may require us to reformulate products on a country or regional basis, obtain additional regulatory approvals, or accept additional risks that our products will not maintain market acceptance or be eligible for third party insurance coverage . Increased regulatory scrutiny and restrictions regarding marketing practices for products that are subject to government reimbursement may impact the sales of such products . There is no guarantee that we will be able to satisfy these new regulatory requirements and may suffer a loss of revenue as a result .

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

Most of our products are biologics. Manufacturing biologic products is complex . Unlike . chemical pharmaceuticals, a biologic product generally cannot be . sufficiently characterized (in terms of its physical and chemical properties) to rely on assaying of the finished product alone to ensure that the product will perform in the intended manner . Accordingly, it is essential to be able to both validate and control the manufacturing process, that is, to show that the process works and that the product is made strictly and consistently in compliance with that process . Slight deviations anywhere in the manufacturing process, including quality control, labeling and packaging, may result in unacceptable changes in the products that may result in lot failures or product recalls, or liability to a third party to the extent we are contract manufacturing products in our facilities for such third party . Manufacturing processes which are used to produce )he smaller quantities of material needed for research and development purposes may not be successfully scaled up to allow production of commercial quantities at reasonable cost or at all. All of these difficulties are compounded when dealing with novel biologic products that require novel manufacturing processes. Additionally, manufacturing is subject to extensive government regulation . Even minor changes in the manufacturing process, require regulatory approval, which, in turn, may require further clinical studies. For some of our products, we rely on others to supply raw materials and to manufacture those products according to regulatory requirements.

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

Our mishandling of hazardous materials could result in substantial costs and harm to our business.

In connection with our research and manufacturing activities, we utilize some hazardous materials . Great care is taken to ensure we have appropriate . procedures and permits in place for storing and handling such hazardous materials . We could be subject to loss of our permits, government fines or penalties and/or other adverse governmental action if such hazardous materials are stored, handled or released into the environment in violation of law or any permit . A substantial fine or penalty, the payment of significant environmental remediation costs or the loss of a permit or other authorization to operate or engage in our . ordinary course of business could result in material, unanticipated expenses and the possible inability to satisfy customer demand .

If any of our third party suppliers or manufacturers cannot adequately meet our needs, our business could be adversely affected.

We use raw materials and other supplies that generally are available from multiple commercial sources . Certain manufacturing processes, however, use materials that are available from sole sources, .

l.}1 or that are in short supply, or are difficult for the supplier to produce and certify in accordance with our specifications. From time to time, concerns are raised with respect to potential contamination of biological materials that are supplied to us . These concerns can further tighten market conditions for materials that may be in short supply or available from limited sources . Moreover, regulatory approvals to market our products may be conditioned upon obtaining certain materials from specified sources . Our ability to substitute material from an alternate source may be delayed pending regulatory approval of such alternate source . Although we work to mitigate the risks associated with relying on sole suppliers, there is a possibility that material shortages could impact production .

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

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

In connection with the production of our flu vaccine products, we must purchase large quantities of chicken eggs. Currently, we purchase those eggs and incubation services from a single supplier and, pursuant to the contract with that supplier, we are required to make specified minimum purchases from that supplier through 2007 . All of the chickens that produce those eggs are located in the United Kingdom . If our supplier were to fail to supply eggs in sufficient quantities or quality, including as a result of any health or other issues related to the chickens, our business would be materially adversely affected.

We are a key provider for the blood scre ening field of nu cleic acid testing and immunodiagnostics. In nucleic acid testing, we rely on our collaborative partner , Gen-Probe; to manufacture the West Nile virus assay , currently in use on an investigational-use basis in the U .S . and the Procleix® HIV-l/ HCV Assay. We currently source the related instrument system fro m third party suppliers . Currently , Gen--Probe is the only manufacturer of nucleic acid testing products using Transc ri ption - Mediated Amplification technology . In immunodiagnostics, under the Ortho-C linical Diagnostics, Inc, contract , we manufacture bulk reagents and antigens and confirmatory test kits sold in the clinical diagnostics and blood screening fields. While we and our partners work to mitigate the ri sks associated with be ing a key provider, there can be no assurance that our partner, Gen-Probe , will be able to provide sufficient quantities of the Proeleix® HIV-l/ HCV Assay or that we will be able to manufacture sufficient bulk reagents and antigens and con firmato ry test kits for immutiodiagnostic products . Our difficulties or delays or those of our partners ' could cause a public health concern for the blood supply, as well as increase costs and cause loss of revenue or market sha re . - -

If we cannot obtain necessary licenses to third party patents for the manufacture or sale ofour products, we may have to withdraw from the market or delay the introduction ofthe affected product.

Third parties, including competitors, have patents and patent applications in the U.S . and other signific ant markets that may be useful or necessary for the m anufacture , use or sale of certain products and products in development by us and our corporate partners . It is likely that third part ies will obtain these patents in the future . Certain of these patents may be broad enough to prevent or delay us and our corporate partners from manufacturing or marketing products important to our current and future business . We cannot accurately predict the scope, validity and enforceability of these patents, if granted , the extent to which we :may wish or need to obtain licenses to these patents , and the cost and availability of these licenses. If we do not or cannot obtain these licenses, products may be withdrawn from the market or delays could be encountered in market introduction while an attempt is made to design around these patents, or we could find that the development, manufacture or sale of such products is foreclosed . We could also incur substantial costs in licensing or challenging the validity and scope of these patents.

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

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

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

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

As we are a key p rovider for the blood screening field of nucleic acid testing and immunodiagnostics , we may have product liability in addition to contract exposure , in the event that our difficulties-or delays or those of our partners could cause a public health concern for the blood supply.

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

We operate in a highly competitive environment, and the competition is expected to increase . Competitors include large pharmaceutical, chemical and blood testing companies, and biotechnology companies . Some of these competitors, particularly large pharmaceutical and blood testing companies, have greater resources than ours . Accordingly, even if we are successful in launching a product, we may find that a competitive product dominates the market for any number of reasons, including :

the possibility that the competitor may have launched its product first ;

the competitor may have greater access to certain raw materials;

the competitor may have more efficient manufacturing processes ;

the competitor may adapt more quickly to technological change ;

the competitor may have greater marketing capabilities ;

the competitive product may have therapeutic or other advantages ; or

new competitors may enter into markets where we currently have significant competitive advantage .

6 2

The technologies applied by our competitors and us are rapidly evolving, .and new developments frequently result in price competition and product obsolescence. In addition, we may be impacted by competition from generic forms of our products or substitute products . Specific to one product, TOBIO, a generic form of this product may be available from our competitors, which may cause loss of revenue or market share. In December 2002, the U.S. Food and Drug Administration tentatively approved an abbreviated new drug application for an inhaled tobramycin for sale in the U .S . following expiration of the orphan drug status of TOBI® in December 2004 . Subsequently, the application was withdrawn and under terms of a settlement agreement reached in October 2003, approval will not be sought to market this generic product until the 2014 expiration of our patent in the U.S . covering the formulation of TOBI® .

Our patents may not prevent competition or generate revenues .

We seek to obtain patents on many of our inventions . Without the protection of patents, competitors may be able to use our inventions to manufacture and market competing products without being required to undertake the lengthy and expensive development efforts made by us and without having to pay royalties or otherwise compensate us for the use of the invention . We have no assurance that patents and patent applications owned or licensed to us will provide substantial protection . Important legal questions remain to be resolved as to the extent and scope of available patent protection for biotechnology products and processes in the U .S. and other important markets . We do not know how many of our pending patent applications will be granted, or the effective coverage of those that are granted. In the U .S. and other important markets, the issuance of a patent is neither conclusive as to its validity nor the enforceable scope of its claims . We have engaged in significant litigation to determine the scope and validity of certain of our patents and expect to continue to do so. An adverse outcome of litigation could result in the reduction or loss of royalty revenues . Engaging in patent litigation against one party may place significant royalty revenues received or to be received from other parties at risk . Even if we aresuccessful in obtaining and defending patents, there can be no assurance that these patents will provide substantial protection. The length of time necessary to resolve patent litigation successfully may allow infringers to gain significant market advantage . Third parties may be able to design around the patents and develop competitive products that do not use the inventions covered by our .patents . Many countries, including certain countries in Europe, have compulsory licensing laws under which a patent owner may be compelled to grant licenses to third parties (for example, the third party's product is needed to meet a threat to public health or safety in that country, or the patent owner has failed to "work" the .invention in that country, or the third party has patented imps ., v ements)_ In addition, most countri es limit the enforceabili ty ., . patents against gove rnment agencies or government contractors. In these countries , the patent owner may be Iimited to monetary relief and may be unable to enjoin infringement, which could materi ally diminish the value of the patent. In addition, royalty revenues will decline as patents expire .

Sales of ourproducts maybe adversely affected by the availability and amount of reimbursement to the user of our products from third parties, such as the govern ment and insurance companies.

In the U .S . and other significan t markets, sales of our products may be affected by the availability of reimbursement from the government or other third pa rties, such as insurance companies . It is difficult to predict the reimbursement status of newly approved, novel biotechnology products, and current reimbursement policies for existing products may ch an ge. In certain foreign markets, govern ments have issued regulations relating to the pricing and profitabili ty of pharmaceutical companies . There have be en proposals in the U .S . (at both the federal and state level) to implement . such controls. If-the United States Congress enacts legislative proposals addressing parallel importa ti on currently being deli berated, revenues from certain products may be affected by this change in U .S_ policy . The growth of managed care in the U .S . also has placed pressure on the p ricing of healthcare products. These. pressures can be expected to continue.

63 If our efforts to integrate acquired or licensed businesses or technologies into our business are not successful, our business could be harmed.

As part of our business strategy, we expect to continue to grow our business through in-licensing, collaborations or acquisitions of products or companies . For example, we are currently in the process of completing the integration of Powder]ect Pharmaceuticals . The failure to adequately address the financial, operational or legal risks raised by such transactions, including our integration of Powderject, could harm our business . Financial aspects related to these transactions may alter our financial position, reported operating results or stock price, and include :

use of cash resources ;

• potentially dilutive issuances of equity securities ;

• the incurrence of debt and contingent liabilities, impairment losses or restructuring charges ;

• large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset; an d

amortization expenses related to other intangible assets .

Operational risks that could harm our existing operations or prevent realization of anticipated benefits from such transactions include :

• challenges associated with managing an increasingly diversified business ;

difficulties in assimilating the operations , products, technology, information systems or personnel of the acquired company ;

• diversion of management's attention from other business concerns ;

• inability to maintain uniform standards, controls, procedures and policies;

the assumption of known and unknown liabilities of the acquired company, including intellectual property claims; and

• subsequent loss of key personnel of the acquired company .

Legal risks may include requirements to obtain the consent of our stockholders or a third party, or the approval of various regulatory authorities.

If such efforts to integrate acquired or licensed businesses or technologies into our business are not successful, our business could be harmed .

If we cannot initiate and maintain revenue-generating relationships with third parties, we may not be able to grow our revenues in the near to medium term :

Fluctuations in interest rates, foreign currency exchange rates and levels of indebtedness could harm our business .

64 financial results could be significantly affected by fluc tu ations in foreign currency exchange rates or by weak economic conditions in foreign markets.

We have significant debt balances following the issuance of our most recent convertible debt offerings . Therefore, our financial results will reflect increased interest expense and we could be adversely affected by a negative change to our credit rating by the debt rating agencies .

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

-We have an alliance with Novartis AG, a life sciences company headquartered in Basel, Switzerland . Under a series of agreements between Chiron and Novartis, and as a. result of subsequent stock issuances by Chiron, Novartis' ownership interest in Chiron was approximately 42% as of September 30, 2003 . The governance agreement between Chiron and Novartis contains provisions that require the approval of Novatlis before we enter into certain corporate transactions . These transactions generally include significant debt or equity issuances, debt or equity repurchases, most mergers and acquisitions, the payment of cash dividends, amendments to Chiron's certificate of incorporation or by-laws, and other transactions that would adversely impact the rights of Novartis, or discriminate against Novartis, as a Chiron stockholder . In addition, a majority of the independent directors must approve any material transactions between Chiron and Novartis. These provisions may limit our ability to enter into transactions with third parties otherwise viewed as beneficial to Chiron . All of our shares owned by Novartis are eligible for sale in the public market subject to compliance with the applicable securities laws . We have agreed that, upon Novartis' request, we will file one or more registration statements under the Securities Act in order to permit Novartis to offer and sell shares of our common stock . Sales of a substantial number of shares of our common stock by Novartis in the public market could adversely affect the market price of our common stock .

Volatility of our stock price could negatively impact our profitability.

fluctuations in earnings from period to period ;

• results of clinical trials conducted by us or by our competitors ;

announcements by us or our competitors regarding product development efforts, including the status of regulatory approval applications ;

the outcome of legal proceedings, including claims filed by us against third parties to enforce our patents and claims filed by third parties against us relating to patents held by the third parties ;

the launch of competing products ;

the resolution of (or failure to resolve) disputes with corporate partners ;

corporate restructuring by us;

the sale of a substantial number of shares held by our existing stockholders ;

licensing activities by us; and

the acquisition or sale by us of products, products in development or businesses .

In connection with our research and development collaborations, from time to time we may invest in equity securities of our corporate partners . The price of these securities also is subject to significant

65 volatility and may be affected by, among other things, the types of events that affect our stock . Changes in the market price of these securities may impact our profitability .

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

We pay taxes principally in the U.S., Germany, Italy, The Netherlands and, with the acquisition of Powderiect, the United Kingdom . A ll of these jurisdictions have in the past and may in the future make changes to their corporate tax rates and other tax laws, which could increase our future tax provision. We have negotiated a number of rulings regarding income and other taxes that are subject to periodic review and renewal . If such rulings are not renewed or are substantially modified, income taxes payable in particular jurisdictions could increase. While we believe that all material tax liabilities are reflected properly in our balance sheet, we are presently under audit in several jurisdictions and may be subject to further audits in the future, and we have no assurance that we will prevail in all cases in the event the taxing authorities disagree with our interpretations of the tax law . In addition, we have assumed liabilities for all income taxes incurred prior to the sales of our former subsidiaries, Chiron Vision (subject to certain limitations) and Chiron Diagnostics . Future levels of research and development spending, capital investment and export sales will impact our entitlement to related tax credits and benefits which have the effect of lowering our effective tax rate .

Volatility of earnings could negatively impact our business.

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

inventory management practices, including wholesale ordering patterns ;

the level of pre-clinical and clinical trial -ielated activities;

seasonality of certain vaccine products ;

the tender driven nature of certain vaccine products;

the nature of our collaborative , royalty and license arrangements and other revenue sources ;

foreign currency exchange rate fluctuations ; an d

the level of product reserves due to various issues, including seasonality patterns, excess and obsolete inventory, and production yields .

Our results in any one quarter are not necessarily indicative of results to be expected for a full year.

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

We must follow accounting standards, financial reporting and corporate governance requirements and tax laws set by the governing bodies and lawmakers in the U .S . and other countries where we do business . From time to time, these governing bodies and lawmakers implement new and revised rules and laws . These new and revised accounting standards, financial reporting and corporate govemance requirements and tax laws may require changes to our financial statements, the composition of our board of directors, the composition, the responsibility and manner of operation of various board-level committees, the information filed by us with the governing bodies and enforcement of tax laws against us. Implementing changes required by such new standards, requirements or laws likely will require a significant expenditure of time, attention and resources, especially by our senior management . It is impossible to predict the impact, if any, on Chiron of future changes to accounting standards, financial reporting and corporate governance requirements and tax laws . In addition, it is-possible that the application of certain current accounting standards may change due to environmental factors, which may necessitate a change in our standard practice related to these accounting standards .

66 item 3 . Quantitative and Qualitative Disclosures About Market Ris k

Market risk mana gement Our cash flow and earnings are subject to fluctuations due to changes in foreign currency exchange rates, changes in interest rates and changes in the fair value of equity securities held for sale . We attempt to limit our exposure to some or all of these market risks through the use of various financial instruments and derivative securities. During the third quarter of 2003, our exposure to market risks changed as our cash balances decreased and our exposure to changes in foreign currency exchange rates increased with the acquisition of Powderject Pharmaceuticals and our debt balances increased with the issuance of $500. 0 million of convertible debt . We seek to manage our exposures to market risks as discussed in further detail in Part 11, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk" in our annual Report on Form I O-K for the year ended December 31, 2002 .

Item 4 . Controls and Procedures

(a) -Evaluation of disclosure controls and procedures As of the end of the period covered by this report, Chiron carried out an evaluation under the supervision and with the participation of Chiron's. management , including Chiron's CEO and CFO, of the effectiveness of the design and operation of Chirons disclosure controls and procedures pursuant to Exch ange Act Rule 13a- 15(e) or 15d-15(e) . Based on that evaluation , Chiron's management , including the CEO and CFO, concluded that Chiron's disclosure controls and procedu res were effective in timely alerting them to mate ri al information relating to Chiron required to be included in Chiron's periodic SEC filings .

Item 1 . Legal Proceeding s

We are party to certain lawsuits and legal proceedings, which are described in Part 1, Item 3 . "Legal Proceedings" of our Annual Report on Form 10-K for the year ended December 31, 2002. The following is a description of material developments during the period covered by this Quarterly Report and should be read in conjunction with the Annual Report on Form IO-K for the year ended December 31, 2002 .

Active Biotech A B

In June 2003, PowderJect Pharmaceuticals Plc ("PowderJect") filed a Request for Arbitration before the Arbitral Tribunal of the Arbitration Institute of the Stockholm Chamber of Commerce in Sweden against Active Biotech AB ("Active Biotech") . PowderJect claims that Active Biotech breached certain warranties and representations made in the July 2, 2001 Agreement by which PowderJect acquired SBL Vaccin AB ("SBL") from Active Biotech (the "Agreement") . PowderJect seeks compensatory damages and legal fees .

In July 2003, the Committee for Proprietary Medicinal Products granted a positive opinion to Chiron's oral travel vaccine Dukoral for the prevention of . cholera. Based on this opinion, Active Biotech sent Chiron a letter in September 2003 stating that pursuant to the Royalty Agreement between Active Biotech and SBL, Chiron would be obligated to pay Active Biotech certain milestone payments and royalties on future sales upon final approval . Chiron disputes these obligations on a variety of grounds . If the parties are unable to resolve this dispute, the dispute may become subject to arbitration.

It is not known when nor on what basis this matter will be resolved .

F. Jfaffmann-La Roche Ltd. and Roche Molecular Systems. Inc.-HIV

On March 11, 2003, the U.S . Patent and Trademark Office issued Chiron's U .S . Patent No. 6,531,276 (addressed to Methods For Detecting Human Immunodeficiency Virus Nucleic Acid) (the "'276 Patent") . Chiron has concluded that under the October 10, 2000 I-IIV Probe License Agreement and the January 1, 2001 HIV Blood Screening Agreement (the "License Agreements") between Chiron, F . Hoffinann-LaRoche Ltd. and Roche Molecular Systems (collectively, "Roche"), Roche is obligated to pay certain licensing fees and ongoing royalties for the sale of certain Roche HIV nucleic acid tests which infringe the'276 Patent . Roche disputes these obligations on a variety of grounds including non-infringement . Roche further contests the rate at which royalties must be paid if in fact its products are covered by the License Agreements . In April 2003, the parties initiated alternative dispute resolution . procedures (the "ADR procedures") mandated by the License Agreements to address these and potentially other disputes . The parties have been unable to .resolve the matter, and in November 2003, Chiron invoked the arbitration provisions provided under the ADR procedures, thereby initiating formal arbitration pursuant to the rules of the CPR Institute for Dispute Resolution.

It is not known when nor on what basis this matter will be resolved .

F. Hofmann-La Roche A . G .-HCV

68 the German Federal Patent court ("Bundespatentgericht") against the same patents . In August 2002, the Bundespatentgericht upheld the validity of the Getman patents, but nullified the German portion of the'931 patent. In November 2002, Chiron filed appeals in the Federal Supreme Court to the nullity decisions with respect to the '931 and'527 patents, and Roche likewise appealed the nullity decisions regarding the German patents . In July 2003, the Landgericht determined that Roche's 1-ICV immunoassay kits containing a certain antigen infringe Chiron's '524 patent . Accordingly, the Landgericht granted Chiron the right to enjoin Roche from the import, use, possession and sale of such kits in Germany, and ordered Roche to provide information about its commercial activities related to such kits since 1998 and to destroy any such kits in its possession in Germany . In August 2003, Chiron enforced the injunction on Roche . This judgment is subject to appeal . Furthermore, the Landgericht has stayed proceedings based on the '104, '527 and '931 patents pending the appeal of the Bundespatentgericht's judgment in the respective nullity suits .

In January 1997, Chiron and Ortho-Clinical Diagnostics, Inc . filed suit against F . Hoffmann-La Roche AG in the Regional Court of Dusseldorf, Germany, asserting that Roche's manufacture and sale of hepatitis C virus immunoassay products infringed Chiron's EP 0 318 216 (the "'216 patent") . The suit sought damages and injunctive relief. In April 1999, the Court granted Chiron's application and entered an injunction, In September 1999, Roche appealed the decision to the Court of Appeals in Dusseldorf. Following withdrawal of certain claims from the'216 patent, Chiron rescinded the injunction and substituted the aforementioned '931 and German patents in the appellate proceeding. In October 2003, the Court of Appeals ruled that Roche's HCV immunoassay kits containing a certain antigen infringe all three German patents . Accordingly, the Court of Appeals granted Chiron the right to enjoin Roche from the import, use, possession and sale of such kits in Germany, and ordered Roche to provide information about its commercial activities related to such kits since 1994 and to destroy any such kits in its possession in Germany . This judgment is subject to appeal. Oral hearings on the '931 patent are stayed pending the appeal of the Bundespatentgericht's judgment in the '931 nullity suit .

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

Laboratory Corporation ofAmerica Holdings

In April 2003, Chiron filed a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings (4LabCorp Holdings"), Laboratory Corporation of America ("LabCorp") and National Genetics Institute ("NGI") (collectively, the "Defendants"), seeking damages and an injunction against Defendants' manufacture, use and sale of the UltraQual'r1 .HCV RT-PCR assay and HCV SUPERQUANTrM assay for infringing Chiron's U.S. Patent No . 6,074,816 (the " '816 patent"). The Defendants also filed a complaint in the United States District Court for the District of Delaware against Chiron seeking a declaratory judgment that Defendants infringe neither the'81 .6 patent, nor U .S. Patent Nos. 5,712;088, 5;863,719, 6,074,816, and 5,714,596 (collectively, the "Chiron Hepatitis C virus-related patents"), and that the Chiron Hepatitis C virus-related patents are invalid . In August 2003, the Delaware Court granted Defendants' motion to enjoin Chiron from proceeding with the California action and compel Chiron to seek dismissal of that action . Chiron has appealed this judgment to the United States Court of Appeals for the Federal Circuit . Meanwhile, the Delaware Court has scheduled the trial fo r May 16, 2005 .

In August 2003, Chiron filed.a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings, Laboratory Corporation of America and National Genetics Institute (collectively, the "Defendants"), seeking damages and an injunction against Defendants manufacture, use and sale of certain HIV assays for infringing Chiron's U .S. Patent No . 6,531,276 (the '276 patent").

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

69 Medicare, Medi-Cal Investigation

In September 2000, the Office of the Attorney General of the State of California Department of Justice (the "California Attorney General") served a subpoena on Chiron . Chiron believes that the subpoena was issued in connection with a pending, but as yet unserved, qui tam lawsuit against Chiron and a number of other pharmaceutical companies. With respect to Chiron, the subpoena seeks information related to pricing to the Medial program of certain generic oncology drugs sold by Cetus-Ben Venue Therapeutics, a joint venture between Chiron and Ben Venue Laboratories . Chiron sold its interest in that joint venture in 1996. In November 2003, the California Attorney General served Chiron with a second subpoena, which Chiron believes is also connected to a qui tam action .

It is not known when nor on what basis this matter will be concluded .

Roxane Laboratories, Inc.

In June 2003, Chiron and Children's Hospital and Regional Medical Center (collectively, the "plaintiffs"), filed a complaint in the United States District Court for the District of Delaware against Roxane Laboratories, Inc . ("Roxane") seeking damages and.an injunction against Roxane's manufacture, use and sale or importation of an alleged generic version of Chiron's tobramycin solution for inhalation (TOBI®) described in Roxane's Abbreviated New Drug Application No . 65-105, for infringing Chiron's U .S . Patent No. 5,508,269 (the "'269 patent")("Aminoglycoside Formulation for Aerosolization") . Plaintiffs also sought a judgment providing that the effective date of any U .S. Food and Drug Administration approval for Roxane to make, use, sell or import said generic be no earlier than the date on which the'269 patent expires . In August 2003, Roxane filed a counterclaim seeking to invalidate the '269 patent, and is declaration o f non-infringement . In October 2003, pursuant to a settlement agreement, the lawsuit was dismissed . Under the terms of the settlement agreement, Roxane, which had previously withdrawn its U.S . Food and Drug Administration application for approval of a generic equivalent of TOBI®, agreed it would not seek U .S . Food and Drug Administration approval to market the product until the expiration of the'269 patent in 2014 . Chiron and Children's Hospital agreed to dismiss their infringement relief claims against Roxaue, and Roxane dropped its challenge to the'269 patent . No party received monetary compensation as part of the. settlement. This matter is now concluded.

Sorin Siomedica/Snia

In June 1994, Sorin Biomedica S .p.A . ("Sorin") filed a lawsuit with the Court of Milan, Italy against Chiron and Ortho Diagnostic Systems S .p.A . seeking a declaration of nullity and non-infringement of the Italian counterpart to Chiron's European Patent 0 318 216 (the "'216 :patent") claiming hepatitis C virus immunodiagnostic technology . Chiron denied Sorin's allegations and filed a counterclaim seeking a declaration of infringement . In February 1997, the Court enjoined Sorin from manufacturing or selling hepatitis C virus immunoassay kits in Italy . After Sorin made further objections, the Court ruled in October 1999 that certain'21 6 patent claims were valid and that Sorin's hepatitis C virus immunoassay infringed the '216 patent. In June 2000, the European Patent Office Technical Board Of Appeals upheld .the validity of the '216 patent in an amended form which deleted claims that Chiron alleged to have been infringed by Soria . In December 2000, Snia S .p.A., Soria's parent company, filed an appeal in the Court of Milan asking the Court to declare the Italian portion of the '216 patent null and void and to award Snia damages. in March 2001, Chiron denied Snia's allegations and asked the Court to dismiss the case. In May 2002, the Court of Appeal of Milan declared that Snia's claims were inadmissible and dismissed Snia's appeal: In July 2003, Snia filed an appeal before the Supreme Court. In October 2003, Chiron filed its counter appeal before the Supreme Court .

} In January 2002, Chiron filed a complaint against Snia in the Court of Milan asserting that Snia's manufacture and sale of certain hepatitis C virus immunodiagnostics infringe the'931 patent . Chiron seeks a declaration of infringement based on the'931 patent, as well as damages . Trial is currently scheduled for December 1, 2004 .

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

Item 4 . Submission of Matters to a Vote of Security Holder s

None .

Item 6 . Exhibits and Reports on Form 8-K

(a) Exhibits

Exhibit Number Exhibit

3 .01 : . Restated; Certificateof Incorporation of Chirou ;, as .tiiled with the Office of the Secretary of State of Delaware on August 17, 1987, incorporatedby: refere ncetoExhibit3 .01 .ofChiron'sreport.on:Form 10-Kforfiscal~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 fiscalyear 1996 . 3.03 - Certificate` of•Antendment efRestat$d Cerfificate of Incorporation ofChiron, as :.filed -with the Office of the Secretary of State.of Delaware" bri May22;1996, incorporated. by,--reference ;ta^ ilubtt 3 :04 o£Chiron `s report on .Form .I0-Qforthe ;:period ended June 30; 1996 3 .04 Bylawsof Chiron , as amended , incorporated byreference to Exhibit 3 .04 to Chiron's report on Form 10-K for fiscal year 2000 . . : 4.01 iridentuie between Chiron and State Street Bank and 7'rust Company, dated as of June12 2001 , incorporated by referenoer to Exhibit 4.01 of -Chiron's report on, Form IO-Q'for .the period ended June ;30,100 1 . 4.02 Registration Rights Agreement , dated as of June 12, 2003, 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 I0-0 for the period ended J une 30, 2001 . 4,03 Form of Liquid 'Yield Option Note T . dtie 2031 . (Zero. Coupon---Senior) (included as exhibits A-1and A-2 to the Indenture filed as - :',.Exhibit 4:01 above) •incosporated '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--3 filed with the Commission on Septem ber 23, 2003 . 4.05 i;egrstration Iiigi ts .Agreetitentdatedas .of July.30~ 2003;:betweetr Chiron and Morgan Stanley & Co„ Goldman, Sachs & Co .; Banc of ericaecurities'LLC and BNP Paribas Securities Corp., incorporated by reference to Exhibit 4 .3 of Chiron's registration statement ou .;. ` Fotm ,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-3 fled with the Commission on September 23, 2003 . 4.07 •';Resetved. .._

71 10 .102 Amended and Restated Re . __ .ing Credit Agreement, dated as of August 13, 2002, by and . . .ween Chiron and Bank of America, N_A ., and exhibits thereto, incorporated by reference to Exhibit 10 .102 of Chiron's report on Form 14-Q for September 30, 2002 . 10 .325 Agreement, dated as of July 1, 2003, between The American National Red Cross and Chiron . (We have omitted certain information from the Agreement and filed it separately with the Securities and Exchange Commission pursuant to our request for confidential treatment under Rule 24-2 . We have identified the omitted confidential information by the following statement : "Confidential Treatment Requested". ) 10 :326 WNV .Association Agreement, dated as. of July 1, 2003, between Americas Blood Centers and Chiron, and Form of Member . Supplement . (Wehave omitted certain information' from the Agreement and filed it separately with the Securities and Exchange Commission pursuant to our request "for confidential treatment under Rule 246-2 . .We have identified the omitted confidential . information by the: following statement : "Confidential Treatment Requested" .) 10 .519 Corporate Governance Guidelines . 10:624 Letter Agreement dated August 12, 2003, between Chiron and Craig A . Wheeler .* 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 Officerputsuant 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 .

Management contract, compensatory plan or arrangement .

(b) Reports on Form S-K

On July 8, 2003, Chiron filed a Current Report on Form 8-K, furnishing under item 5, announcement that the recommended cash offer being made by UBS Investment Bank on behalf of Chiron 's indirect wholly-owned subsidiary, Chiron UK-I Limited, to acquire all of the issued and to be issued share capital of Powderlect Pharmaceuticals plc, as set out in the offer document dated May 19, 2003, had been declared unconditional and would remain open for acceptance until further notice .

On July 23, 2003, Chiron filed a Current Report on Form 8-K, furnishing under Item 2, announcement that its indirect wholly-owned subsidiary, Chiron UK-I Limited, had acquired or agreed to acquire or had received valid acceptances of 83,069,482 shares, representing 90 .07% of the issued and to be issued share capital of Powderiect Pharmaceuticals ple for 550 pence per PowderJect ordinary share (the "Offer"), and that as of July 21, 2003, Chiron had paid $804 .7 million to purchase 88 .5 million PowderJect shares, representing 93 .9% of the existing issued share capital of PowderJect as of that date .

On July 23, 2003, Chiron filed a Current Report on Form 8-K, furnishing under .ltem 9, Chiron's preliminary results for its second quarter ended June 30, 2003, via a press release .

On July 28, 2003, Chiron filed a Current Report on Form 8-K, furnishing under Item 5, announcement that it intended to raise approximately $450 million through an offering of convertible debentures, and may raise up to an additional $50 million upon exercise of an option to purchase additional convertible debentures granted by Chiron in connection with the offering. The convertible

72 debentures will be 1 .625% interest coupons convertible into shares of Chiron common stock . Chiron intends to use the net proceeds from the offering for general corporate purposes.

On September 15, 2003, Chiron filed a Current Report on Form 8-K, furnishing under Item 5, announcement that its chairman, Sean P . Lance intends to retire from active service with Chiron and its board of directors as of the annual meeting of stockholders in May 2004 . The board has determined that it would elect Chiron president and chief executive officer Howard H . Pien as chairman at that same meeting .

On September 22, 2003, Chiron filed an Amendment No . Ito its Current Report on Form 8-K/A, relating to the acquisition of PowderJect Pharmaceuticals plc, and furnishing under Item 7 the audited consolidated financial statements of PowderJect Pharmaceuticals plc and subsidiaries as of and for the year ended March 31, 2003, giving effect to Chiron's acquisition of PowderJect for approximately $919 .3 million.

On September 23, 2003, Chiron filed a Current Report on Form 8-K, furnishing under Item 5, announcement that it has filed a registration statement on Form S-3 with the Commission relating to the resale of $500 million principal amount of its 1 .625% convertible debentures due 2033 and the shares of its common stock issuable upon conversion of the debentures. Chiron will not receive any proceeds from any resale by the selling security holders of the debentures . or the shares of common stock issuable upon conversion of the debentures .

73 CHIRON CORPORATION

September 30, 200 3

SIGNATURES

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

CHIRON CORPORATION

DATE: November 12, 2003 BY: Is! HOWARD H . PIEN

1-toward H . Piers President and Chief Executive Ofcer

DATE: November 12, 2003 BY: Is! DAVID V. SMIT H

David V . Smith Vice President, Finance and Chief FinancialOfcer

74 EXHIBIT D OuickLinks -- Click here to rapidly navigate through this documen t

UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington , D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2004

O R

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

For the transition period from to

Commission file number 0-1279 8

CHIRON CORPORATION (Exact name of registrant as specified in its charter)

Delaware 94-2754624 (State or other jurisdiction of incorporation or organization ) ( I .R .S . Employer Identi fication No .)

4560 Horton Street, Emeryville , California 9460 8 (Address of principal executive offices) (Zip code)

(510) 655--8730 (Registrant's telephone number, including area code)

Not Applicable (Former name, former address and former fiscal year, if changed since last report )

Yes [ No ❑

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

Yes1l No ❑

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

Title of Class Outstanding at April 28, 2004 Common Stock, $0 .01 par value 188,953,967

i CHIRON CORPORATION TABLE OF CONTENTS

Page No.

PART 1 FINANCIAL INF'ORMATIO N ITEM 1 . Financial Statements (Unaudited ) Condensed Consolidated Balance Sheets at March 31, 2004 and December 31, 2003 3 Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003 5 Condensed Consolidated Statements of Comprehensive Income for the three months ended March 31, 2004 and 2003 . 6 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 7 •.. ; Notes to Condensed Consolidated Financial . Statements 8 ITEM 2 . Management' s Discussion and Analysis of Financial Condition and Results of Operations 2 3 ITEM 3 . Quantitative and Qualitative Disclosures About Market Risk . .4 8 ITEM 4 . Controls and Procedures 4 8 PART 11. OTHER INFORMATIO N ITEM 1 . Legal Proceedings 50 ITEM 4. Submission of Matters to a Vote of Security Holders 50 ITEM 6. Exhibits and Reports on Form 8-K 5 1 SIGNATURES 53

2 Item 1 . Financial Statements

CHIRON CORPORATIO N

CONDENSED CONSOLIDATE)) BALANC E SHEETS

(Unaudited)

(In thousands , except share data)

March31, Deceniber3l, 2004 2003

ASSET S Current assets : - Cash and cash equivalents $ 259,079 $ 364,270 Short-term investments in marketable debt securities -291,392 174,21 2

Total cash and short-term investments 550,471 538,482 Accounts receivable, net of allowances 369,508 382,93 3 Current portion of notes receivable 1,489 - 1,479 Inventories, net of reserves 236,299 199,625 Assets held forsale. ... .,, 3,076 2,992 . Current net deferred income tax assets 51,355 50,204 Derivative financial instruments 1,822 9,46 3 Income taxes, net 11,119 - - Other current assets 80,349 72,47 1

Total current assets 1,305,488 1,257,64 9 Noncurrent investments in marketable debt securities 535,022 560,29 2 Property, plant, equipment and leasehold improvements, at cost : Land and buildings 358,223 366,27 5 Laboratory, production and office equipment 634,198 615,81 4 Leasehold improvements .'` 126,650 112,20 0 Construction-in-progress 156,005 144,16 2

1,275,070 1,238,45 1 Less accumulated depreciation and amortization (567,286) (548,701 )

Property,: plant, equipment and leasehold improvements, net 707,790 689,750 _- Purchased technologies, net 231,489 236,70 7 Goodwill" ': 801,837 787,587 . Other intangible assets, net 477,677 486,88 9 Investments : m: equity securities and-Affiliated companies 126,586 121,57 6 Equity method investments 867 95 3 Noncurrent notes receivable 7,500 7,50 0 Noncurrent derivative financial instruments - 7,39 1 Other noncurrent assets 42,621 38,87 5

$ 4,236,877 $ 4,195,16 9

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

3 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED BALANCE SHEETS (Continued )

(Unaudited )

(In thousands, except share data)

March 31, December 31, 2004 2003

LIABILITIES AND STOCKHOLDERS' EQUITY . Current liabilities : Accounts ; payable $ 11I,297 $ 102,20 1 Accrued compensation and related expenses 70,033 83,31 1 Current portion of capital .lease 441 570 Current portion of unearned revenue 52,950 47,87 3 Income taxes payable 15,270 Other current liabilities 163,109 187,68 8

Total current liabilities 397,830 436,91 3 Long-term debt 929,780 926,709 Capital lease 157,615 157,677 Noncurrent derivative financial instruments 2,460 - Noncurrent net. deferred income tax liabilities 110,863 107,496 Noncurrent unearned revenue 40,393 . 45,564 Other noncurrent liabilities 83,308° 69,448 Minority interest 7,877 7,002

Total liabilities 1,730,126 1,750,809

Commitments and contingencies Stockholders' equity : , Common stock 1,917 1,91 7 Additional paid-in capital 2,514,292 2,503,195 Deferred stock compensation (14,529) (12,871) . ...Accumulated de ficit (32,273) (46,634) Accumulated other comprehensive income 192,683 216,302 Treasury stocic, .at cost (3;008,000 shares at March 31 . 2004 and 4,567,000 shares at Decetltber. 31, 2003 ) (155,339) (217,549)

Total stockholders ' equity 2,506,751 2,444,36 0

$ 4,236,877 $ 4,195,169 . rr_rrrrrs

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

4 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

Three Months Ended March 31 ,

2004 200 3

Revenues : : Product sales, net $ 281,066 $ 218,620 Revenues from joint business arrangement 30,361 26,45 2 Collaborative agreement revenues 6,515 4,11 4 Royalty and license fee revenues 54,792 53,42 4 Other revenues 6,938 18,42 5

Totalrevenues 379,672 321,03 5

Operating expenses: Cost of sales 126,701 85,589 Research and development 98,410 82,13 0 Selling, general an d administrative 104,740 73,04 2 Amortization expense 21 ,332 7,61 3 Other operating expenses 2,116 1,69 1

Total operating expenses . 353,299 250,065

Income from operations . 26,373 70,970 Interest expense (5,925) (3,462 ) Interest and other income, net " 16,074 14,31 8 Minority interest (620) (400 ) income from continuing operations beforeincome taxes 35,902 81,42 6 Provision for income taxes 8,975 20,35 7

Income from continuing operahons 26,927 61,06 9 Gain from discontinued operations 12,845 1,42 6

Net income .'.. $ 39,772 $ 62,49 5 wwwwwrrr .n.r. r~~ Basic earnings per share : =income from continuing operations $ 0 .14 $ 0,3 3

Net income $ 0 .21 $ 0 .3 3

Diluted earnings per share : ' Income from continuing operations $ 0 .14 $ 0 .3 2 r+rr ~ ~

Net income ' $ 0 .21 $ 0 .3 3

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

5 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

(In thousands)

Three Months Ended M6rch 31 ,

26(14 2003

Net income $ 39,772 $ 62,495

Other comprehensive income (loss) : Change in foreign currency .transiation adjustment during the .period (21,628) 9,295

Unrealized gains (losses) from investments : Net unrealized holding gains (losses) arising : during the period, net of tax (provision) benefit of $(2,498) and $257 for the three . months ended March 31, 2004 and 2003, respectively 1,277 (443) Reclassification adjustment for net gains included in net income, net of tax provision o f $6,388 and $1,792 for the three months ended March 31, 2004 and 2003, respectively (3,268) (2,804)

Net unrealized.losses .f 6m investments (1,991) . (3,247)

Other comprehensive income (loss) (23,619) 6,048

Comprehensive income $' 16,153 S 68,543

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

6 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

Three Months Ended Ma rch 31 ,

2004 2003

Net cash provided by operating'acgvities $ 11,080 $ . 65,316

Cash flows from investing activities : Purchases of investments . in marketable debt secu rities: (202,899 ) (190,569) Proceeds from sales and maturities of investments in marketable debt secu rities 109,542 192,77 7 Capital expenditures (44,600) (33,891 ) Purchases of equity securities and interests in affiliated companies - (2,390) (1,440 ) Proceeds .from sale of equity securities and interests in a ffi liated companies 3,537 2,007 Cash paid for acquisitions , net of cash acquired (1,006) (205 ) Other, net .-'. (766) (51065 )

Net cash used in investing activities (138,582) (36,386 )

Cash flows from financing activities .. .. : Net repayment of short-term borrowings - (71 ) Repayment ofdebt and capital leases:' . (84) (22 ) Payments to acquire treasury stock (8,459) (37,084 ) Proceeds from reissuance of treasu ry stock 35,603 3,54 2 Proceeds from issuance of debt 973 - Proceeds from put options - 1,39 8

Net cash provided by (used in) fi nancing activities 28,033 (32,237)

Effect t fexchange ratechanges on cash ;and cash equivalents (5,722) 864- .

Net decrease in cash and cash equivalents (105,191) (2,443 ) Cash and cash equivalents at beginning of ti a period 364,270 247,95 0

Cash and cash equivalents at end of the period $ 259,079 $ 245,50 7 ~rrrtrrrrr~r ~rr~+r~t~

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement . 7

'~1 CHIRON CORPORATIO N

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENT S

March 31, 200 4

(Unaudited )

Note l-Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

The information presented in the Condensed Consolidated Financial Statements at March 31, 2004, and for the three months ended March 31, 2004 and 2003, is unaudited but includes adjustments, consisting only of all normal recurring adjustments, which Chiron Corporation believes to be necessary for fair presentation of the periods presented .

The Condensed Consolidated Balance Sheet amounts at December 31, 2003, have been derived from audited financial statements . Historically, Chiron's operating results have varied considerably from period to period due to the nature of Chiron's collaborative, royalty and license arrangements and the seasonality of certain vaccine products . In addition, the mix of products sold and the introduction of new products will affect comparability from quarter to quarter . As a consequence, Chiron's interim results in any one quarter are not necessarily indicative of results to be expected for a full year . This information should be read in conjunction with Chiron's audited Consolidated Financial Statements for the year ended December 31, 2003, which are included in the Annual Report o n Form 10-K filed by Chiron with the Securities and Exchange Commission ,

Principles of Consolidatio n

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

On July 8, 2003, Chiron acquired PowderJect Pharmaceuticals plc, a company based in Oxford, England that develops and commercializes vaccines . Chiron included PowderJect Pharmaceuticals' operating. results in its consolidated operating results beginning July 8, 2003 . PowderJect Pharmaceuticals is part of Chiron's vaccines segment. -

Chiron is a limited partner of several venture capital funds . Chiron is obligated to pay $60 .4 million over ten years in equity contributions to these venture capital funds, of which approximately $34.5 million was paid through March 31, 2004. Chiron accounts for these investments under the equity method of accounting.

Adoption of New A ccounting Pronouncements

Financial Accounting Standards Board (or FASB) Interpretation No . 46 (or FIN 46), "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No . 51" as revised, requires a variable interest entity (or VIE) to be consolidated by a company if that company absorbs a majority of the VIE's expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interest in the VIE. Prior to the adoption of FIN 46, VIES were generally consolidated by companies owning a majority voting interest in the VIE. The consolidation requirements of FIN 46 applied immediately to VIES created after January 31, 2003, however, the FASB deferred the effective date for VIEs created before February 1, 2003 to the quarter ended March 31, 2004 for calendar year companies . Adoption of the provisions of FIN 46 prior to the deferred effective date was permitted .

We adopted the remaining provisions of FIN 46 in the first quarter of 2004. The adoption of these provisions did not have a material effect on our Condensed Consolidated Financial Statements.

Use ofEstimates and Reclassifications

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

Chiron's blood-testing segment includes Chiron's one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc., a Johnson & Johnson company . Chiron accounts separately for research and development and manufacturing cost reimbursements and certain product sale revenues received from Ortho-Clinical Diagnostics, but relating to the joint business contractual arrangement . Chiron's joint business arrangement with Ortho-Clinical Diagnostics is a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the first quarter 2003, Chiron had accounted for revenues relating to Ortho-Clinical Diagnostics' non-U .S. affiliate sales on a.one-quarter lag, with an adjustment of the estimate to actual-in the subsequent quarter. More current information of Ortho-Clinical Diagnostics' non-U .S . affiliate sales became available in the first quarter 2003, and as a result, Chiron is able to recognize revenues relating to Ortho-Clinical Diagnostics' non-U .S. affiliate sales on a one-month lag . The effect of this change, net of tax, was an increase to net income by $3 .2 million for revenues from the joint business contractual arrangement for the three months ended . March 31, 2003 .

Chiron currently owns a facility in London, England for international operations . This facility became available for sale inthe fourth quarter of2003 and Chiron expects to complete the sale of this facility within one year of the date it became available for sale . Chiron has committed to a plan to sell this facility and is actively marketing this facility. This facility is classified as "Assets held for sale" in the Condensed Consolidated Balance Sheet at March 31, 2004 . Chiron, prior to filing its financial statements on Form l0-Q, publicly releases an unaudited condensed balance sheet and statement of operations . Between the date of Chiron's earnings release and the filing of Form l0-Q, reclassifications may be required. These reclassifications, when made, have no effect on income from continuing operations, net income or earnings per share. There has been no such reclassification in the first quarter of 2004 .

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

Inventories

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

Inventories, net of reserves, consisted of the following :

March 31, December 31, 2004 2003

. . : , Finished :goods ` . . .: . . . $ 37,488 S 38,640 Work-in-process 135,950 105,359 Raw materials .62,861 55,62 6

$ 236,299 $ 199,625 rrr~~ Income Taxes

The effective tax rate for the three months ended March 31, 2004 and 2003 was 25% of pretax income from continuing operations . The effective tax rate may be affected in future periods by changes in Chiron's estimates with respect to the deferred tax assets, acquisitions and other items affecting the overall tax rate.

Put Options

Chiron has, in the past, used written put options to reduce the effective costs of repurchasing its common stock . After expiration of existing put options in the second quarter of 2003, Chiron discontinued the use of put options . Chiron had no put options outstanding at March 31, 2004.

Stock-Based Compensatio n

Chiron measures compensation expense for its stock-based employee compensation plans using the intrinsic value method . Compensation expense. is based on the difference, if any, between the fair value of Chiron's common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant . This amount is recorded as "Deferred stock compensation" in the

a` ~a1 Condensed Consolidated Balance Sheets and amortized as a charge to operations over the vesting period of the applicable options or share rights. Compensation expense is included primarily in "Selling, general and administrative" in the Condensed Consolidated Statements of Operations .

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

Three Months Ended March 31 ,

2004 2003

(in thousands , except per share data )

Net income: As reported S 39,772 $ 62,49 5 Add : Stock based employee compensation expense included i n reported-net income;:neto€related tax effects 1,340 90 1 Less: Total stock-based employee compensation expense determine d under fair value based method for all awards, net of related tax effects 21,507 18,11 2

Pro forma $ 19,605 $ 45,284

Basic net income per share : As reported . . : $ .0.21- $ 0.3 3

Pro forma $ 0.10 $ 0 .24 • rrrrrrrr~ Diluted net zncome pershare : : As reported $ 0.21. $ 0 .3 3 ~wwwr rnrr nrarnrur

Pro forma $ 0 .10 $ 0 .2 4 rw ~~

Comprehensive Income

For the three months ended March 31, 2004 and 2003, the foreign currency translation component of comprehensive income was not adjusted for income taxes, as they relate to permanent investments in non-U.S . subsidiaries .

Treasury Stock

Treasury stock is stated at cost . Gains on reissuance of treasury stock are credited to "Additional paid-in capital ." Losses on reissuance of treasury stock are charged to "Additional paid-in capital" to the extent of available net gains on reissuance of treasury stock . Otherwise, losses are charged to "Accumulated deficit." For the three months ended March 31, 2004 and 2003, Chiron charged losses of $25 .4 million and $7 .5 million, respectively, to "Accumulated deficit" in the Condensed Consolidated Balance Sheets. For the three months ended March 31, 2004, Chiron did not repurchase any Chiron common stock . Chiron made payments of $8 .5 million in January 2004 for treasury stock repurchases recognized in December 2003 . In any period, cash used in financing activities related to common stock repurchases may differ from the comparable change in stockholders' equity, reflecting timing differences between the recognition of the share repurchase transactions and their cash settlement.

Note 2-Earnings Per Share

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

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

Three Months Ended March 31 ,

2004 2003

Iricome..(Numerator): Income from continuing operations $ 26,927 $ 61,06 9

Shares (Denominator);.F, ,, . . :„ .. : ..: . Weighted-average common shares outstanding 187,809 186,649 Effect of dilutive securities : . Stock options and equivalent s 4,190 3,03 8

.Weighted-average common shares outstanding, plus impact from assumed conversions' . : :..> ; 191,999 189,687

Basic earnings per share . $ 0 .14 $ 0 .33 ~~ nr Diluted earnings per share . . ... S - 0 .14 $ 0 .32

12 The following table sets forth the computai, . .,; for basic and diluted earnings per share on net income (in t, ._ _..,ands, except per share data) :

Three Months Ended March 31 ,

2004 2003

income (numerator) : Net income 5 39,772 S 62,495

Shares (Denominator) : Weighted- average common shares outstanding 187,809 186,649 Effect of dilutive securities - " .. Stock options and equivalents 4,190 3,03 8

Weighted-average common shares outstanding, plus impact from assumed conversions 191,999 189,687

Basic earnings per share $ 0 .21 $ 0 .33 ~rr .r r.r.~rri

Diluted earnings .per share $ 0 .21 $ 0 .33 rr~www~w w~w~

For the three months ended March 31, 2004 and 2003, stock options to purchase 7.0 million and 17 .3 million shares, respectively, with exercise prices greater than the average market prices of common stock, were excluded from the respective computations of diluted earnings per share as their inclusion would be antidilutive.

Excluded from the computations of diluted earnings per share for the three months ended March 31, 2004 and 2003, were 8 .5 million and 5 .2 million shares, respectively of common stock issuable upon conversion of the Liquid Yield Option Notes and 7 .3 million shares of common stock issuable upon conversion of the Convertible Debentures for the three months ended March 31, 2004, as their inclusion would be antidi lutive .

Note 3---Discontinued Operations

In a strategic effort to focus on its core businesses of blood-testing, vaccines and biophamtaceuticals, Chiron completed the sale of Chiron Diagnostics and Chiron Vision in 1998 and 1997, respectively .

In the first quarter of 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, Chiron was required to make a payment to Bayer during the first quarter 2003 . Pursuant to this settlement, Chiron recorded a charge, net of adjustment to its previously provided reserve for indemnity obligations, of 57 .6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of $1 .4 million, which was reported as a "Gain from discontinued operations" for the three months ended March 31, 2003 .

13 Chiron and Bayer also were involved in a separate dispute with respect to their respective rights to certain royalty refunds receivable for which a settlement was reached in 2004 . Under this settlement agreement, Chiron will make a payment to Bayer. This settlement includes an agreement that all outstanding items with Bayer related to the sale of Chiron Diagnostics are resolved an d no future indemnity obligations are required. Chiron released previously established reserves in excess of the required payments for the indemni ty obligations in the first quart er of 2004 . This sett lement resulted in a benefit of $0.3 million and an income tax benefit of $ 12 .5 million, resulting in a net gain of $12 .8 million, which was report ed as a "Gain from discontinued operations " for the three months ended March 31, 2004.

Note 4--Acquisitions

PowderJect Pharmaceuticals plc On July 8, 2003, Chiron acquired PowderJect Pharmaceuticals, a company based in Oxford, England that develops and commercializes vaccines . Chiron acquired all of the outstanding shares of common stock of PowderJect Pharmaceuticals for 550 pence per ordinary share, which, including estimated acquisition costs, resulted in a total preliminary purchase price of approximately $947 .8 million. Powderlect Pharmaceuticals is part of Chiron's vaccines segment. PowderJect Pharmaceuticals' products, including vaccines for influenza, expand Chiron's portfolio of vaccine products . Chiron accounted for the acquisition as a business combination and included PowderJect Pharmaceuticals' operating results in its consolidated operating results beginning July 8, 2003 .

The components of the preliminary purchase price, and the allocation thereof based on estimated fair values are summarized in the following table (in thousands) . Chiron is in the process of finalizing certain estimates ; thus both the purchase price and the allocation of the purchase price are subject to change . The preliminary purchase price and allocation reflect management's decision to cease operations at the Madison, Wisconsin facility and the Swedish facility . Chiron has accrued approximately $28 .1 million in estimated exit costs associated with these operations . These exit costs

7 are included in the estimated acquisition costs . in addition, Chiron is finalizing certain estimates associated with various other direct acquisition cost s

Consideration and acquisition costs: Cash paid for common stock S 831,02 6 Cash paid for options on common stock 59,15 3 Acquisition costs paid as of March 31, 2004 17,72 2 Acquisition costs not yet paid as of March 31, 2004 39,924

Total preliminary purchase price $ 947,82 5

Allocation of preliminary purchase price : Cash and c ash equivalents S 92,17 8 Short-term marketable securities . 8,840 Accounts receivable, net 42,73 2 Inventories 68,375 Property, plant and equipment 64,59 9 Goodwill 502,96 1 Acquired intangible assets 335,500 Other assets 6,36 1 Income taxes payable (17,741 ) Current liabilities ( 61,465) Net deferred tax liability (60,170) ,.Long-term liabilities (79,645) Purchased in-process research and development 45,300

Total preliminary purchase price $ 947,825

Chiron allocated the preliminary purchase price based on the fair value of the assets acquired and liabilities assumed . Chiron allocated a portion of the purchase price to purchased in-process research and development, which it charged to earnings in 2003_ Purchased in-process research and development represented thevaluation of acquired, to-be-completed research projects . Purchased in-process research and development was determined using the income approach, which is based on the premise that the value of a security or asset is the present value of the future earning capacity that is available for distribution to the subject investors in the security or asset . In valuing the purchased in-process research and development, Chiron used probability-of-success-adjusted cash flows and a 14% discount rate . Cash flows from projects including those relating to (i) certain travel vaccines and (ii) vaccines for allergies were assumed to commence between 2004 and 2012 . Given the high risk associated with the development of new drugs, Chiron probability adjusted the revenue and expense forecasts to reflect the risk of advancement through the regulatory approval process based on the stage of development in the regulatory process . Such a valuation requires significant estimates and assumptions. Chiron believes that the fair value assigned to purchased in-process research and development is based on reasonable assumptions . However, these assumptions may be incomplete or inaccurate, and unanticipated events

1 5

1 and circumstances may occur. To assist in determining the value of the purchased in-process research and development, a third-party valuation was obtained as of the acquisition date ,

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

Income taxes payable of $17 .7 million relates to current tax liabilities associated with PowderJect Pharmaceuticals at the date of acquisition. The net deferred tax liability of $60 .2 million is comprised of current and non-current deferred tax assets of $40 .5 million primarily related to net operating losses incurred from April 1, 2003 through the acquisition date, reserves and depreciation timing differences and a non-current deferred tax liability of $100 .7 million related to acquired intangibles.

Chiron paid $1 .0 million, which was previously accrued, related to acquisition costs for PowderJect Pharmaceuticals for the three months ended March 31, 2004. Chiron paid $0 .2 million related acquisition costs for Matrix Pharmaceutical for the three months ended March 31, 2003 . These payments are reflected in the Condensed Consolidated Statement of Cash Flows as a component of "Cash paid for acquisitions, net of cash acquired" for the three months ended March 31, 2004 and 2003 .

16 Note 5-Intangible Assets

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

March 31, 2004 December 31, 200 3

Gross Gross Carrying Accumulated Net Carrying Carrying Accumulated Net Carryin g Value Amortization Value Value Amortization Value

Purchased technologies $ 332,377 :$ ` 100,888 $ 231,489 $ 332,543 . :$. .. 95836 $ 236,707

Patents $ 121,735 $ 63,887 $ 57,848 $ 119,675 $ 61,747 5 57,92 8 Trademarks 60,164 20,974 .39,190" 6.1 ;082 20,507 40,575 Licenses and technology rights 48,740 30,259 18,481 49,087 27,818 21,269 . Developed . product technologies 356,979 _ : . 35,606 321,373 347,233 . .. . 23,093 324,140 Customer relationships 28,092 10,067 18,025 28,824 9,952 18,87 2 Know how(l) . .12,758 : 6;100 6,658 13,090 6,023 7;067 Databases. . 7,100 . . -1,65: . . 7 5,443 . 7,100 1,538 5,562 Other . 26,282 ; 15;623 10,659 26,328 1 4,8 5 2 i 1,476

Total other intangible assets S 661,850 S 184,173 477,677 $ 652,419 $ 165,530 $ 486,88 9

Total intangible assets subject to amoitizatioti $ .994,227 '$ :. 285,061 $ . .: . ..709,166 $ 984,962 1 261,366 : 5 723,59 6

(1 j

Upon acquisition of a 100% interest in Chiron Behring by the second quarter 1998, Chiron acquired a portfolio of products that were created b y Behring and are currently being sold internationally. These products embody Chiron Behring's proprietary "know-how" consisting of unpatented technology and trade secrets . Since the unpatented technology and trade secrets meet the separability criterion, Chiron has recognized the m collectively at a separate intangible asset apart from goodwill in accordance with SFAS No . 14 1, "Business Combinations" .

Aggregate amortization expense is as follows (in thousands) :

For the three months ended March 31,2004 (reported) ` .. $ 23,264 For the remaining nine months in the year ended December 31, 2004 (estimated) 67,02 1

For the year ended December 31 ;:2004 (estimated) $ 90,28 5 For the year ended December 31, 2005 (estimated ) $ 89,45 7 For the year ended December 31, 2006 (estimated) $ 93,90 4 For the year ended December 31, 2007 (estimated ) $ 91,74 9 For the year ended December :31, 2008 (estimated) . $ 67,13 3 For the year ended December 31, 2009 (estimated) $ 43,20 1 17 The changes in the carrying value of gooah .., by reporting unit consisted of the following (in thousands) :

Biopharmaceuticals Vaccines Total

Balance as of December 31, 2003 $ 187;492 S 600,095 787;58 7 Effect of exchange rate changes - 14,250 14,250

Balance a, of March"31, 2004 .;. $ 187,492 $ ` - 614;345 S 801,837 ter. ~~ Note 6--Segment Information

Chiron is organized based on the products and services that it offers. Under this organizational structure, there are three reportable segments : (i) blood-testing, (ii) vaccines and (iii) biopharmaceuticals . The blood-testing segment consists of an alliance with Gen-Probe Incorporated and Chiron's one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho--Clinical Diagnostics, Inc ., a Johnson & Johnson company . Chiron's alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection. Chiron's joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint busiriess contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . The vaccines segment consists principally of adult and pediatric vaccines for viral and bacterial infections. Chiron sells these vaccines in the U .S ., Germany, Italy, the United Kingdom and other international markets. The vaccines segment is also involved in the development of novel vaccines and vaccination technology . The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases, using the development and acquisition of technologies related to therapeutic proteins and small molecules. .

The accounting policies of Chiron's reportable segments are the same as those described in Note 1-Basis of Presentation and Summary of Significant Accounting Policies above and in Chiron's Annual Report on Form 10-K for the year ended December 31, 2003 . Chiron evaluates the performance of its segments based on each segment's income (loss) from continuing operations .

18 The following segment information excludes all signific ant intersegment transactions as these transactions are eliminated for management reportin g purposes (in thousands) :

Three Months Ended March 31 ,

2004 200 3

Revenues Blood-testing : Product sales , net. Procleix ® System $ 61,886 $ 42,12 3 Oithv-Clinical Diagnostics 6,234 6,408

Total product sales, net 68 ,120 48,53 1 Revenues from joint business arrangement 30,361 26,45 2 Collaborative agreement revenues 2,064 1,94 9 Royalty and license .fee revenues ,16,434 ..; .,. :: . 15,636. . Other revenues 195 -

Total blood-testing revenues 117,174 92,568. Vaccines : Product sales, net. Influenza vaccines 7,705 4,25 3 Meu3ugafe® 4549 7,53 8 Travel vaccines 23,010 25,70 0 Pediatric and other vaccines 51,182 30,91 3

Total product sales, net 86,446 68,404 'Collaborative .agreement revenues 3,96 6 Royalty and license fee revenues 2,650 3,18 5 Other revenues 3,643 2,741 .

Total vaccines revenues 96,705 74,382 Biopharmaceuticals : Product sales, net : Betaserone 30,136 29,300 TOBI® 52,524 40,734 Proleukin® 31,868 25,483' Other 11,972 5,668

Total product sales, net 126,500 101,685 Collaborative agreement revenues 485 2,163 Royaltyandlicense fee revenues. 17,297 17,81 7 Other re venues 3,100 15,63 4

Total biopharmaceuticals revenues 147,382 137,299 Other: Royalty "d license'fee revenues 18,411 16,78 6

Total revenues $ 379,672 $ 321,03 5

i i

19 Income (Joss) from continuing operation s Blood-testing $ 63,640 $ 50,54 2 Vaccines ` (50,039) (5 302) Biopharmaceuticals 19,249 24,94 3 Other (6,477) 76 7

Segment income from 26,373 70,97 0 operations Interest expense (5,925) (3,462) Interest and other income, 16,074 14,31 8 net Minority interest ., (620) (400)

Income from continuing $ 35,902 $ 81,42 6 operations before income taxe s

Note 7-Debt Obligations

In June 2001, Chiron issued zero coupon Liquid Yield Option Notes (LYONS) with a face value of $730 .0 million and a yield to maturity of 2 .0% . The LYONs are carried net of an original issue discount of $328 .2 million, which is being accreted to interest expense over the life of the LYONs .using the effective interest method . No beneficial conversion feature existed at the time of the issuance of the LYONs . The LYONs mature on June 12, 203 1, at a face value of $1,000 per note. The LYONs are uncollateralized and unsubordinated, and rank equal in right of payment to Chiron's existing and future uncollateralized and unsubordinated indebtedness .

Beginning on June 12, 2004 and continuing through June 12, 2006, the holder may receive contingent additional principal if Chiron 's stock price falls below the threshold specified in the indenture . The contingent additional principal is based on two factors: Chiron's stock price and Chiron's senior debt rate. Based on Chiron's senior debt rate of 3 .15% at March 31, 2004, if Chiron's average closing stock price for 20 consecutive trading days ending on the third trading day prior to June 12, 2004 was below $41 .61 Chiron would become obligated to pay contingent additional principal. The contingent additional principal will replace the original issue discount and bear an effective yield of 2 .0 to 9 .0% per year for the two-year period . After June 12, 2006, the original issue discount will continue to accrue at 2.0% per year.

Beginning after June 12, 2006, the holder may receive contingent cash interest during any six-month period if the average market price of the LYONs is greater than or equal to the threshold specified in the indenture . The contingent cash interest in respect of any quarterly period will equal 0 .0625% of the average market price of a LYON for a five trading day measurement period preceding the applicable six-month period .

20 1 At the option of the holder , Chiron may be re quired to purchase all, or a portion, of the LYONs on the following dates at the following prices for each note with face value of S1,000 :

Date Pric e

June 12,2004- : $ . 584.31 June 12, 2006 S 608.04 June 12 , 2011 : ' ; - 671 :65 June 12, 2016 $ 741 .92 June :12;2021` . . $ 819 :54 June 12, 2026 $ 905 .2 9 The purchase prices would increase for any accrued contingent additional principal and accrued original issue discount thereon . If the holders require Chiron to purchase all, or a portion, of the LYONs, Chiron may choose to pay the purchase price in cash, Chiron common shares, or any combination of the two . Given Chiron's ability to pay the purchase price in Chiron's common shares, the LYONs continue to be classified as long-term liabilities as of March 31, 2004 .

Holders may convert the LYONs at any time on or before the maturity date . For each LYON converted, the holder will receive 7.1613 shares of Chiron common stock . Any accrued original discount, contingent additional principal and unpaid contingent cash interest are ineligible for conversion .

Upon a change in control of Chiron occurring on or before June 12, 2006, each holder may require Chiron to purchase all or a portion of such holder's LYONs for cash at a price equal to 100% of the issue price for such LYONs plus any accrued original issue discount and contingent additional principal (and accrued original issue discount thereon) to the date of purchase . The change in control definition allows Novartis to acquire beneficial ownership of up to 79-9% of Chiron's common stock without triggering a change in control for purposes of the LYONs .

Chiron may redeem all or a portion of the LYONs for cash at any time after June 12, 2006, at specified redemption prices .

Note 8-Commitments and Contingencies

In November 2003, Chiron's Board of Directors approved $50 .7 million in expenditures for a 25-year lease for buildings and $42 .2 million for capital improvements, both of which are part of a $97 .0 million project for a new flu vaccines manufacturing facility in Liverpool, England . The new manufacturing facility will replace existing flu vaccines manufacturing facilities in Liverpool, England . In December 2003, Chiron entered into a 25-year lease for these buildings . As of March 31, 2004, Chiron has incurred $3 .9 million for these capital improvements.

In April 2001, Chiron entered into a collaboration with Rhein Biotech N .V. (now part of Bema Biotech) and GreenCross Vaccine Corporation to research and develop certain pediatric combination vaccine products for sale outside of Europe and North America. The collaboration agreement requires capital commitments from Chiron, Berna Biotech and GreenCross Vaccine . Chiron's commitment is

21 approximately 26.4 million Euro ($32 .2 million) for the expansion of Chiron's Italian manufacturing facilities, of which Chiron had incurred costs of 19 .1 million Euro ($23 .3 million) as of March 31, 2004 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008 .

In March 2004, Chiron entered into a worldwide, exclusive, multi-product, collaborative arrangement with XOMA Ltd . for the development and commercialization of antibody products for the treatment of cancer . Under the terms of the arrangement, the parties agreed to jointly research, develop, and commercialize multiple antibody product candidates . Under the arrangement, the parties agreed to share development and commercialization expenses, including preclinical and clinical development, manufacturing and worldwide marketing costs, as well as revenues, generally on a 70-30 basis, with Chiron's share being 70% and XOMA's share being 30% . Chiron agreed to make an initial payment of $10.0 million, of which we have paid $5 .0 million as of March 31, 2004, and to make a loan facility of up to $50 .0 million available to XOMA, starting on January 1, 2005 to fund XOMA's share of development expenses . The collaboration will initially focus on preclinical, process development and scale up work, with a potential Investigative New Drug ([ND) filing anticipated early in the collaboration .

Chiron is subject to indemnification provisions under its agreements with other companies in its ordinary course of business, typically with business partners, contractors, clinical sites, insurers and customers . Under these provisions, Chiron generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of Chiron's activities . These indemnification provisions generally survive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Chiron could be required to make under these indemnification provisions is unlimited . The estimated fair value of the indemnity obligations of these agreements is minimal . Accordingly, Chiron has no liabilities recorded for these agreements as of March 31, 2004 . Chiron has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreements .

Chiron is party to various claims, investigations and legal proceedings arising in the ordinary course of business . These claims, investigations and legal proceedings relate to intellectual property rights, contractual rights and obligations, employment matters, claims of product liability and other issues . While there is no assurance that an adverse determination of any of such [clatters could not have a material adverse impact in any future period, management does not believe, based upon information known to it, that the final resolution of any of these matters will have a material adverse effect upon Chiron's consolidated financial position and results of operations or cash flows .

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

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

Overview

This 10-Q contains forward-looking statements regarding our expectations, hopes or intentions regarding the future, including statements relating to sales growth, product development initiatives, new product marketing ; acquisitions, competition, in - and out-licensing activities and expected cost savings that involve risks and uncertainties and are subject to change . You should read the discussion below in conjunction with Part 1, Item 1 ., "Financial Statements, " of this 10-Q and Part If, Items T; 7A . and 8., "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures About Market Risk" and "Financial Statements and Supplementary Data, " respectively, of our Annual Report an Form 10-K for the year ended December 31, 2003. The forward-looking statements contained in this l0-Q reflect our current beliefs and expectations on the date of this 10-Q . Actual results, performance or outcomes may dyer from current expectations. Our actual performance may differ from current expectations due to many factors. including the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, stock-price and interest-rate volatility, and marketing effectiveness . In particular, there can be no assurance that we will increase sales of existing products, successfully - develop and receive approval to market new products, or achieve market acceptance for such new products . There can be no assurance that our out-licensing activity will generate significant revenue, or that our in-licensing activities willfully protect us from claims of infringement by third parties . In addition, we may engage in business opportunities, the successful completion of which is subject to certain risks, including stockholder and regulatory approvals and the integration of operations. We have discussed the important factors, which we believe could cause actual results to differ from what is expressed in the forward-looking statements, under the caption "Factors That May Affect Future Results" in this 10--Q. Consistent with SEC Regulation FD, we do not undertake an obligation to update theforward-looking information contained in this 10-Q.

We are a global pharmaceutical company that participates in three healthcare markets : blood testing, vaccines and biopharmaceuticals . Our revenues consist of product sales, revenues from a joint business contractual arrangement, collaborative agreement revenues, royalty and license fee revenues and other revenues, primarily consisting of contract manufacturing and grant revenues .

The blood-testing segment consists of an alliance with Gen-Probe incorporated and our one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our alliance with Gen-Probe is focused on- developing and commercializing nucleic acid testing products using transcription-mediated amplification technology to screen donated blood and plasma products for vital infection. Our joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity. Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and. retrovituses and provide supplemental .tests and microplate and chemiluminescent instrument systems to automate test performance and data collection.

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

The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases . Our in-house capabilities span three types of therapeutics, including small molecules, therapeutic proteins and monoclonal antibodies . Th e

2 3

i biopharmaceuticals segment also includes collaborations with Berlex Laboratories, Inc, and its parent company, Schering AG of Germany, related to BctaseronO interferon beta-1 b . We view certain other revenues and expenses as not belonging to any one segment. As a result, we have aggregated these items into an "Other" segment .

On July 8, 2003, we acquired PowderJect Pharmaceuticals plc, a company based in Oxford, England that develops and commercializes vaccines . We accounted for the acquisition of this business under the purchase method of accounting and included PowderJect Pharmaceuticals' operating results in our consolidated operating results beginning July 8, 2003 . PowderJect Pharmaceuticals is part of our vaccines segment .

For the three months ended March 31, 2004, our income from continuing operations was $26 .9 million, or $0 .14 per diluted share compared to $6 1 .1 million or $0.32 per diluted share for the three months ended March 31, 2003 . The decline was primarily due to (i) the seasonal impact of the PowderJect acquisition, which has flu sales primarily in the second half of the year ; however, costs associated with Powderject are incurred throughout the year, (ii) the decline in the Betaseron royalty rate and (iii) amortization expense from intangible assets associated with the acquisition of PowderJect, For the three months ended Match 31, 2004, total revenues were $379.7 million compared to $321 .0 million for the three months ended March 31, 2003 . For the three months ended March 31, 2004, product sales were $281 .1 million compared to $218.6 million for the three months ended March 31,-2003 .Our total revenues were affected by the movement in exchange rates, in particular the movements in the Euro and British Pound against the U .S . dollar. For the three months ended March 31, 2004, the movement in exchange rates added approximately 5% to our total revenues . However, since our Euro and British Pound expenses have also increas ed due to the movement in exchange rates, our earnings per share from continuing operations declined $0 .01 per diluted share due to movement in exchange rates .

For the three months ended March 31, 2004, increases in product sales were seen across all three of our business units, and in particular Procleix8 products, TOBI® tobramycin and pediatric and other vaccines . Revenues from joint business arrangements, royalty and license fees, collaborative agreement revenues and other revenues were $98 .6 million for the three months ended March 31, 2004 compared to $102.4 million for the three months ended March 31,-2003 . There were increases primarily related to increased profitability of the joint business arrangement, increased revenues fol lowingour acquisition of PowderJect and the timing of contract manufacturing activities . These increases were offset by the favorable effect of the Mogen and Seronosettlements in connection with the McCormick patents owned by Schering's U .S. subsidiary, Betlex reported in the three months ended March 31, 2003 .

For the three months ended March 31, 2004, gross margins decreased to 55% from 61% in the three months ended March 31, 2003, largely due to (i)"the addition of PowderJect facilities, a portion of which traditionally is not in flu production for a significant part of the first quarter, (ii) the product mix reflected the shift of the traditionally high margin tick-borne encephalitis vaccines sales to the fourth quarter 2003 and (iii) the reduction in the royalty rate related to - 13etaseron®.

For the three months ended March 31, 2004, research and development expenses totaled $98 .4 million, compared to $82 .1 million for the three months ended March 31, 2003 . Research and development expenses for PowderJect Pharmaceuticals were $6 .8 million for the three months ended March 31, 2004. Excluding PowderJect, the main beneficiaries of this increase, include our meningococcal vaccines franchise, our flu cell culture program, tifacogin, cyclosporine solution for inhalation, and a dry powder formulation of inhaled TOBI® . These increases were partially offset by decreases due to transfer of responsibility for the SILCAAT trial, discontinuance of development of PA-2794 and lower costs related to the development of new manufacturing processes for Betaseron &

For the three months ended March 31, 2004, selling, general and administrative expenses totaled $104 .7 million compared to $73 .0 million for the three months ended March 31, 2003 with PowderJect -

24 -

i`„ Pharmaceuticals contributing approximately $10.6 million for the three months ended March 31, 2004 . The remaining increase in selling, general and administrative expenses resulted from additional costs associated with headcount, increased facility costs, higher depreciation expense related to information systems, the Euro to U .S . Dollar exchange rate change and ongoing sales and marketing programs .

The effective tax rate for the three months ended March 31, 2004 and 2003 was 25% of pretax income from continuing operations .

Critical Accounting Policies and The Use of Estimates

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

Our blood-testing segment includes our one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ottho-Clinical Diagnostics, Inc ., a Johnson & Johnson company. Our joint business arrangement with Ortho-Clinical Diagnostics is a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses-and provide supplemental tests and microplate'and chemiluminescent instrument systems to automate test performance and data collection . Prior to 2003, we had accounted for revenues relating to non-U.S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter. More current information of non-U . S . affiliate sales of our joint business contractual arrangement became available for the three months ended March 31, 2003, and as a result, we are able to recognize revenues relating to non-U .S . affiliate sales on a . . one-month lag . The effect of this change, net of tax, was an increase to net income by .$3 .2 million for revenues from the joint business arrangement for the three months ended March 31, 2003 ,

Our critical accounting policies, which incorporate our more significant judgments and estimates usedin the preparation of our Condensed Consolidated Financial Statements are the same as those described in Part 11, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Chiron's Annual Report on Form 10-K for the year ended December 31, 2003 . -

Results of Operations

Blood-testing

Product sa fes Our blood-testing segment recognized product sales of $68 .I million and 348 .5 million for the three months ended March 31, 2004 and 2003, respectively . - - -

Procleix® System On February 27, 2002, the U.S . Food and Drug Administration approved the ProcleixO HIV--II HCV Assay . Under a collaboration agreement with Gen-Probe incorporated, we market and sell the ProcleixO HIV-1I HCV Assay and the related instrument system . In addition to selling directly in the U.S ., we also sell in various European and Asia / Pacific markets, directly and through distributors . We record revenue based upon the reported results obtained fromthe customer

25 from the use of assays to screen donations or upon sale and delivery of the assays, depending on the underlying contract . In the case of equipment sales or leases, we record revenue upon the sale and transfer of the title of the instrument or ratably over the life of the lease term, respectively . For the provision of service on the instruments, we recognize revenue ratably over the life of the service agreement .

Worldwide product sales related to tests, instruments and the provision of services were $61 . 9 million and $ 42 .1 million for the three months ended March 31 , 2004 and 2003, respectively . The increase in product sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to (i) the introduction of the West Nile virus assay on an investigational-use basis in the U .S. and (ii ) market share gains in the U .S . and continued penetration into several markets abroad for the Procleix ® HIV-l/ HCV Assay . In March 2003, the U .S . Food and Drug Administration accepted an investigational new drug ( IND) for the West Nile virus assay . The new assay runs on the same instrumentation platform as the currently approved Procleix® HIV - l/HCV assay .

Ortho-Clinical Diagnostics Under our joint business contractual arrangement with Ortho-Clinical Diagnostics , Inc., we manufacture bulk reagents and antigens and confirmatory test kits for immunodiagnostic products . We recognized product sales under this arrangement of $6 .2 million and $ 6 .4 million for the three months ended March 31, 2004 and 2003, respectively. The decrease for the three months ended March 31, 2004 as comp ared with the three months ended March 31, 2003, primarily related to the timing of manufactu ring services under the arrangement . We also supply bulk antigens for Ortho-Clinical Diagnostics to be included in products to be sold by Bayer under a June 2001 agreement with Ortho-Clinical Diagnostics and Bayer Corporation (see also "Royal ty and license fee revenues-Bayer" below) .

We expect competitive pressures related to our blood .testing,products to continue, primarily as a result ofthe introduction of competing products into the market, as listed in Part I, Item 1 . "Business-Competition" of our Annual Report on Form 10-K for the year ended December 31, 2003 .

Revenues from joint business arrangement Revenues from our joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc. was $30.4 million and $26 .5 million for the three months ended March 31, 2004 and 2003, respectively . The increase in revenues from our joint business arrangement for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily resulted from (i) higher profits from Ortho-Clinical Diagnostics' U.S . operations driven by manufacturing efficiencies and (ii) a positive adjustment of the fourth quarter 2003 estimate of revenue to actual results . These increases are offset by a one-time benefit for the three months ended March 31, 2003 due to a change in estimate from a three-month lag to a one-month lag relating to the Ortho-Clinical Diagnostics, Inc .'s non-U.S. affiliate sales .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Under the Ortho-Clinical Diagnostics, Inc . joint business arrangement, we conduct research and development services related to immunodiagnostic products . Our blood-testing segment recognized total collaborative agreement revenues of $2 .1 million and $1 .9 million for the three months ended March 31, 2004 and 2003, respectively . The majority of collaborative agreement revenues recognized by our blood-testing segment related to immonodiagnostic products . The fluctuations between the three months ended March 31, 2004 and the three months ended March 31, 2003 primarily related to the timing of research services. -

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under revenues results in ly collaboration and the achievement of milestones . Due to the nature of our collaborative agreement , any one period are not necessari ; indicative of results to be achieved in the future . Our ability to generate additional collaborative . 11

26 agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners .

Royalty and license fee revenues Our blood-testing segment earns royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing our hepatitis C virus and HIV-related patents, for use in the blood screening and plasma fractionation markets . Our blood-testing segment also earns license fees related to our hepatitis C virus and HIV-related patents for technologies used by third parties to develop products for use in the blood screening and plasma fractionation markets . The blood-testing segment recognized royalty and license fee revenues of $16 .4 million and $15 .6 million for the three months ended March 31, 2004 and 2003, respectively .

F. Hoffmann-La Roche settlement In October 2000, we entered into three license agreements with F. Hoffmann-La Roche Limited and several of its affiliated companies related to the settlement of certain litigation in the U .S . and certain other countries for the use of our hepatitis C virus and HIV intellectual property. Two agreements relate to in vitro diagnostic products . See "Other~Royalty and license fee revenues" below. The third agreement for blood screening was superseded in May 2001 by two new agreements, one for each of hepatitis C virus and HIV . Revenues under these agreements were $15 .1 million and $14 .4 million for the three months ended March 31, 2004 and 2003, respectively . The increase for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 related to a positive adjustment of the fourth quarter 2003 estimate to actual results . Under these new agreements, royalties continue through the lives of the hepatitis C virus and HIV-related patents covering F . Hoffmann-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents begin to expire in 2015 for the U .S . and in 2010 for Europe. Currently, the applicable issued HIV-related patent in Europe expires in 2005 . An HIV-related patent was issued in the U.S . on March 13, 2003 . This patent will expire seventeen years from the date of issuance . As permitted under the terms of its licensing agreement, F . Hoffmann-La Roche has decided to institute arbitration proceedings . in regard to the . application of the U .S . patent . During any pending arbitration proceedings, F. Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by us if it is determined in the arbitration that such royalty payments were not due .

Bayer In June 2001 Chiron and Ortho-Clinical Diagnostics, Inc . entered into an agreement with Bayer Corporation for the clinical diagnostic market . Under this agreement, Bayer manufactures and sells certain of Ortho-Clinical Diagnostics' hepatitis C virus and HIV immunodiagnostic products for use on Bayer's instrument platforms . Bayer paid us a license fee of $45 .3 million, which we deferred (due to our continuing manufacturing obligations) and began recognizing as revenue in the third quarter 2001 . We will recognize the remaining amount ratably through 2010 .

Royalty and license fee revenues may fluctuate based on the nature of the related agreements and the timing of receipt of license fees . Results in any one period are not necessarily indicative of results to be achieved in the future . In addition, our ability to generate additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies . We have no assurance that we will be able to do so. or that future royalty and license fee revenues will not decline.

Gross profit Blood-testing gross profit as a percentage of net product sales was 43 % and 40% for the three months ended March 31, 2004 and 2003, March 31, respectively . The increase in .blood-testing gross profit margin for the three months ended March 31, 2004 as compared with the three months ended 2003 was driven by an amendment in November 2003 to the worldwide blood screening collaboration agreement between Chiron and Gen- Probe Incorporated in order to adopt permanent, fixed revenue shares for each party . Effective January 1 ; 2004 , Gen-Probe 's share was set at 45 .75% of net revenues for assays, which include a test for the hepatitis C virus . For commercial assays, which do

27 not test for hepatitis C virus, such as the West Nile test, the agreement remains unchanged with each party retaining 50% of the net revenues after deduction of appropriate expenses.

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

Research and development Our blood-testing segment recognized research and development expenses of $5.1 million and $5.2 million for the three months ended March 31, 2004 and 2003, respectively . The research and development spending for both periods related to the continued development of nucleic acid testing products and activities under the Ortho-Clinical Diagnostics joint business arrangement .

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

Selling, general, and administrative Our blood-testing segment recognized selling, general and administrative expenses of $9 .3 million and $7 .9 million for the three months ended March 31, 2004 and 2003, respectively . The increased selling, general and administrative expenses for the three months ende d March 31, 2004 as compared with the three months ended March 31, 2003 related to increased headcount to support the expansion of our customer base for the Procleix® HIV-1/HCV Assay in the U .S., Europe and other international markets .

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

Vaccines

Product sales We sell flu, meningococcal, travel, pediatric, and other vaccines in the U.S., Germany, Italy and the United Kingdom, as well as in other international markets . Vaccine product sales were $86 .4 million and $68 .4 million for the three months ended March 31, 2004 and 2003, respectively . .

Sales of our flu vaccines were $7.7 million and $4 .3 million for the three months ended March 31, 2004 and 2003, respectively . Flu vaccines sales increased for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily as a result of additional sales of flu vaccine products following our third quarter 2003 acquisition of PowderJect Pharmaceuticals. . PowderJect Pharmaceuticals flu vaccine sales were $2.4 million for the three months ended March 31, 2004 . Excluding PowderJect Pharmaceuticals, sales of our remaining flu vaccines increased primarily as a result of additional sales to Argentina and the benefit of the movement in the Euro to U.S. Dollar exchange rate .

Menjugate®, our conjugate vaccine against meningococcal infection caused by the bacterium N. meningitidis serogroup C, sales were $4.5 million an d $7 .5 million for the three months ended March 31, 2004 and 2003, respectively. The decrease in Menjugate(P sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 was primarily driven by the timing of outbreaks and vaccination programs in Ireland, France and Italy ..

Sales of our travel vaccines, comprised of tick-borne encephalitis, rabies vaccines and two products . we obtained as part of our third quarter 200 3 acquisition of PowderJect Pharmaceuticals, ArilvaxTM and DukoralT^', were $23 .0 million and $25 .7 million for the three months ended March 31, 2004 and i 2003, respectively . The decrease in travel vaccines sales for the three months ended March 31,2004 as compared with the three months ended March 31, 200 3 was primarily related to a portion of tick-borne encephalitis vaccine sales shifted from the first quarter 2004 to the fourth quarter 2003 due to customer demand, that are typically sold in the first half of the year, offset by (i) increased demand in Asia and

if. ~i the U .S . for our rabies vaccine, (ii) the benefit of the movement in the Euro to U .S . dollar exchange rate and (iii) additional sales of travel vaccine products following our acquisition of PowderJect Pharmaceuticals .

Sales of our pediatric and other vaccines were $51 .2 million and $30 .9 million for the three months ended March 31, 2004 and 2003, respectively . The increase in pediatric and other vaccines sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 was primarily due to the timing of tender sales for our polio vaccines and diphtheria, tetanus and pertussis vaccines and increased sales following our acquisition of PowderJect Pharmaceuticals .

.Certain of our vaccine products are seasonal, particularly our flu vaccines, which have higher sales primarily in the second half of the year. In addition, we expect Menjugate® sales to continue to fluctuate as public health authorities consider adoption of broad vaccination programs .

We expect competitive pressures related to many of our vaccine products to continue into the future, primarily as a result of the introduction of competing products into the market , including, but not limited to, new combination vaccines, as listed in Part 1, Item L, "Business-Competition" of our Annual Report on Ponn IO--K for the year ended December 31, 2003 .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones. Our vaccines segment recognized collaborative agreement revenues of $4 .0 million for the three months ended March 31, 2004 primarily related to an agreement to supply a vaccine for meningoococcal meningitis caused by the bacterium N . meningitidis serogroup B to the Ministry of Health in New Zealand and increased collaborative agreement revenues following our acquisition of PowderJect Pharmaceuticals.

Royalty and . license fee revenues Our vaccines segment earns royalties . on third party sales of, and license fees on, several . products . The vaccines segment recognized royalty and license fee revenues of $2 .7 million and $3 .2 million for the three months ended March 31, 2004 and 2003, respectively .

G1axoSmithKline An agreement with GlaxoSmiihKline plc provides for royalties on sales of certain vaccine products . Under this agreement, we recognized $1 .9 million and $1 .8 million of such royalties for the three months ended March 31, 2004 and 2003, respectively .

Other We recognized $0.4 million and $1 .4 million .for the three months ended: March 31, 2004 and 2003, respectively, of royalty revenues primarily on third party sales of hepatitis B virus-vaccine products . The decline . is primarily related to royalties associated with a hepatitis B virus contract that ended in 2003, ;.

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

Royalty and license fee revenues may, fluctuate based on the nature of the related agreements, the timing of receipt of license fees and the expiration of patents. Results in any one period are not necessarily indicative of results to be achieved in the future . In addition, our ability to generat e 29 additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies .

Other revenues Our vaccines segment recognized other .revenues o€ $3 .6 million and $2 .8 million for the three months ended March 31, 2004 and 2003, respectively .

Grant and contract revenues Our vaccines segment other revenues included grant and contract revenues of $2 .9 million and $2.2 million for the three months ended March 31, 2004 and 2003, respectively. We have entered into a series of agreements with the U.S . National institutes of Health to advance our HIV vaccine program into human clinical trials . We recognized grant and contract revenues under these arrangements of $2 .4 million and $1 .8 million for the three. months ended March 31, 2004 and 2003, respectively .

The balance of other revenues consisted of various other agreements , which individually we re not material .

Other revenues recognized in our vaccines segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues .

Gross profit Vaccines gross profit as a percentage of net product sales was 33% and 49% for the three months ended March 31, 2004 and 2003, respectively . The decrease in gross profit margins for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 relate to the addition of PowderJect facilities, a portion of which traditionally is not in flu production for a significant part of the first quarter. In addition, the product mix reflected the shift of the traditionally high margin tick-borne encephalitis vaccines sates from the first quarter of 2004 to the fourth quarter 2003 .

Vaccines gross profit percentages may fluctuate significantly in future periods due to product and customer mix, seasonality and ordering patterns and production yields .

Research and development Our vaccines segment recognized research and development expenses of $34 .4 million and $20 .6 million for the three months ended March 31, 2004 and 2003, respectively . The increase in research and development spending for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 resulted mainly from the advancement of several programs in our meninggococcal franchise and flu cell culture . Also, there was $6.8 million of incremental research and development expense following our purchase of PowderJect in the third . quarter of 2003 .

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

Selling, general , and administrative Our vaccines segment recognized selling, general and administrative expenses of $39 .0 mill ion and $22 .2 million for the three months ended March 31, 2004 and 2003, respectively. The increase in selling, general and administrative expenses for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to additional expenses following our third quarter of 2003 acquisition of Powderiect Pharmaceuticals . Excluding $10 .6 million of additional selling, general and administrative expenses associated with Powderiect Pharmaceuticals, the remaining increase in selling, general and administrative resulted from ongoing sales and marketing, programs and .increase in headcount . .

Amortization expense Our vaccines segment recognized amortization expense of $15 .1 million and $1 .4 million for the three months ended March 31, 2004 and 2003, respectively. The increase in amortization expense for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 related to the intangibles acquired following our acquisition of PowderJect Pharmaceuticals in the third quarter 2003 .

30 Biopharmaceuticals

Product sales Biopharmaceutical product sales were $126 .5 million and $101 .7 million for the three months ended March 31, 2004 and 2003, respectively. Biopharmaceutical product sales in the first quarter of 2004 and 2003 consisted principally of Betaseron®, TOBIO and Proieukin® .

Betaseron® interferon beta-lb We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc . (collectively "Schering"), under the trade names Betaseron® (in the U .S and other non-European markets) and Betaferon® (in Europe) . Boehringer Ingelbeim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by us, we recognize a portion of revenue for product sales upon shipment to Schering and the remainder based on a contractual percentage of sales by Schering, both of which we record as product sales . For product manufactured by Boehringer Ingelheim and marketed by Schering in Europe under the trade name Betaferon®, we receive royalties calculated at the same percentage of sales less the amount paid or incurred by Schering for supply costs, which we recoid in royalty and license fee revenues . Starting in the fourth quarter 2003, the amount we recorded as product sales, based on a percentage of sales by Schering, and Betaferon® royalties, declined by five percentage points pursuant to our contractual agreement with Schering, As a result, we estimate that the percentage of sales per unit on which our payments are based will decrease, reducing our per unit revenue by approximately 18% (for sales of Chiron product) and approximately 34% (for royalties from sales of Boehringer Ingeiheint product) from that received prior to the decline . However, there are a number of mitigating considerations, including (i) the transitional supply agreement, discussed in "Royalty and license fee revenues-BetaferonO interferon beta-lb" below, (ii) the volume mix of Chiron product and Boehringer ingelheim product and (iii) the launch of product upgrades with ease-of-use features . We believe these considerations will partially offset this contractual change . In order to supply Betaferon® to Schering, we continue to make capital improvements to our existing manufacturing facilities to increase capacity . See "Research and development" below .

In October 2003, the U.S. Food and Drug Administration approved a new pre-filled diluent syringe for Betaseron® . The pre-filled diluent syringe was launched in January 2004 and enhances the delivery mode and shortens preparation, helping to simplify injections of Betaseron® . In the first quarter 2003, the U.S . Food and Drug Administration approved new labeling for Betaseron® . The labeling expands the indication for Betaseron® to treat all relapsing forms of multiple sclerosis to reduce the frequency of clinical exacerbations- Relapsing forms of multiple sclerosis include relapsing-remitting, the most common form, and secondary progressive multiple sclerosis with relapses .

Betaseron® product sales were $30 .1 million and $29 .3 million for the three months ended March 31, 2004 and 2003, respectively . The increase in ' Betaseron40 product sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to (i) increased - patient demand attributed to key marketing programs and an overall increase in the market for beta interferon products for multiple sclerosis, (ii) price increases : . These increases were partially offset by fluctuations in ordering patterns and a decline in the royalty rate by fiv "e and (iii) the movement in foreign exchange rates percentage points pursuant to our contractual agreement with Schering .

YOBI®tobramycin We sell TOBI® directly in the U.S. and certain international markets . We recognized TOBI® sales of $52 .5 million and $40.7 million for the three months ended March 31, 2004 and 2003, respectively . Increased TOBI® sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to (i) patient demand across Europe and increased use and improved compliance in the U .S ., (ii) price increases, (iii) the benefit of the movement in the Euro to U.S . Dollar exchange rate and (iv) wholesaler ordering patterns.

We continue to pursue the use of TOBI® to treat other serious lung infections and to seek approval mother countries . Wholesaler ordering patterns as well as reimbursement and government

31 pressures, competition, foreign currency exchange rates and the level of rebates may influence future TOBI® sales .

Proleukin® (aldesleukin) Proleukin$ is approved in Canada and the U .S . for the treatment of metastic (Stage IV) melanoma and in the U .S. and Canada and in over 50 countries for the treatment of metastic (Stage IV) renal cell carcinoma . Sales of Proleukin® were $31 .9 million and $26.0 million for the three months ended March 3 i, 2004 and 2003, respectively . The increase in Proleukin® product sales for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to (i) wholesaler ordering patterns, (ii) price increases and (iii) the benefit of the movement in the Euro to U .S. Dollar exchange rate .

Wholesale ordering patterns, reimbursement pressures and foreign currency exchange rates may influence future Proleukin® sales .

The balance of product sales recognized in our biopharmaceuticals segment consisted of various other products, which individually were not material.

We expect competitive pressures related to many of our biopharmaceutical products to continue into the future, primarily as a result of the introduction of competing products into the market, as listed in Part 1, Item L, "Business-Competition" of our Annual Report on Form IO-K for the year ended December 31, 2003 .

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and our achievement of performance milestones . Due to the nature of our collaborative agreement revenues ; results in any one period are not necessarily indicative of results to be achieved in the future . In addition, the collaboration agreements typically provide for certain milestone payments and various royalties on future product sales if the collaborative partners commercialize a product using our technology . Also, our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners.

Royalty and license fee revenues Our biopharmaceuticals segment earns royalties on third party sales of several products, including Betaferon® and recombinant insulin and glucagon products . Our biopharmaceuticals segment also earns license fees for technologies, such as hepatitis C virus-related patents, used by third parties to develop therapeutic products. The biopharmaceuticals segment recognized royalty and license fee revenues of $17.3 mil lion-and $17.8 million for the three months ended March 31, 2004 and 2003, respectively .

Betaferon® interferon beta--lb We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc . (collectively "Schering"), under the trade names BetaserontE (in the U .S and other non-European markets) and Betaferon® (in Europe). Boehringer Ingelheim also supplies Betaferon® to Schering for sale in Europe . For product manufactured by Boehringer Ingelheim, we receive royalties calculated as a percentage of sales less the amount paid or incurred by Schering for supply costs, including Schering's cost to purchase product from Boehringe r Ingelheim.

For the three months ended March 31, 2004 and 2003, we recognized Betaferont royalties of $13 .8 million and $14 .0 million, respectively, under this arrangement . Betaferon® royalties decreased for -

32 the three months ended March 31, 2004 as compared with the three months ended March 3 1, 2003 primarily as the result of a decline in the royalty rate by five percentage points, pursuant to our contractual agreement with Schering. This decrease is partially offset by (i) the benefit of the movement in the Euro to U .S .. Dollar exchange rate, (ii) increase in demand and (iii) the benefit of a reduction of the allocated cost under a three-year limited'cost sharing arrangement under the transitional supply agreement with Schering .

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

• Novo Nordisk We earn royalty revenues on insulin and glucagon product sales by Novo Nordisk AS . We recognized $1 .4 million and $2.0 million for the three months ended March 31, 2004 and 2003, respectively under this arrangement . Patents related to the production of insulin and glucagon began expiring in late 2003 and as a result, significant reductions in royalty revenue recognized under this arrangement are expected .

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

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

Other revenues Our biopharmaceuticals segment recognized other revenues of$3 .1 million and $15 .6 million for the three months ended March 31, 2004 and 2003, respectively .

Con tract manufacturing revenues Our biopharmaceuticals segment recognized contract-manufacturing revenues of $2.8 million and $0 .1 million for the three months ended March 31, 2004 and 2003, respectively . The increase resulted from the level of activity and the timing of contract manufacturing activities . .

Biogen and Serono settlements A U.S . Court of Appeals partially reversed a District Court ruling in connection with certain patents owned by Chiron and licensed exclusively to Schering AG's U .S. subsidiary, Berlex Laboratories . As a result of the ruling and prior agreements between Biogen and Berlex, Bingen was required to make a settlement payment to Schering . In accordance with an earlier contract between Chiron and B erlex, we recognized approximatel y $13 .0 million for the three months ended March 31, 2003, which represented our share of this settlement payment. In addition, there was a similar settlement between Berlex and Serono of which we recognized approximately $1 .4 million for the three months ended March 31, 2003 .

33 The balance of other revenues recognized in our biopharmaceuticals segment consisted of various other arrangements, which individually were not material .

Gross profit Biopharmaceutical gross profit as a percentage of net product sales was 76% and 79% for the three months ended March 31, 2004 and 2003, respectively . The decrease in biopharmaceutical gross profit margins for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 was primarily the result of less favorable mix of biopharmaceutical sales, the increased cost of producing the Betaseron® pre-filled syringe presentation, decline in Betaseron® product sales ; based on a percentage of sales by Schering, by five percentage points pursuant to our contractual agreement with Schering, offset by price increases and increased efficiencies' in the manufacturing process .

Biopharmaceutical gross profit percentages may fluctuate significantly in future periods due to production yields, increased cost to produce the Betaseron® pre-filled syringe presentation, the decline in Betaseron® product sales, based on a percentage of sales by Scheting, by five percentage points pursuant to our contractual agreement with Sobering and as the biophannaceutical product and customer mix changes .

Research and development Our biopharmaceuticals segment recognized research and development expenses of $58 .6 million and $56.4 million for the three months ended March 31, 2004 and 2003, respectively .

The increase in research and development spending for the th ree months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to activities related to the development of (i) tifacogin , as discussed be low, (ii ) development of cyclosporine solution for inhalation , a therapy under evaluation for the tre atment of rejection and re duction of mortality in lung transplant patients and (iii) a dry powder formulation of our inhaled TOBI® product for the treatment of pseudomonas aeruginosa in cystic fibrosis patients. These increases were partially offset by (i) decrease in spending on development of manufacturing processes for Betaseron ®, (ii) transfer of responsibility of the SILCAAT trial to the investigators in the first quarter 2003, discussed below and (iii) decline in spending due to discontinuance of development of PA-2794. We discontinued development of tezacitabinc in the first-quart er of 2004 based on an analysis of the data from a Phase II trial in patients with gastroesophageal cancer . The discontinuation of this trial did not have a material impact on quarterly spending . -

In the fourth quarter 2002, we reached an agreement in principle to transfer responsibility for the SILCAAT (referred to also as Proleukin® (aldesleukin) for HIV) trial, a Phase II I study for recombinant human interleukin-2 (IL-2, aldeseleukin ) to the National Institutes Allergy and Infectious Disease (NIA[D) and the University of Minnesota . Responsibili ty for the SILCAAT study was transferred to NIAID and University of Minnesota effective February 14, 2003. Ou r research and development expenses related to the SILCAAT trial are expected to decrease in 2004 as a result of transferring re sponsibility for the trial . Under the agreement , we are obligated to fund a maximum of $18 .0 million over the lifetime of the trial and to supply clinical mate ri als and certain other support services of which $ 9 .0 million has been paid through March 31, 2004.

In October 2003, we acquired all of Pfizer, Inc: s, formerly Pharmacia Corp .'s, interest in tifacogin , i n return for which Pfizer will receive royalties on sales of tifacogin. We are proceeding with a Phase IEI trial for tifacogin in patients with severe community-acquired pneumonia .

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

34 Selling, general, and administrative Our biopharmaceuticals segment recognized . selling, general and administrative expenses of $32 .0 million and $26 .2 million for the three months ended March 31, 2004 and 2003, respectively . The increase in selling, general and administrative expenses for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 related to increased expenses for programs and headcount in support of TOBI® and Proleukin®, and the Euro to U .S . Dollar exchange rate fluctuation, offset in part by a reduction in expenses to enhance business processes .

Amortization expense Our biopharmaceuticals segment recognized amortization expense of $6 .2 million for each of the three months ended March 31, 2004 and 2003, respectively.

Other

Royalty and license fee revenues Our other segment cams royalties on third party sales of, and license fees on, several products . Our other segment recognized royalty and license fee revenues of $18.4 million and $16 .8 million for the three months ended March 31, 2004 and 2003, respectively . The majority of royalty and license fee revenues related.to the use of our hepatitis C virus and HIV-related patents by various third parties . -

F. Hofmann-La Roche settlement In October 2000, we entered into three license agreements with F . Hoffmattn-La Roche Limited related to the settlement of litigation in the U .S . and certain other countries for use of our hepatitis C virus and HIV nucleic acid testing intellectual property for use in clinical diagnostics .

Under the hepatitis C virus agreement, we received $85.0 million, of which we recognized $40 .0 million in the fourth quarter 2000 . We deferred the remaining $45 .0 million, which becomes nonrefundable ratably through 2005 . In the first quarter 2001, we began recognizing portions of the $45 .0 million based upon the greater of(i) the scheduled quarterly minimum non-refundable amount or (ii) the actual earned credits as royalties on future sales related to F . Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products. The agreement also provides for royalties on future sales related to F. Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products, which commenced in the first quarter. 2001 . Royalty revenues increased for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003, primarily as a result of an increase in the quarterly minimum amounts we recognize under this agreement and an increase in the positive adjustment of estimate to actuals in the subsequent quarter. These increases were offset by decreased product sales recognized by F . Hoffinan-LaRoche .

The, HIV agreement also provides for royalties on future sales related to F. Hoffmann-LaRoche's use of our HIV related patent in its in vitro diagnostic products, which also commenced in the first quarter 2001 when the European Patent Office Board of Technical Appeals upheld our HIV related patent . Royalty' revenues recognized under this agreement for the three months ended March 31, 2004 were consistent with the three months ended March 31, 2003 .

Under these agreements, such royalties will continue through the lives of the hepatitis C virus and HIV-related patents covering F . Hoffmann- La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents expire in 2015 for the U.S . and in 2010 for Europe . Currently; the applicable issued HIV-related patent in Europe expires in 2005 . An HIV-related patent directed to nucleic acid testing methods for H[V-1 was issued in the U .S. on March 13, 2003 . This patent will expire seventeen years from the date of issuance . The issuance of the patent triggered a milestone payment to Chiron of $10 .0 million from F. Hoffrnann-LaRoche, which was received in April 2003 . As permitted under the terms of its licensing agreement, F . Hoffmann--L .a Roche has decided to institute arbitration proceedings in regard to the application of the U .S . patent. We have deferred recognition of this $10 .0 million milestone payment and interest as of March 31, 2004. During

3 5

1 any pending arbitration proceedings, F. Hof maim- La Roche remains obligated to make all quarterly royalty payments, subject to a right to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due.

Bayer A cross - license agreement provides for royalties to us on HJV and hepatitis C virus products sold by Bayer , which increased for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to (i) additional royalties under the HlV-related patent issued in the U. S . in March 2003, discussed above, ( ii) increased royalty rates and ( iii) increased donations.

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

Selling, general, and administrative Our other segment recognized selling, general and administrative expenses of $24.6 million and $16.8 million for the three months ended March 31, 2004 and 2003, respectively . The increase in selling, general and administrative expenses for the three months ende d March 31, 2004 as compared with the three months ended March 31, 2003 primarily resulted from increased facility related costs, higher depreciation expense related to information systems and higher employee related expenses .

Interest expense We recognized interest expense of $5 .9 million and $3 .5 million for the three months ended March 31,2004 and 2003, respectively . The increase -for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 primarily related to interest expense recognized on the $500.0 million convertible debentures that were issued on July 30, 2003 .

Interest and other income, net Interest and other income, net, primarily consisted of interest income on our cash and investment balances and, other non-operating gains and losses . We recognized interest income of $5 .1 million and $7 .0 million for the three months ended March 31 ; 2004 and 2003, respectively . The decrease in interest income for the three months ended March 31, 2004 as compared with the three months ended March 31, 2003 was primarily due to lower average cash and investment balances following the acquisition of PowderJect Pharmaceuticals .

We recognized gains of $9 .7 million and $4 .6 million for the three months ended March 31, 2004 and 2003, respectively, related to the sale of certain equity securities .

On December 31, 1998, we completed the sale of our 30% interest in General Injectibles & Vaccines, Inc ., a distribution business, to Henry Schein, Inc . and received payment in full of certain advances we made to General Injectibles & Vaccines. The agreement also provided for us to receive additional payments, calculated as a pre-determined percentage of Henry Schein's gross profit, through 2003 . We received $3,5 million for 2003 and $2 .0 million for 2002 during the three months ended March-31, 2004 and 2003, respectively .

Income taxes The effective tax rate for the three months ended March 31, 2004 and 2003 was 25% of pretax income from continuing operations . The effective tax rate may be affected in future periods by changes in management's estimates with respect to our deferred tax assets and other items affecting the overall tax rate .

Management believes the acquisition of Powderdect Pharmaceuticals may cause an increase in the future effective tax rate and is in the process of evaluating certain options that may mitigate any

36 potential increase. Specifically, most of PowderJect Pharmaceuticals's profits are earned in the United Kingdom, subject to a 30% marginal tax rate .

Disconti nued Operations In the first quarter of 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement; we . were required to make a payment to Bayer during the first quarter 2003 . Pursuant to this settlement, we recorded a charge, net of adjustment to our previously provided reserve for indemnity obligations, of $7 .6 million, offset by an income tax benefit of $9.0 million, resulting in a net gain of $1 .4 million, which was reported as a "Gain from discontinued operations" for the three months ended March 31, 2003 .

Chiron and Bayer also were involved in a separate dispute with respect to their respective rights to certain royalty refunds receivable for which a settlement was reached in 2004. Under this settlement agreement, we will make a payment to Bayer . This settlement includes an agreement that all outstanding items with Bayer related to the sale of Chiron Diagnostics are resolved and no future indemnity obligations are required. We released previously established reserves i n excess of-the required payments for the indemnity obligations in the fast quarter of 2004 . This settlement resulted in a benefit of $0 .3 million and an income tax - benefit of $12.5 million, resulting in a net gain of $12 .8 million, which was reported as a "Gain from discontinued operations" for the three months ende d March 31, 2004.

Liquidity and Capital Resources

Our capital requirements have generally been funded by cash flow from operations, borrowings from commercial banks and issuance of debt securities and common stock. Our cash, cash equivalents and investments in marketable debt securities, which totaled $1,085 .5 million at March 31, 2004, are invested in a diversified portfolio of financial instruments, including money market funds and instruments, corporate notes and bonds, government or government agency securities and other debt securities issued by financial institutions and other issuers with strong credit ratings . By policy, the amount of credit exposure to any one institution is limited. Investments are generally not collateralized and primarily mature within three years .

In June 2001 we issued zero coupon convertible Liquid Yield Option Notes (LYONS). The holders of the LYONs niay require us to purchase all, or a portion of, their LYONS on June 12, 2004 at a purchase price of $584 .31 per LYON: The accreted value on June ,12, 2004 will be $426 .5 million. We may choose to pay the purchase price in cash, shares of Chiron common stock or any combination thereof. Given our-ability to pay the purchase price in shares of Chiron common stock, we continue to classify the LYONS as long-term liabilities as of March 31, 2004. Additional alte rnatives open to us to satisfy requests to purchase the LYONS include issuing new debt or equity securities . The next dates on which the holders may require us to purchase the LYONS following June 12, 2004 are June 12, 2006, and every fifth year thereafter until maturity in 2031 . .

We believe that our cash, cash equivalents and marketable debt securities, together with funds provided by operations and leasing arrangements, will be sufficient to meet our•foreseeable operating cash requirements over .at least the next twelve months including any cash utilized under our stock repurchase program, the potential purchase of all, or a portion of the LYONS and our contractual obligations . In addition, we believe we could access additional funds from the debt and capital markets.

Sources anduses of cash We had cash and cash equivalents of $259.1 million and $245 .5 million at March 31, 2004 and 2003, respectively .

J Operating activities for the three months ended March 3 1, 2004 net cash provided by operating activities was $11 .1 million as compared with $65 .3 million for the three months ended March 31, 2003 .

1 The decrease in cash provided by operating activities primarily was due to (i) lower income from continuing operations before depreciation and amortization and other non-cash charges mainly due to higher costs in our vaccines segment related to the addition of PowderJect facilities, which traditionally are not in flu production for a significant part of the first quarter, (ii) $14 .4 million of cash received as a result of the Biogen and Serono settlements in connection with the McCormick patents for the three months ended March 31, 2003, (iii) royalty payments received under the Roche royalty arrangements for the three months ended March 31, 2003 and, (iv) increased research and development costs . These decreases were partially offset by a payment made to Bayer. Corporation during the three months ended March 31, 2003 as a result of a settlement agreement relating to certain claims raised by Bayer in connection with the Stock Purchase Agreement dated September 17, 1998.

At March 31, 2004, Chiron had foreign net operating loss catryforwards of approximately $20.8 million, of which approximately $5 .3 million begin expiring over the period 2008 to 2018 and the remaining $15 .5 million is available to offset future taxable income without limitation . At March 31, 2004, Chiron had unutilized foreign net operating loss carryforwards attributable to the acquisition of PowderJect Pharmaceuticals of approximately $0 .7 million, which are available to offset future taxable income without limitation . At March 31, 2004, Chiron had federal net operating loss catryforwards attributable to the acquisition of Matrix Pharmaceutical, Inc. of approximately $49 .2 million, which are available to offset future domestic taxable income ratably through 2021 . At March 31, . 2004, Chiron had federal net operating loss carryforwards attributable to the acquisition of PowderJect Pharmaceuticals of approximately $13 .0 million, which are available to offset future domestic taxable income ratably through 2022 . At March 31, 2004, Chiron had $23 .4 million of state net operating loss carryforwards, which expire between 2004 and 2021 and state net operating loss carryforwards of attributable to the acquisition of Matrix Pharmaceutical, Inc . of approximately $27 .3 million, which are available to offset future state taxable income ratably through 2013 . At March 31, 2004, Chiron had state business tax credit carryovers of $16 .3 million, which are available to offset future state tax liabilities without limitation, and foreign business tax credit carryovers of $22 .2 million .

We anticipate that research and development expenditures in 2004 will primarily be driven by (i) those activities under our December 2001 and June 2002 collaboration agreements with Nektar Therapeutics (formerly Inhale Therapeutic Systems, Inc .) related to, among'other things, the development of a dry powder formulation of our inhaled TOB1® product for the treatment of pseudomanas aeruginosa in cystic fibrosis patients, (ii) those activities related to the development of interleukin-2 in combination with various monoclonal antibodies, (iii) expansion of our meningococcal franchise, (iv) development of flu cell culture , (v) research activities focused on identifying several novel vaccines and therapeutics for clinical development in the areas of oncology and infectious disease and (vi) those activities related to development with tifacogin in severe community-acquired pneumonia . In addition, we are required to make capital improvements to our existing manufacturing facilities to support the supply of Betaferon® to Schering . In connection with this project, we are continuing to incur expenses relating to the development of new processes and the performance of test tuns related to installed equipment . Net cash from operating activities are expected to fund these research and development activities .

Investing activities For the three months ended March 3 I, 2004, net cash used in investing activities consisted of purchases of investments in"marketable debt securities of $202 .9 million, capital expenditures of $44 .6 million, purchases of equity securities and interests in affiliated companies of $2,.4 million, cash paid for direct PowderJect acquisition costs of $1 0 million and other uses of cash of $0 .8 million. Cash used in investing activities was offset by proceeds from sales and maturities of investments in marketable debt securities of $109 .5 million and proceeds from the sale of equity securities and interests in affiliated companies of $3 .5 million .

In April 2001, we entered into collaboration with Rhein Biotech N .V. (now part of Bertia Biotech) and GreenCross Vaccine Corporation to research and develop certain pediatric combination vaccine

38 products for sate outside of Europe and North America. The collaboration agreement requires capital commitments from Chiron, $erna Biotech and GreenCross Vaccine . Our commitment is approximately 26 .4 million Euro ($32 .2 million) for the expansion of Chiron's Italian manufacturing facilities, of which Chiron had incurred costs of 19 .1 million Euro ($23 .3 million) as of March 31, 2004 . This agreement began in the fourth quarter 2001 and is expected to continue through 2008.

In 2003, our Board of Directors approved $50 .7 million in expenditures for a 25-year lease for buildings and $42 .2 million for capital improvements, both of which are part of a $97 .0 million project for a new flu vaccines manufacturing facility in Liverpool, England . The new manufacturing facility will replace existing flu vaccines manufacturing facilities in Liverpool, England. In December 2003, we entered into a 25--year lease for these buildings, As of March 31, 2004, we have incurred $3 .9 million for these capital improvements .

The purchases of equity securities and interests in affiliated companies consisted of equity contributions under several venture capital funds including $1 .2 million in capital contributions under two 2003 limited partnership agreements, a $0.8 million capital contributions under a 2001 limited partnership agreement and a $0.4 million capital contribution under a 2002 limited partnership agreement. We are obligated to pay $60.0 million over ten years in equity contributions to these venture capital funds, of which $34 .5 million was paid through March 31, 2004.

For the three months ended March 31, 2003, net cash used in investing activities consisted of purchases of investments in marketable debt securities of $190 .6 million, capital expenditures of $33 .9 million, purchases of equity securities and interests in affiliated companies of $1 .4 million, cash paid for acquisitions, net of cash acquired of $0.2 million and other uses of cash of $5 .i million . Cash used in investing activities was offset by proceeds from the sale and maturity of investments in marketable debt securities of $192.8 million and proceeds from sale of equity securities and interests in affiliated companies o f $2.0 million .

Financing activities For the three months ended March 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 by financing activities was offset by $8 .5 million for the acquisition of treasury stock, $0.08 million for the repayment of debt and capital leases .

Our Board of Directors has authorized the repurchase of our common stock on the open market. On December 5, 2003, the Board of Directors granted authority to buy 5,0 million shares and authorized the repurchases through December 31, 2004 .

For the three months ended March 31, 2003, net cash used in financing activities consisted of $37 .1 million for the acquisition of treasury stock, $0 .1 million for the net repayment of short-term borrowings, and $0 .02 million for the repayment of debt. Cash used in financing activities was offset by $3 .5 million in proceeds froth the reissuance of treasury stock (related to stock option exercises), and $1 .4 million in proceeds from put options .

From time to time, we evaluate a number of business development opportunities . To the extent that we are successful in reaching agreements with third parties, those transactions may involve selling a significant portion of our current investment portfolio, incurring additional debt or issuing additional Chiron shares .

Borrowing arrangements Under a revolving, committed, uncollateralized credit agreement with a major financial institution, we can borrow up to $100.0 million in the U.S. This credit facility is guaranteed by Novartis AG under a November 1994 Investment Agreement, provides various interest rate options and matures in February 2006, There were no borrowings outstanding under this credit facility at March 31, 2004 and December 31, 2003 . In December 1999, Chiron and Novartis amended the November 1994 Investment Agreement to reduce the maximum amount of our obligations that Novartis would guarantee from $725.0 million to $702 .5 million .

39 We also have various credit facilities ava- . .,.e outside the U.S . There were no outstanding borrowings uu . .__ . these facilities at March 31, 2004 and December 31, 2003 . One facility is maintained for our 5I %--owned Indian subsidiary, and allows for total borrowings of 200 million Indian Rupee ($4 .4 million at March 31, 2004) . Our Italian subsidiary also has various facilities, related to its receivables, which allow for total borrowings of 10 .9 million Euro ($13 .3 million at March 31, 2004).

Capital Lease In July 2003, we entered into a new six-year lease to rent a research and development facility in Emeryville, California following the expiration of the existing operating lease . Effective July 1, 2003, we accounted for this new lease as a capital lease and, as a result, recorded the leased facility and the corresponding liability on out balance sheet . The amount recorded on the balance sheet for the leased facility is $157 .5 million . The amount of the leased facility less the expected value of the facility at the end of the lease term is being amortized on a straight-line basis over the lease term . We expect the value of the facility at the end of the lease term to be approximately $151 .6 million. At the inception of the lease, the future minimum lease payments, exclusive of a residual value guarantee, are approximately $15 .7 million over the lease term. The interest payments represent variable-rate interest payments indexed to a three-month London interbank offered rate plus 40 basis points . The lease provides a $156 .0 million residual value guarantee from us to the lessors in the event of property value declines . Consequently, our maximum payment obligation is $156 .0 million upon termination of the lease on or before July 1, 2009 . On or before July 1, 2009, we can choose to either purchase the facility from the lessors or sell the facility to a third party . This option accelerates if we default on our lease payments or in the event of other. defined events . As of July 1, 2003, Novartis AG had guaranteed (under provisions of the Investment Agreement) payments on this lease commitment, including payment of the residual value guarantee, to a maximum of $173 .3 million .

Factors That May Affect Future Result s

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

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

We focus our research and development activities on areas in which we have particular strengths and on technologies that appear promising . These technologies often are on the "cutting edge" of modem science. As a result, the outcome of any research or development program is highly uncertain . Only a very small fraction of these programs ultimately result in commercial products or even product candidates . Product candidates that initially appear promising often fail to yield successful products . In many cases, preclinical or clinical studies will show that a product candidate is not efficacious (that is, it lacks the intended therapeutic or prophylactic effect), or that it raises safety concerns or has other side effects, which outweigh the intended benefit . Success in preclinical or early clinical trials (which generally focus on safety issues) may not translate into success in large-scale clinical trials (which are designed to show efficacy), often for reasons that are not fully understood . Further, success in clinical trials will likely lead to increased investment, adversely affecting short-term profitability, to bring such products to market . And even after a product is approved and launched, general usage or post-marketing studies may identify safety or other previously unknown problems with the product which may result in regulatory approvals being suspended, limited to narrow indications or revoked, or which may otherwise prevent successful commercialization.

40 Conflicts with or decisions by third parties we collaborate with could harm our business.

An important part of our business strategy depends upon collaborations with third parties, including research collaborations and joint efforts to develop and commercialize new products . As circumstances change, Chiron and our strategic partners may develop conflicting priorities or other conflicts of interest . We may experience significant delays and incur significant expenses in resolving these conflicts and may not be able to resolve these matters on acceptable terms . Even without conflicts of interest, we may disagree with our strategic partners as to how best to realize the value associated with a current product or a product in development . In some cases, the strategic partner may have responsibility for formulating and implementing key strategic or operational plans . In addition, . merger and acquisition activity within the. pharmaceutical and biotechnology industries may affect our strategic partners, causing them to reprioritize their efforts related to the research collaborations and other joint efforts with us . Decisions by corporate partners on key clinical, regulatory, marketing (including pricing), inventory management and other issues may prevent successful commercialization of the product or otherwise impact our profitability .

if we fail.to obtain or maintain the regulatory approvals we need to market our products, our business will suffer.

We must obtain and maintain regulatory approval in order to market most of our products . Generally, these approvals are on a product-by=product and country-by-country basis . In the case of therapeutic products, 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 clinical trials often are susceptible to varying interpretations that may delay, limit-or prevent approval or result in the need for post-marketing studies . In addition, regulations may be amended from time to time . Revised regulations may require us to reformulate products on a country or regional basis, obtain additional regulatory approvals, or accept additional risks that our products will not maintain market acceptance of be eligible for third party insurance coverage . Increased regulatory scrutiny and restrictions regarding . . marketing practices for products that are subject to government reimbursement may impact the sales of such products . There is no guarantee that we will be able to satisfy these new regulatory requirements and may suffer a loss of revenue as a result .

Most of our products are biologics . Manufacturing biologic products is complex. Unlike chemical pharmaceuticals, a biologic product generally cannot be sufficiently characterized (in terms of its physical and chemical properties) to rely on assaying of the finished product alone to ensure that the product will perform in the intended manner. Accordingly, it is essential to be able to both validate and control the manufacturing process, that is, to show that the process - works and that the product is made strictly and consistently in compliance with that process . Slight deviations anywhere in the manufacturing process, including quality control, labeling and packaging, may result in unacceptable changes in the products that may result in lot failures or product recalls, or liability to a third patty to the extent we are contract manufacturing products in our facilities for such third parry . Manufacturing processes which are used to produce the smaller quantities of material needed for research and development purposes may not be successfully scaled up to allow production of commercial quantities at reasonable cost or at all. All of these difficulties are compounded when dealing with novel biologic products that require novel manufacturing processes . Additionally, manufacturing is subject to extensive government regulation . Even minor changes in the manufacturing process require regulatory approval, which, in rum, may require further clinical studies : For some of our products, we rely on others to supply raw materials and to manufacture those products according to regulatory requirements. 41 In addition, any prolonged interruption in our operations or those of our partners could result in our inability to satisfy the product demands of our customers. A number of factors could cause interruptions, including equipment malfunctions or failures, interruptions due to labor action, damage to a facility due to natural disasters, such as an earthquake, suspension of power supplied to these facilities arising out of regional power shortages or terrorist activities and armed conflict, including as a result of the disruption of operations of our subsidiaries and our customers, suppliers, distributors, couriers, collaborative partners, licensees and clinical trial sites .

Our mishandling of hazardous materials could result in substantial costs and harm to our business.

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

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

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

We purchase bulk powdered tobramycin, the primary basic raw material in TOBIt9 tobramycin, from two of the principal worldwide suppliers of the drug. We anticipate that either one of these suppliers alone will be able to supply sufficient quantities to meet current needs ; however, there can be no assurance that these suppliers will be able to meet future demand in a timely and cost-effective manner . As a result, our operations could be adversely affected by a n interruption or reduction in the supply of bulk-powdered tobramycin . .

We have entered into contracts with third parties for the production and packaging ofTOH1 ®. Over time, we can use alternative production and packaging sources. However, if the contracted third pa rt ies become unable to produce or package su ffi cient quantities of T0.1310 due to work stoppages or other factors, our operations could be disrupted until alternative sources are secured .

In connection with the production of our flu vaccine products , we must purchase .large quantities of chicken eggs. Currently, for Fluvirin® vaccine, we purchase those eggs and incubation services from a single supplier in the United Kingdom and, pursuant to the contract with that supplier, we are required to make specified minimum purchases from that supplier thro ugh 2007. If our supplier were to fail to supply eggs in sufficient quantities or quality , including as a re sult of any health or other issues related to the chickens, our business would be materi ally adversely affected .

We are a key provider for the blood screening field of nucleic acid testing and immunodiagnostics . In nucleic acid testing, we rely on our collaborative partner, Gen-Probe, to manufacttire the West Nile

5(~ virus assay, currently in use on an investigational-use basis in the U .S. and the Procleix® HIV-l/ HCV Assay . We currently source the related instrument system from third party suppliers . Currently, Gen-Probe is the only manufacturer of nucleic acid testing products using Transcription-Mediated Amplification technology. In immunodiagnostics, under the Ortho-Clinical Diagnostics, Inc . contract, we manufacture bulk reagents and antigens and confirmatory test kits sold in the clinical diagnostics and blood screening fields . While we and our partners work to mitigate the risks associated with being a key provider, there can be no assurance that our partner, Gen-Probe, will be able to provide sufficient quantities of the Procleix® HIV-l/ HCV Assay or that we will be able to manufacture sufficient bulk reagents and antigens and confirmatory test kits for immunodiagnostic products . Our difficulties or delays or those of our partners' could cause a public health concern for the blood supply, as well as increase costs and cause foss of revenue or market share .

Ifwe cannot obtain necessary licenses to third party patents for the manufacture or sale of our products, we may have to withdraw from the market or delay the introduction of the affected product.

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

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

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

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

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

As we are a key provider for the blood screening field of nucleic acid testing and immunodiagnostics, we may have product liability in addition to contract exposure, in the event that -

.43 our difficulties or delays or those of our partners could cause a public health concern for the blood supply .

If we are unable to successfully compete in the highly competitive healthcare industry, our business could be harmed

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

The possibility that the competitor may have launched its product first ;

The competitor may have greater access to certain raw materials ;

The competitor may have more efficient manufacturing processes ;

The competitor may adapt more quickly to technological change ;

The competitor may have greater marketing capabilities ;

The competitive product may have therapeutic or other advantages ; or

New competitors may enter into markets where we currently have significant competitive advantage .

Our patents may not prevent competition or generate revenues . -

We seek to obtain patents on many of our inventions . Without the protection of patents , competitors may be able to use our inventions to manufacture and market competing products without being required to undertake the lengthy and expensive development efforts made by us and without having to pay royalties or otherwise compensate us for the use of the invention . We have no assurance that patents and patent applications owned or licensed to us will provide substantial protection . Important legal questions remain to be resolved as to the extent and scope of available patent protection for biotechnology products and processes in the U .S . and other important markets. We do not know how many of our pending patent applications will be granted, or the effective coverage of those that are granted . In the U .S. and other important markets, the issuance of a patent is neither conclusive as to its validity nor the enforceable scope of its claims . We have engaged in significant litigation to determine the scope and validity of certain of our patents and expect to continue to do so . An adverse outcome of litigation could result in the reduction or loss of royalty revenues . Engaging in patent litigation against one party may place significant royalty revenues received or to be received from other parties at risk. Even if we are successful in obtaining and defending patents, there can be no assurance that these patents will provide substantial protection. The length of time necessary to resolve patent litigation successfully may allow infringers to gain significant market advantage . Third parties may be able to design around the patents and develop competitive products that do not use the inventions covered by our patents . Many countries,' including certain countries in Europe, have compulsory licensing laws under which-a patent owner may be compelled to grant licenses to third parties (for example, the third party's product is needed to meet a threat to public health or safety in that country, or the patent owner has failed to "work" the invention i n that country, or the third party has patented improvements) . In addition, most countries limit the enforceability of patents agains t

44 i '

government agencies or government contractors . In these countries , the patent owner may be limited to monetary relief and may be unable to enjoin infringement , which could materi ally diminish the value of the patent . In addition, royalty revenues may decline as patents expire.

Sales of our products may be adversely affected by the availabili ty and amount of reimbursement to the user of our productsfrom third parties, such as the government and insurance companies.

In the U.S. and other significant markets, sales of our products may be affected by the availability of reimbursement from the government or other third parties, such as insurance companies . It is difficult to predict the reimbursement status of newly approved, novel biotechnology products, and current reimbursement policies for existing products may change . In certain foreign markets, governments have issued regulations relating to the pricing and profitability of pharmaceutical companies . There have been proposals in the U.S . (at both the federal and state level) to implement such controls . If the United States Congress enacts legislative proposals addressing parallel importation currently being deliberated, revenues from certain products may be affected by this change in U.S . policy. The growth of managed care in the U .S . also has placed pressure on the pricing of healthcare products . These pressures can be expected to continue .

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

As part of our business strategy, we expect to continue to grow our business through in-licensing, collaborations or acquisitions of products or companies . For example, we are currently in the process of completing the integration of PowderJect Pharmaceuticals including the disposition of non-strategic assets . The failure to adequately address the financial, operational or legal risks raised by such transactions, including our integration of Powderlect, could harm our business. Financial aspects related to these transactions may alter our financial position, reported operating results or stock price, and include :

Use of cash resources ;

Potentially dilutive issuances of equity securities ;

The incurrence of debt and contingent liabilities, impairment losses or restructuring charges ;

•_ Large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset ; and

• Amortization expenses related to other intangible assets ..

Operational risks that could harm our existing operations or prevent realization of anticipated benefits from such transactions include :

Challenges associated with managing an increasingly diversified business ;

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

• Diversion of management's attention from other business concerns ;

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

• The assumption of known and unknown liabilities of the acquired company, including intellectual property claims ; and

Subsequent loss of key personnel .

45 Legal risks may include requirements to , . .n the consent of our stockholders or a third party, or the apE Al of various regulatory authorities .

If such efforts to integrate acquired or licensed businesses or technologies into our business are not successful, our business could be harmed .

If we cannot initiate and maintain revenue-generating relationships with third parties, we may not be able to grow our revenues in the near to medium term

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

Fluctuations in interest rates. foreign currency exchange rates and levels of indebtedness could harm our busines s

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

We have significant debt balances following the issuance of our most recent convertible debt offerings . Therefore, our financial results will reflect increased interest expense and we could be harmed by a negative change to our credit rating by the debt rating agencies .

The holders of the Liquid Yield Option Notes (LYONs) due 2031 may require us to purchase all, or a portion, of the LYONs on June 12, 2004 . We may choose to pay the purchase price in cash or in shares of Chiron common stock . To the extent we elect to purchase the LYONs for cash, our inability to replace the . LYONs with new debt securities could adversely affect our cash balances and our business. To the extent we elect to pay for the LYONs in shares of Chiron common stock, the existing common stockholders would experience dilution as a result of the newly issued shares of Chiron common stock .

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

We have an alliance with Novartis AG, a life sciences company headquartered in Basel, Switzerland . Under a series of.agreements between Chiron and Novartis, and as a result of subsequent stock issuances by Chiron, Novartis' ownership interest in Chiron was approximately 42% as of March 31, 2004 . The governance agreement between Chiron and Novartis contains provisions that require the approval of Novartis before we enter into certain corporate transactions . These transactions generally include significant debt or equity issuances, debt or equity repurchases, most mergers and acquisitions, the payment of cash dividends, amendments to Chiron's certificate of incorporation or by-laws, and other transactions that would adversely impact the rights of Novartis, or discriminate against Novartis, as a Chiron stockholder . In addition, a majority of the independent directors must approve any material transactions between Chiron and Novartis. These provisions may limit our ability to enter into transactions with third parties otherwise viewed as beneficial to Chiron . All of our shares owned by Novartis are eligible for sale in the public market subject to compliance with the applicable securities laws . We have agreed that, upon Novartis' request, we will file one or more registration .statements under the Securities Act in order to permit Novartis to offer and sell shares .of our common stock. Sales of a substantial number of shares of our common stock by Novartis in the public market could adversely affect the market price of our common stock . 46 ::1 Volatility of our stock price could negatively impact our profitability.

The price of our stock, like that of other pharmaceutical companies, is subject to significant volatility . Any number of events, both internal and external to 3 us, may affect our stock price . These include, without limitation :

• Fluctuations in earnings from period to period;

• Results of clinical trials conducted by us or by our competitors ;

• Announcements by us or our competitors regarding product development efforts, including the status of regulatory approval applications ;

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

• The launch of competing products ;

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

• Corporate restructuring by us ;

• The sale ofa substantial number of shares held by our existing stockholders ;

• Licensing activities by us ; and

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

In connection with our research and development collaborations, from time to time we may invest in equity securities of our strategic partners . The price o f i these securities also is subject 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 these securities may impact our profitability.

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

We pay taxes principally in the U.S ., Germany, Italy, The Netherlands and, with the acquisition of PowderJect, the United Kingdom . All of these jurisdictions have in the past and may in the future make changes to their corporate tax rates and other tax laws, which could increase our future tax provision . We have negotiated a number of rulings regarding income and other taxes that are subject to periodic review and renewal . If such rulings are not renewed or are substantially modified, income taxes payable in particular jurisdictions could increase, While we believe that all material tax liabilities are reflected properly in our balance sheet, we are presently under audit in several jurisdictions and may be subject to further audits in the future, and we have no assurance that we will prevail in all cases in the event the taxing authorities disagree with our interpretations of the tax law . In addition, we have assumed liabilities for all income taxes incurred prior to the sales of our former subsidiaries, Chiron Vision (subject to certain limitations) and Chiron Diagnostics . Future levels of research and development spending, capital investment and export sales will impact our entitlement to related tax credits and benefits which have the effect of lowering our effective tax rate.

Volatility of earnings could negatively impact our business .

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

Inventory management practices, including wholesale ordering patterns ;

The level of pre-clinical and clinical trial-related activities;

4 7

y • Seasonality of certain vaccine products ;

The tender driven nature of certain vaccine products ;

• s The nature of our collaborative , royalty and license arrangements and other revenue sources ;

Foreign currency exchange rate fluctuations ; and

The level of product reserves due to various issues, including seasonality patterns, excess and obsolete inventory, and production yields .

Our results in any one quarter are not necessarily indicative of results to be expected for a full year .

We must follow accounting standards, financial reporting and corporate governance requirements and tax laws set by the governing bodies and lawmakers in the U .S . and other countries where we do business. From time to time, these governing bodies and lawmakers implement new and revised rules and laws . These new and revised accounting standards, financial reporting and corporate governance requirements and tax laws may require changes to our financial statements, the composition of our board of directors, the composition, the responsibility and manner of operation of various board--level committees, the information filed by us with the governing bodies and enforcement of tax laws against us . Implementing changes required by such new standards, requirements or laws likely will require a significant expenditure of time, attention and resources, especially by our senior management . It is impossible to predict the impact, if any, on Chiron of future changes to accounting standards, financial reporting and corporate governance requirements and tax laws . In addition, it is possible that the application of certain Current accounting standards may change due to environmental factors, which may necessitate a change in our standard practice related to these accounting standards.

Item 3 . Quantitative and Qualitative Disclosures About Market Ris k

Item 4, Controls and Procedure s

(a) Evaluation of disclosure controls and procedures As of the end of the period covered by this report, Chiron carried out an evaluation under the superv ision and with the participation of Chiron' s management , including Chiron's CEO and CFO, of the effectiveness of the design and operation of Chiron's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(e) or 15d--15(e) . Based on that evaluation, Chiron's man agement, including the CEO and CFO, concluded that Chiron's disclosure controls and procedures were effective in timely alerting them to material information relating to Chiron required to be included in Chiron's periodic SEC filings.

48 } Changes in internal controls There have been no significant changes in Chiron's internal controls over financial reporting or in other factors that could significantly affect internal controls over financial reporting during the most recent fiscal quarter .

(G1 Limitations on the effectiveness of controls It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met . In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events . Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions .

49 PART I I

Item I _ Legal Proceedings

We are party to certain lawsuits and legal proceedings, which are described in Part I, Item 3 . "Legal Proceedings" of our Annual Report on Form 10-K for the year ended December 31, 2003 . The following is a description of material developments during the period covered by this Quarterly Report and should be read in conjunction with the Annual Report on Form 10-K for the year ended December 31, 2003 .

Active Biotech A B

In June 2003, Powderiect Pharmaceuticals Plc ("Powderiect") filed a Request for Arbitration before the Athitral Tribunal of the Arbitration Institute of the Stockholm Chamber of Commerce in Sweden against Active Biotech AB ("Active Biotech") . PowderJect claimed that Active Biotech breached certain warranties and representations made in the July 2, 2001 Agreement by which PowderJect acquired SBL Vaccin AB ("SBL") from Active Biotech (the "Agreement"), and sought compensatory damages and legal fees . In a settlement agreement reached in April 2004, Active Biotech agreed to waive all rights to further royalty and milestone payments upon payment by PowderJect of $4 .5 million, and PowderJect withdrew all claims relating to the Agreement . The matter is thus concluded .

Laboratory Corporation ofAmerica Holdings

In April 2003, Chiron filed a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings ("LabCorp Holdings"), Laboratory Corporation of America ("LabCorp") and National Genetics Institute ("NGI") (collectively, the "Defendants"), seeking damages and an injunction against Defendants' manufacture, use and sale of the UltraQualTM HCV RT-PCR assay and HCV SUPFRQUANTTM assay for infringing Chiron's U .S . Patent No . 6,074,816 (the "816 patent") . The Defendants filed a complaint in the United States District Court for the District of Delaware against Chiron seeking a declaratory judgment that Defendants infringe neither the "816 patent, nor U .S . Patent Nos. 5,712,088, 5,863,7 19, 6,074,816, and 5,714,596 (collectively, the "Chiron Hepatitis C virus-related patents"), and that the Chiron Hepatitis C virus-related patents are invalid . In August 2003, the Delaware Court granted Defendants' motion to enjoin Chiron from proceeding with the California action and compel Chiron to dismiss that action . Chiron has appealed this judgment to the United States Court of Appeals for the Federal Circuit, and a hearing was held in March 2004 . Chiron is awaiting a decision from the court. The Delaware Court has scheduled a trial for May 2005 .

In August 2003, Chiron filed a complaint in the United States District Court for the Northern District of California against Laboratory Corporation of America Holdings, Laboratory Corporation of America and National Genetics Institute (collectively, the "Defendants"), seeking damages and an injunction against Defendants manufacture, use and sale of certain HIV assays for infringing Chiron's U .S . Patent No . 6,531,276 (the "276 patent") . In February 2004, Chiron voluntarily dismissed this case without prejudice and refilled the complaint before the United States District Court for the Central District of California .

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

Item 4. Submission of Matters to a Vote of Security Holders

None.

50 Item 6 . Exhibits and Reports on Form 8-K

(a) Exhibit s

Exhibit Number Exhibi t

3 .41 Restated Certificate of Incorporation of Chiron, as filed with the Office of the Secretary of State o f Delaware on August 17, 1987, incorporated by reference to Exhibit 3 .01 of Chiron's report o n Form 10-K for fiscal year 1996 . 3 .02 Certificate of Amendment of Restated Certificate of Incorporation of Chiron, as filed with th e Office of the Secretary of State of Delaware on December 12, 1991, incorporated by reference t o 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 th e 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 10 .304 o f Chiron's report on Form 10-K for fiscal year 2003 . 4.01 Indenture between Chiron and StateStreet Bank and Trust Company, dated as of June 12, 2001 , incorporated by reference to Exhibit 4 .01 of Chiron's report on Form I" for the period ended June 30, 2001 . 4.02 Registration Rights Agreement dated as of June 12, 2001, between Chiron and Merrill Lynch & Co ., Inc., and Merrill Lynch, Pierce, Fenner & Smith, Incorporated, incorporated by reference t o Exhibit 4 .02 of Chiron's report on Form I0-Q for the period ended June 30, 2001 . 4.03 Form of Liquid Yield Option Note?"' due 2031 (Zero Coupon-Senior) (included as exhibits A- I and A-2 to the Indenture filed as Exhibit 4.01 hereto), 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-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 ., Bane of America Securities LLC and BNP Paribas Securities Corp . , incorporated by reference to Exhibit 4 .3 of Chiron's registration statement on Form-3 filed wit h 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--3 filed with the Commission o n September 23, 2003 . 10 .102 Amended and Restated Revolving Credit Agreement, dated as of August 13, 2002 (the "Credi t Agreement"), by and between Chiron and Bank of America, N .A. (the "Bank"), and exhibits thereto, incorporated by reference to Exhibit 10 .102 of Chiron's report on Form I0-Q for September 30, 2002. 10 .519 Chiron Corporate Governance Guidelines, as amended. 31 .1 Certification of the Chief Executive Officer pursuant to Rules l3a-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 adopte d pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 .

5 1

`,i 32 .2 Certification of the Chief!- . . .:ial Officer pursuant to 18 U.S.C . Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 . (b) Repo rt s on Form 8-K

On January 9, 2004, Chiron filed a Current Report on Fonn 8-K, furnishing under Item 5, the announcement that the Securities and Exchange Commission had declared effective its registration statement on Form S-3, relating to the resale of $500 million principal amount of its 1 5/8% Convertible Debentures due 2033 and the shares of its common stock issuable upon conversion of the debentures .

On January 28, 2004, Chiron filed a Current Report on Form 8-K, furnishing under Item 12, Chiron's preliminary results for its fourth quarter ended December 31, 2003, via a press release.

7 CHIRON CORPORATION March 31, 2004

SIGNATURES

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

CHIRON CORPORATION

DATE: April 30, 2004 By : 1s! HOWARD H . PIEN

Howard H. Pie n President and Chief Executive Officer

DATE: April 30, 2004 Hy : /s/ DAVID V_ SMIT H

David V. Smith Vice President and ChiefF'inancialOfcer

53 EXHIBIT E ` 1~

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UNITED STATES SECURITIES AND EXCHANGE COMMISSIO N Washington , D.C . 2054 9

FORM 1Q-Q

(Mark one )

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

For the quarterly period ended June 30, 2004

O R

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

For the transition period from to

Commission File Number . 0-12798

CHIRON CORPORATIO N (Exact name of registrant as specified in its charter)

Delaware 94 -2754624 (State or other jurisdiction of (I .R .S . Employer Identification No .) incorporation or organization )

4560 Horton Street , Emeryville, California 94608 (Address of principal executive offices) (Zip code )

(510)655-8730 (Registrant's telephone number, including area code)

Not Applicable (Former name, former address and former fiscal year, if changed since last report )

Yesll No D

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

Yes l l No 0

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

Title of Class Outstanding at July 30, 2004 Common Stock, $ 0.01 par value 187,718,517 CHIRON CORPORATION TABLE OF CONTENTS

Page No.

PART I. FINANCIAL INFORMATION ITEM 1 . F in ancial Statements (Unaudited) Condensed Consolidated Balatice Sheets at June 30., 204A and December 31 , 2003- 3 Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003 5 Condensed Consolidated Statements of Comprehensive Income for the three and six months ended June 30; 2004 and 2003 6 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003 7 Notes to Condensed Consolidated :Financial+Statements ; . ITEM 2 . Management's Discussion and Analysis of Financial Condition and Results of Operations 24 ITEM 3 : Quan titative and Qualitative Disclosures.AboutMarket_Risk 51 ITEM 4 . Controls and Procedures 5 1 PART.•II. OTHER INFORMATION ITEM 1 . Legal Proceedings 5 3 ITEM 2 . Changes in Securities and Use of Proceeds 5 3 ITEM 4 . Submission of Matters to a Vote of Security Holders 5 4 ITEM 6 . Exhibits and Reports on Form :. 8-K 5 5 SIGNATURES 57

2 Item 1 . Financial Statements

CHIRON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands , except share data)

June30, December 31, 2004 2003

ASSETS .': Current assets : Cash and cash equivalents $ 595,023 364,270 Short-term investments in marketable debt securities 235,964 174,21 2

Total cash and short-term investments 830,987 538,48 2 Accounts receivable, net of allowances 329,856 382,93 3 Current portion-of notes receivable 500 1,47 9 Inventories, net of reserves 275,574 199,62 5 Assets held for sale 3,044 2,992 Current net deferred income tax assets 59,992 50,204 Derivative financial instruments 3,871 9,463 Other current assets 78,217 72,47 1

Total current assets 1,582,041 1,257,649 Noncurrent investments in marketable debt securities 202,979 560,292 Property, plant, equipment and leasehold improvements, at cost : Land and buildings 368,791 366,275 Laboratory, production and . office equipment 614,178 615 ;81 4 Leasehold improvements 114,377 112,200 Construction--in-progress 175,956 144,16 2

1,273,302 1,238,45 1 Less accumulateddepreciation and amortization (544,635) (548,701 )

Property, plant, equipment and leasehold improvements, net 728,667 689,75 0 Purchased technologies ; net 226,297. 236,70 7 Goodwill 806,759 787,58 7 Other intangible assets; net . 464,695 486,88 9 Investments in equity securities and ,tftilia[ed companies 114,633 121,57 6 Equity method investments 889 953 Noncurrent notes receivable 7,500 7,500 Norictirrent. derivative`financial instruments,... Other noncurrent assets 51,031 38,875

$ 4,185,491 .., $ :4,195,169

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

i CHIRON CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS ( Continued)

(Unaudited)

(In thousands , except share data)

June 30, December 31 ; 2004 2003

,LIABILI'TI(ESEANDSTOCK]IOLDERS' FQUIT Y Current liabilities : Accounts payable $ 112,778 $ ., 102,20 1 Accrued compensation and related expenses 64,296 83,31 1 Current portion of capital lease 244 570 Current portion of unearned revenue 60,334 47,87 3 Income taxes payable 16,192 15,270 Other current liabilities 124,940 187,68 8

Total current liabilities . 378,784 436,913 Long-term debt 938,087 926,709 Capital lease 157,075 157,677 Noncurrent derivative financial instruments 3,677 - Noncurrent net defennad ;income,tax'liabilities 90,848. 107,496 Noncurrent unearned revenue 35,330 45,564 Other noncurrentliabilities 85,776 69,44 8 Minority interest 7,984 7,002

Total liabilities . 1,697,561 1,750,809

Commitments and contingencies Stockholders' equity : Common stock 1,917 1,91 7 Additional paid-in capits l 2,527,313 .2,503,195 Deferred stock compensation (18,929) (12,871 ) Retained earnitigs.{Accmriutated deficit} 7,562 (46,634) Accumulated other comprehensive income 171,779 216,302 Treasury.stook at cost (4 063,000 shares at June"30 2004 and 4 ;567,000 shares at _" - i}eceniber 31, 2003) . (201,712) (217,549 )

Total stockholders' equity 2,487,930 2,444,360

4,185,491 $ 4,195,16 9

The accompanying Notes to Condensed Consolidated Financial Statements are integral to this statement . 4 CHIRON CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATION S

(Unaudited)

(In thousands, except per share data )

Three Months Ended Six Months Ended . June 30, June 30,

2004 2003 2004 2003

Revenues: Product sales, net $ 295,092 5 245,928 $ 576,158 $ 464,548 Revenues from joint business arrangement 28,532 27,475 58,893 53,92 7 Collaborative agreement revenues 3,828 3,624 .10,343 7,73 8 Royalty and license fee revenues 55,196 66,876 109,988 120,30 0 Other re venues 10,975 6,369 17,913 24,79 4

Total revenues 393,623 350,272 773,295 671,307 .

Operating expenses : Cost of sales . 130,725 971420 257,426 183,009 Research and development 100,326 89,915 198,736 172,045 Selling,- general and administrative 106,857 80,226 211 ;597 153,268 Amortization expense 21,179 7,701 42,511 15,31 4 -Other operating expenses 4,643 1 259 6,759 2,950

Total operating expenses 363,730 276,521 717,029 526,58 6

Income from operations .... 29,893 73,751 . . 56,266 144,72 1 Interest expense (6,452) (2,839) (12,377) (6,301 ) Interest and other income, net 19,809 11,613 35,883 25,931 Minority interest (459) (581) (1,079) (981 )

Income -from continuing operations before income taxes 42 ;791 81,944 : : . 98,693 163,37 0 Provision for income taxes 10,698 20,485 19,673 40,84 2

Income from con tinuing operations 32,093 61';459 59;020 122,528 . Gain from discontinued operations 12,459 538 25,304 1,964

Net-in6ame $ 44,552 ::. S 61,997 . $ 84,324 $ 124,492

Basic earnings per share: :Income from continuing operations .0 .17 S 033 S 0.31 $ 0 .66 .

Net income $ 0 .24 S 0.3 3 S 0.45 $ 0 .6 7 , .~ www awwww~w t rr - r+.ri rr~ ~

Diluted. eamings per-share: Income from continuing operations $ 0 .17 $ 0 .3 2 $ 0,31 S 0.65 rsrrr~~ arrrr.nrr .r.rrr ~ s Net income : '. $ 0.23 $ 0.3 3 $ 0.44 '0.66 MEMO "= w.n ~rrrrrrr t..~++r +

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

5 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOM E

(Unaudited )

(In thousands)

Three Months Ended Su Months Ended June 30, June 30 ,

2004 2003 2004 200 3

Net income $ 44,552 . $ 61,997 84,324 $ 124,492

Other comprehensive income (loss) : - Change in foreign currency translation adjustment during the period (15,810) 35,823 (37,438) 45,11 8

Unrealized gains (losses) from investments : Net unrealized holding gains (losses) arising during the period , net of tax ..(provision) benefit of$4,610 and ($1,541) for the three months ended June 30, 2@04 and 2003, respectively, and $2,11 2 and ($1 ;284)''for the six months ended June 30 ; 2004' arid 2003, respectively . 6,267 3,083 7,544 2,64 0 Reclassification adjustment for net gains included in net income, net of tax provision of $2,965 and $1,834 for the three months ended June 30, 2004 and 2003, respectively, and $9,353 an d $3,626 for the six months ended June 30, 2004 and 2003 , respectively (11,361) (2,940) (14,629) (5,744 )

Net unrealized gains (losses) :from investments . . . . (5,094) 143 : (7,085) (3,104)

Other comprehensive income (loss) (20,904) 35,966 (44,523) 42,01 4

Comprehensive income $ ; 23,64.8 .:$ 97,963 S -_,39,801 : $ 166,506 -

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

6 CHIRON CORPORATIO N

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

} (Unaudited)

(In thousands)

Six Mouths Ended June 30,

2004 2003

Net cash provided byoperatiag activities 730 112,706

Cash flows from investing activities: Purchases of investments in marketable debt : securities (21$,815) (277,514) Proceeds from sales and maturities of investments in marketable debt securities 508,121 917,79 4 Capital expenditures (93,770), (52,371) Purchases of equity securities and interests in affiliated companies (4,349) (36,889) Erogpeds from sale of equity securities and interests in affiliated companies 16,277 - • 7;428 . Cash paid for acquisitions, net of cash acquired (19,548) (1,180) Other; net 783 (777) `

Net cash provided by investing activities 188,699 556,49 1

Cash flows from-financing-activities : Net repayment of short-term borrowings - (71 ) Repaytnentofdebtand.capital leases (380;035) ." , . . : : (95 ) Payments to acquire treasury stock (71,726) (68,079 ) Proceeds . om reissuanee ofareasurystock 45,001 - 24,52 6 Proceeds from issuance of debt 2,31 7 PaY►►tent.ofbond issuance costs (7;766) - Proceeds from issuance of convertible debentures 385,00 0 Proceeds from put .options ,, - 2,144

Net cash used in financing activities (27,209) (41,575 )

Fflecz'aeie iangc•rate changes on ~ashattilrasli equtvalent "(5;467) 47I ..

Net increase in cash and cash equivalents 230,753 628,09 3 Cash and cash equivalents at:beginnin oftheporiod ; 364,270 , .. 247,950

Cash and cash equivalents at end of the period $ 595,023 $ 876,04 3

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

7 CHIRON CORPORATIO N

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENT S

June 30, 200 4

(Unaudited)

Note 1--Basis ofPresentation and Summary of Significant Accounting Policies

Basis of Presentatio n

The-information presented in the Condensed Consolidated Financial Statements at June 30, 2004, and for the three and six months ended June 30, 2004 and - 2003, is unaudited but includes adjustments, consisting only of all normal recurring adjustments, which Chiron Corporation believes to be necessary for fair presentation of the periods presented.

The Condensed Consolidated Balance Sheet amounts at December 31, 2003, have been derived from audited financial statements. Historically, Chiron's operating results have varied considerably from period to period due to the nature of Chiron's collaborative, royalty and license arrangements and the seasonality of certain vaccine products. In addition, the mix of products sold and the introduction of new products will affect comparability from quarter to quarter . As a consequence ; Chiron's interim results in any one quarter are not necessarily indicative of results to be expected for a full year . This information should be read in conjunction with Chiron's audited Consolidated Financial Statements as of and for the year ended December 31, 2003, which are included in the Annual Report on Form 10-K filed by Chiron with the Securities and Exchange Commission .

Principles of Consolidatio n

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

On July 8, 2003, Chiron acquired PowderJect Pharmaceuticals plc, a company based in Oxford, England that develops and commercializes vaccines . Chiron included PowderJect Pharmaceuticals' operating results in its consolidated operating results beginning July 8, 2003 . PowderJect Pharmaceuticals is part of Chiron's vaccines segment.

Chiron is a limited partner in several venture capital funds . Chiron is obligated to pay up to $60 .0 million over ten years in equity contributions to these venture capital funds, of which approximately $36 .5 million was paid through June 30, 2004. Chiron accounts for these investments under the equity method of accounting.

Adoption of New Accounting Pronouncements

Financial Accounting Standards Board (or FASB) Interpretation No . 46 (or FIN 46), "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51" as revised, requires a variable interest entity (or VIE) to be consolidated by a company if that company absorbs a majority of the VIEs expected losses, receives a majority of the entity's expected residual returns, or both, as a result of ownership, contractual or other financial interest in the WE . Prior to the adoption of FIN 46, VIES were generally consolidated by companies owning a majority voting interest in the VIE. The consolidation requirements of FIN 46 applied immediately to VIEs created after January 31, 2003, however, the FASB deferred the effective date for VIEs created before February 1, 2003 to the quarter ended March 31, 2004 for calendar year companies . Adoption of the provisions of FIN 46 prior to the deferred effective date was permitted .

We adopted the remaining provisions of FIN 46 in the first quarter of 2004 . The adoption of these provisions did not have a material effect on our Condensed Consolidated Financial Statements .

Use of Estimates and Reclass ficaiion s

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

Chiron's blood-testing segment includes Chiron's one-half share in the pretax operating earnings generated by thejoint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company. Chiron accounts separately for research and development and manufacturing cost reimbursements and certain product sale revenues received from Ortho-Clinical Diagnostics, but relating to the joint business contractual arrangement . Chiron's joint business arrangement with Ortho-Clinical Diagnostics is a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to the first quarter 2003, Chiron had accounted for revenues relating to Ortho-Clinical Diagnostics' non-U .S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter. More current information of Ortho-Clinical Diagnostics' non-U .S . affiliate sales became available in the first quarter 2003, and as a result, Chiron is able to recognize revenues relating to Ortho-Clinical Diagnostics' non-U .S . affiliate sales on a one-month lag. The effect of this change, net of tax, was an increase to net income by $3 .2 million for revenue from the joint business contractual arrangement for the six months ended June 30, 2003 .

Chiron currently owns a facility in London, England for international operations. This facility became available for sale in the fourth quarter of 2003 and Chiron expects to complete the sale of this facility within one year of the date it became available for sale . Chiron has committed to a plan to sell this facility and is actively marketing this facility . This facility is classified as "Assets held for sale" in the Condensed Consolidated Balance Sheet at June 30, 2004 . Chiron, prior to filing its financial statements on Form 10-Q, publicly releases an unaudited condensed balance sheet and statement of operations . Between the date of Chiron's earnings release and the filing of Form l0-Q, reclassifications may be required . These reclassifications, when made, have no effect on income from continuing operations, net income .or earnings per share. There has been no such reclassification in the second quarter 2004 .

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

Inventories

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

Inventories, net of reserves, consisted of the following:

Juue3 0, Deeember3l, 2004 2003

Finished goods 49,734 $ 38,640 Work-in-process 169,715 105,359 Raw materials 56;125 . 55,62 6

$ 275,574 $ 199,625 wrr~+.rrrr~ Income Taxes

The effective tax rate for the three and six months ended June 30, 2004 and 2003 was 25% of pretax income from continuing operations . The effective tax rate may be affected in future periods by changes in Chiron's estimates with respect to the deferred tax assets, acquisitions and other items affecting the overall tax rate.

Put Options

Stock-Based Compensatio n

Chiron measures compensation expense for its stock-based employee compensation plans using the intrinsic value method . Compensation expense is based on the difference, if any, between the fair value of Chiron's common stock and the exercise price of the option or share right on the measurement date, which is typically the date of grant. This amount is recorded as "Deferred stock compensation" in th e

1 Condensed Consolidated Balance Sheets and amortized as a charge to operations over the vesting period of the applicable options or share rights . Compensation expense is included primarily in "Selling, general and administrative" in the Condensed Consolidated Statements of Operations .

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

Three Months Ended Six Months Ended June 30, June 30 ,

2004 2003 2004 2003

(in thousands, except per share data )

Net income : As reported $ 44,552 $ 61,997 S 84,324 $ 124,492 Add: Stock-based employee compensation expense included in reported itet income, net of re lated tax effects 1,349 1,750 .2,689 2,651 Less : Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 22,769 19,933 44,277 38,04 5

Pro forma S 23,132 $ 43,814 $ . 42,736 $ 89,098 rr ..rrrri ~~ ~ M ~rrrr~rs

Basic net income per share : As report ed" $ 0.24 $ 0 .33 . $ 0 .45 $ . 0.67 Pro forma $ 0.12 $ 0,24 $ 0 .23 S 0 .48 Diluted net hicome .per share : As reported $ 0.23 $ 0 .33 $ 0 .44 $ 0.66 Pro forma . $ 0.12 . $ . 0.23 $ 0 .22 $ 0.47

Comprehensive Income

For the three and six months ended June 30, 2004 and 2003, the foreign currency translation component of comprehensive income relates to permanent investments in nom-U.S . subsidiaries, and accordingly, was not adjusted for income taxes .

Treasury Stock

11 Note 2-Earnings Per Shar e

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

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

Three Months Ended Six Months Ended June30, June 30 ,

2004 2003 2004 200 3

Income ( Numerator): Income from continuing operations $ 32,093 $ 61 ,459 $ 59,020 $ 122,52 8

Shares (Denominator) : Weighted- average common shares outstanding 188,275 186,408 187,952 186,58 4 E ffect of dilutive- curities :;:' :'` .` Stock options and equivalents 2,710 3,550 3,450 3,294 5 Put :options . 3

Weighted-average common shares outstanding , plus impact fro m assumed conversions 190,985 189,963 191,402 189,88 1

Basic earnings per share $' 0.17 $ 0.33 $ 0 .31 $ 0.66

Diluted earnings per share $ 0.17 $ 0.32 S 0 .31 $ 0.6 5

12 ~1 The following table sets forth the computa, ._ . .a for basic and diluted earnings per share on net income (in . .sands, except per share data) :

Three Months Ended Six Mosiths Ended Jude 30 ; June 30,

2004 2003 2004 2003 income (Numerator) : . .. . Net incom e $ 44,552 $ 61,997 $ 84,324 $ 124,49 2

Shares (Denominator): Weighted-average co mmon shares outstanding 188,275 186,408 187,952 186,584 Effect of dilutive securities:,,.. Stock options and equivalents 2,710 3,550 3,450 3,294 Put options 5 3

Weighted-average common shares outstanding, plus impact from assumed conversion s 190,985 189,963 191,402 189,881

Basic earnings per share .: . .. $ 9 .24. : $ 0.33 . $ : . 0.45 $ 0.67

Diluted earnings per share $ 0 .23 $ 0 .33 $ O .Q4 $ 0.66 trw~rrarirr.rrs

For the three months ended June 30, 2004 and 2003, stock options to purchase 14 .8 million and 16.8 million shares, respectively, and for the six months ended June 30, 2004 and 2003, stock options to purchase 7.6 million and 17. 1 million shares, respectively, with exercise prices greeter than the average market prices of common stock, were excluded from the respective computations of diluted earnings per share as their inclusion would be antidilutive _

For the three and six months ended June 30, 2004 ; 4.1 million and 6 .2 million shares of common stock that would be issued upon conversion of the Liquid Yield Option Notes (LYONS) were excluded from the computations of diluted earnings per share, as their inclusion would be antidilutive . For each of the three and six months ended June 30, 2003, 5 .2 million shares of common stock that would be issued upon conversion of the LYONs were excluded from th e computation of diluted earnings. per.share, as their inclusion would be antidilutive.. During the second quarter of 2004, Chiron was required to purchase a significant portion of the LYONs as discussed in Note 7 "Debt Obligations".

Chiron issued contingently convertible debentures in the second quarter of 2004 as discussed in Note 7 "Debt Obligations" . The terms of the conversion features of these debentures are substantive and therefore, the shares of common stock issuable upon conversion of the convertible debentures are not included in . the computation of diluted earnings per share until such time as the terms of the conversion features are met . The conversion terms were not met during the second quarter of 2004 .

On July 30, 2003, Chiron issued $500 .0 million aggregate principal amount of convertible debentures, which mature on August 1, 2033 . The terms of the conversion features of these debentures are substantive. and therefore, the shares of common stock issuable upon conversion of the convertible debentures are not included in the computation of diluted earnings per share until such time as the terms of the conversion features are met . The conversion terms were not met during the second quarter of 2004 .

13 Note 3-Discontinued Operation s

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

In the first quarter 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, Chiron was required to make a payment to Bayer during the first quarter 2003 . Pursuant to this settlement, Chiron recorded a charge, net of adjustment to its previously provided reserve for indemnity obligations, of $7 .6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of $1 .4 million which was reported as a "Gain from discontinued operations" for the six months ended June 30, 2003 .

In the second quarter 2003, we reversed approximately $0 .5 million related to unutilized reserves of Chiron Diagnostics and Chiron Vision, which were recorded as a "Gain from discontinued operations" for the three and six months ended June 30, 2003 .

Chiron and Bayer also were involved in a separate dispute with respect to their respective rights to certain royalty refunds receivable for which a settlement was reached in 2004 . Under this settlement agreement, Chiron made a payment to Bayer in 2004 . This settlement includes an agreement that all outstanding items with Bayer related to the sale of Chiron Diagnostics are resolved and no future indemnity obligations are required. Chiron released previously established reserves in excess of the required payments for the indemnity obligations in the first quarter of 2004 . This settlement resulted in a benefit of $0 .3 million and an income tax benefit of $12 .5 million, resulting in a net gain of $12 .8 million, which was reported as a "Gain from discontinued operations" for the six-months ended June 30, 2004 .

In the second quarter 2004, Chiron and the IRS entered into a settlement agreement closing the open tax years 1996 to 1998 . Pursuant to this settlement agreement Chiron recognized a tax benefit of approximately $12 .5 million, which was reported as a "Gain from discontinued operations" for the three and six . months ended June 30, 2004.

Note 4-Acquisition s

PewderJect Pharmaceuticals pie On July 8, 2003, Chiron acquired Powderlect Pharmaceuticals, a company based in Oxford, England that develops and commercializes vaccines . Chiron acquired all of the outstanding shares of common stock of PowderJect Pharmaceuticals for 550 pence per ordinary share, which, including estimated acquisition costs, resulted in a total preliminary purchase price of approximately $947 .8 million .

During the second quarter of 2004, Chiron completed the planned divestiture of certain research operations in Madison, Wisconsin and Oxford, England and certain vaccines operations in Sweden. The divestiture of these operations included the disposition of net assets of $14,7 million which included $15.5 million of cash, deferred tax assets of $9 .4 million, and exit liabilities of$21 .6 million. The net impact of the divestiture resulted in an increase to goodwill of $2 .5 million . Also during second quarter of 2004, Chiron adjusted the previously recorded obligation related to an assumed defined benefit plan,

14 which resulted in an increase to goodwill of $8 .1 million . The purchase price includes accruals for estimated exit costs and certain other direct acquisition costs . As a result of the adjustment to exit liabilities and estimated direct acquisition costs, the purchase price was revised to $925 .8 million . The aggregate purchase price and the allocation of the purchase price may change upon finalization of these estimates .

PowderJect Pharmaceuticals is part of Chiron'svaccines segment . Powderject Pharmaceuticals' products, including vaccines for influenza, expand Chiron's portfolio of vaccine products . Chiron accounted for the acquisition as a business combination and included PowderJect Pharmaceuticals' operating results in its consolidated operating results beginning July 8, 2003 :

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

Consideration and acquisition costs : Cash paid for common stock $ 831,02 6 Cash paid for options on common stock 59,153 , Acquisition costs paid as of June 30, 2004 20,73 9 Acquisition . costs not. yet paid ass of June 30, 2004 14,88 3

Total purchase price $ 925,80 1

Allocation ofpurchase price ; . Cash and cash equivalents $ 76,68 5 Short-term marketable securities 8,840 Accounts receivable, net 39,600 . Inventories 64,924 Property, plant and equipment 60,58 9 Goodwill 513,520 Acquired intangible assets 335,500 Other assets .. .,; 4,876. . , :. income taxes payable (17,741 ) Gurrent-tiabilnes (54,383 ) Net deferred tax liability (69,566) Long-term liabilities (82,343 ) Purchased in-process research and development 45,30 0

Total purchase price $ 925,80 1

Chiron allocated the purchase price based on the fair value of the assets acquired and liabilities assumed. Chiron allocated a portion of the purchase price to purchased in-process research and development, which it charged to earnings in 2003 . Purchased in-process research and development represented the valuatio n of acquired, to-be--completed research projects . Purchased in-process research and development was determined using the income approach, which is based on the premise that the value of a security or asset is the present value of the future earning capacity that is available fo r

15 distribution to the subject investors in the security or asset. In valuing the purchased in-process research and development, Chiron used probability-of-success-adjusted cash flows and a 14% discount rate . Cash flows from projects including those relating to (i) certain travel vaccines and (ii) vaccines for allergies were assumed to commence between 2004 and 2012 . Given the high risk associated with the development of new drugs, Chiron probability-adjusted the revenue and expense forecasts to reflect the risk of advancement through the regulatory approval process based on the stage of development in the regulatory process . Such a valuation requires significant estimates and assumptions . Chiron believes that the fair value assigned to purchased in-process research and development is based on reasonable assumptions. However, these assumptions may he incomplete or inaccurate, and unanticipated events and circumstances may occur. To assist in determining the value of the purchased in-process research and development, a third-party valuation was obtained as of the acquisition date .

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

Income taxes payable of$17.7 million relates to current tax liabilities associated with PowderJect Pharmaceuticals at the date of acquisition . The net deferred tax liability of $69 .6 million is comprised of current and non-current deferred tax assets of $31 .1 million primarily related to net operating losses incurred from April 1, 2003 through the acquisition date, reserves and depreciation timing differences and a non-current deferred tax liability of $100 .7 million related to acquired intangibles.

For acquisition costs related to PowderJect Pharmaceuticals, Chiron paid $4 .0 million for the six months ended June 30, 2004 . These payments are reflected in the Condensed Consolidated Statement of Cash Flows as a component of "Cash paid for acquisitions, net of cash acquired" for the six months ended June 30, 2004.

16 Note 5-- -Intangible Asset s

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

June 30, 2004 December 31, 200 3

Gross Net Cross Ne t Carrying Accumulated Carrying Carrying Accumulated Carrying Value Amortization Value Value Amortization Valu e

Purchased technologies $ -332 ;338 .$ - 106,041 $ 226,297 $ . 332,543 . $ 95,836 $ 236,707

Patents $ 123,804 $ 66,171 $ 57,633 S 119,675 $ 61,747 $ 57,92 8 Trademarks ; . 60,033 21,725 38,308 61,082 20,507 40,57 5 Licenses and technology rights 48,473 32,693 15,780 49,087 27,818 21,26 9 Developed product technologies` . 353,195 46,972 . 306,223 347,233 23,093 . 324,14 0 Customer relationships 27,912 10,369 .17,543 28,824 9,952 18,87 2 Knowhow:(l) 12;676 6,289 .. . . .' 6,387 .. . 13,090 6,023 7,06 7 Databases 7,100 1,775 5,325 7,100 1,538 5,56 2 Other 34;884 17,388 17,496 - - - -26,328 14,852 11,476

Total other intangible assets $ 668,077 $ 203,382 $ 464,695 $ - 652,419 $ 165,530 $ 486,88 9 wwt~ ..~w- ~ maw ~ ~ "Total intangible assets'subject to amartization $ 1,000,415 $ 309,423 $ 690,992 $ 984,962 $ , . 261,366 $ 723,596 tr.r.rrrrrrrrrrrar t~rwrwttrr att~rarrr~r_ r~trrr

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

Aggregate amortization expense is as follows (in thousands) :

For the six months ended June 30, 2004 (reported) $ 47,549 For the remaining six . months in the year ended December 31, 2004 (estimated) 44,640

For the yearendedDecember 31, 2004 (estimated) - $ . 92,18 9 For the year ended December 31, 2005 (estimated) $ 89,73 2 For the year ended December 31 2006 .(estiimated) $ 94,13 0 For the year ended December 31, 2007 (estimated) $ 91,98 7 Forth - year ended Decemberi'31 ; 2008 .( estimated) $ 67,47 4 For the year ended December 31, 2009 (estimated) $ 43,82 5 17 The changes in the carrying value of goodh. . 4 reporting unit consisted of the following (in thousands) : ,

Biopharmaceuticals Vaccines Total

Balance as of December 31, 2003 ...... $ 187,492 $ 600,095 :, $ 787,587 Powderlect adjustments (See Note 4) 10,559 10,55 9 Effect of exchange rate changes - 8,613 8,6I3

Balance as of June 30, 2004 $ 187,492 $ 619,267 $ 806,759 ~~ wwww~wrrrr_

Note 6-Segment Informatio n

Chiron is organized based on the products and services that it offers . Under this organizational structure, there are three reportable segments : (i) blood-testing, (ii) vaccines and (iii) biopharmaceuticals . The blood-testing segment consists of an alliance with Gen-Probe Incorporated and Chiron's one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company. Chiron'salliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using Transcription-Mediated Amplification technology to screen donated blood and plasma products for viral infection. Chiron's joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through Chiron's joint business contractual arrangement with Ortho-Clinical Diagnostics, Chiron sells a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provides supplemental tests and microplate and chentiluminescent instrument systems to automate test performance and data collection . The vaccines segment consists principally of adult and pediatric vaccines for viral and bacterial infections . Chiron sells these-vaccines primarily in the U.S ., Germany, Italy, and the United Kingdom, as well as in other international markets. The vaccines segment is also involved in the development of novel vaccines and vaccination technology . The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases, using the development and acquisition of technologies related to therapeutic proteins and small molecules .

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

18 The following segment information exclu. 311 significant intersegment transactions as these transactions eliminated for management reporting purposes (in thousands) :

Th ree Months Ended Sin Months Ended June 30, June 30 ,

2004 2003 2004 2003

Revenues .. Blood-testing : Product sales ; net . ' Procleix® System $ 60,589 $ 45,981 $ 122,475 $ 88,104 Ortho-Clinical Diagnostics 6,608 7,123 12,842 13,53 1

Total product sales, net . 67,197 53,104 135,317 101,63 5 Revenues from joint business arrangement 28,532 27,475 58,893 53,927 Collaborative agreement revenues 2,325 2,340 4,389 4,28 9 Royalty and license fee revenues 16,267 .232160 32,701 38,796 Other revenue s 235 - 430 -

Total -blood--.testingrevenues . -` . 114,556 106;079 231,730 - .198,64 7

Vaccines : Product sales, net : Influenza vaccines 8,207 3,783 15,912 8,03 6 Menlugate® 5,016 . 131696 . 9;565 : . 21;23 4 Travel vaccine s 40,132 23,052 63,142 48,752 , . Pediatand other vaccines 47,619 - 45,026 98,802 . . . : .75,939

Total product sales, net 100,974 85,557 187,421 153,96 1 Collaborative. agreement revenue 1,214 166 5,180 167 s s Royalty and license fee revenue 25 3,343 2,675 6,529 Other revenues 5,914 . 3,218 . 9,556. . 6;009

108,127 92,284 204,832 166,666

Betaseron0 31,626 30,479 61 ;762 59,778 TOBI® 51,342 38,984 103,866 79,71 8 .Pr6leukin®- 35,057 29,381 66,925 55;364 Other 8,896 8,424 20,867 14,09 2

Tatal ;pinduc't sales net 126,921 107,267 253,420' 208;952 .. Collaborative agreement revenues 289 1,118 774 3,28 2 Royalty. and license fee revenues 15,183 20,758 32,480 -- 38,574 Other revenues 4,826 3,151 7,927 18,78 5

Total biopharmaceuticals revenues 147,219 132,294 294,601 269,593.

Other: Royalty and .license fee revenues 23 ,721 19,615 42,132 36,40 1

Total revenues $ 393,623 $ 350,272 $ 773,295 $ 671,30 7

19 Income_ (loss) from continuing operations Blood-testing $ 59,208 $ 62,441 $ 122,848 5 113,00 3 (33,938) 794 (83,977) Vaccines .. . . : : (4,508} Biopharmaceuticals 8,777 8,353 28,026 33,45 2 Other (4,154) 2,163 ( 10631 ) ". 2,774 .

Segment income from operations 29,893 73,751 56,266 144,72 1 Interest expense (6,452) (2,839) -, (12,377) (6,301 ) Interest and other income, net 19,809 11,613, 35,883 25,93 1 Minority interest" (459) (581 ) (1,079) (981)

Income from continuing operations before income taxes $ 42,791 $ 81,944 $ 78,693 $ 163,370 wwrw~wwre www~ ~~ ~~ Note 7-Debt Obligation s

Convertible Debentures

On June 22 , 2004, Chiron issued $385 .0 million aggre gate principal amount of convertible debentures, which mature on June 30 , 2034, The convertible debentures accrue interest at a rate of 2 .75% per year and interest is payable on June 30 and December 30 commencing on December 30, 2004 . The debentures are senior, unsecured obligations of Chiron and rank equal in ri ght of payment with all of Chiron's existing and future unsecure d and unsubordinated indebtedness.

The holders of the debentures may convert their debentures when certain Chiron common stock price targets have been met at certain times, if the trading price for the debentures falls below certain levels for a specified period of time, if the debentures have been called for redemption, if the credit rating assigned to Chiron's long-term senior debt is below specified levels, upon the occurrence and continuance of specified corporate transactions or in connection with a transaction or event constituting a change in control . The initial conversion rate is 14 .9254 shares of Chiron common stock per $1,000 principal amount of debentures . This is equivalent to an initial conversion price of approximately $67 .00 per share of Chiron common stock .

If the debentures are tendered for conversion, the value ("Conversion Value") of cash and shares of Chiron's common stock, if any, to be received by a holder converting $1,000 principal amount of the debentures will be determined by'multiplying the applicable conversion rate by a weighted average price . Chiron will deliver the Conversion Value to debenture holders as follows : (1) an amount in cash ("Principal Return") equal to the lesser of (a) the aggregate Conversion Value of the debentures to be converted and (b) the aggregate principal amount of the debentures to be converted and (2) if the aggregate Conversion Value of the debentures to be converted is greater that the Principal Return, an amount in shares ("Net Shares") equal to the aggregate Conversion Value less the Principal Return ("Net Share Amount") . The number of Net Shares to be paid will be determined by dividing the Net Share Amount by a weighted average price .

} 20

4 s~J

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

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

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

Bond issuance costs in connection with the issuance of the debentures amounted to approximately $8.6 million and are being amortized to interest expense on a straight-line basis, which approximated the effective interest method, over six years, which represents the period from the issue date to the earliest put date . Bond issuance costs are recorded in "Other intangible assets, net" in the Condensed Consolidated Balance Sheets at June 30, 2004 .

Liquid Yield Option Notes

In June 2001 , Chiron issued zero coupon Liquid Yield Option Notes (LYONs) with a face value of $730. 0 million and a yield to maturity of 2 .0%. The LYONs were carried net of an original issue discount of $328 .2 million, which was being accreted to interest expense over the life of the LYONs using the effective interest method . No benefi cial conversion feature existed at the time of the issuance of the LYONs . The LYONs mature 'on June 12, 2031, at a face value of $1 , 000 per note . The LYONs are uncollateralized and unsubordinated , and rank equal in right of payment to Chiron's existing and future uncollateralized and unsubordinated indebtedness .

On June 12, 2004, certain LYONs holders, at their option , tendered , $ 649 .9 million in aggregate p rincipal amount at maturi ty for purchase by Chiron . The purchas e price for the LYONs was $584 . 31. in cash per $ 1,000 in p ri ncipal amount at -maturity . The aggregate purchase price for all the LYONs validly surrendered for purchase was $379 .7 million . At June 30, 2004 ; there remains outstanding $ 80 .1 million in aggregate principal amount at maturity and an accreted balance of $ 46 .8 million for the LYONS,

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

Dat e Price

S June 12 ;1006 . 608.0 4 June 12, 2011 $ 671 .65 June 12 2016 . $ 741 .92 June 12 :2021%- S 819 .54 June 12,2026 $ 905 .2 9 Other Loans Payable

Chiron has entered into various agreements with a governmental body in Italy for which Chiron may borrow up to 11 .0 million Euro ($13 .4 million at June 30, 2004) for research purposes . Under these facilities , Chiron has an outstanding balance of 3 .0 million Euro ($3 .6 million) as of June 30, 2004 with . . interest rates that range from 2% to 6% and maturities that range from 2010 to 2013 .

Note 8-Commitments and Contingencie s

In March 2004, Chiron entered intoa worldwide, exclusive, multi-product, collaborative arrangement with XOMA Ltd . for the development and commercialization of antibody products for the treatment of cancer . Under the terms of the arrangement, the parties agreed to jointly research, develop, and commercialize multiple antibody product candidates . Under the arrangement, the parties agreed to share development and commercialization expenses, including preclinical and clinical development, manufacturing and worldwide marketing costs, as well as revenues, generally on a 70-30 basis, with Chirons share being 70% and XOMA's share being 30% . Chiron agreed to make an initial payment of $10 .0 million, which has been paid as of June 30, 2004, and to make a loan facility of up to $50.0 million available to XOMA, starting on January 1, 2005 to fund XOMA's share of development expenses . The collaboration will initially focus on preclinical, process development and scale up work, with a potential Investigative New Drug (IND) filing anticipated early in the collaboration .

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

Chiron is subject to indemnification provisions under its agreements with other companies in its ordinary course of business, typically with business partners, contractors, clinical sites, insurers and customers . Under these provisions, Chiron generally indemnifies and holds harmless the indemnified party for losses suffered or incurred by the indemnified party as a result of Chiron's activities . These indemnification provisions generally survive termination of the underlying agreement. In some cases, the maximum potential amount of future payments Chiron could be required to make under these indemnification provisions is unlimited . The estimated fair value of the indemnity obligations of these agreements is minimal. Accordingly, Chiron has no liabilities recorded for these agreements as of 22 June 30, 2004 . Chiron has not incurred material costs to defend lawsuits or settle claims related to these indemnification agreement s

Chiron is party to various claims, investigations and legal proceedings arising in the ordinary course of business . These claims, investigations and legal proceedings relate to intellectual property rights, contractual rights and obligations, employment matters, claims of product liability and other issues . While there is no assurance that an adverse determination of any of such matters could not have a material adverse impact in any future period, management does not believe, based upon information known to it, that the final resolution of any of these matters will have a material adverse effect upon Chiron's consolidated financial position and results of operations or cash flows .

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

In the second quarter 2004, Chiron and the IRS entered into a settlement agreement closing the open tax years 19945 to 1998 . Pursuant to this settlement agreement, Chiron recognized a tax benefit of approximately $12 .5 million, which was reported as a "Gain from discontinued operations", as discussed in Note 3 "Discontinued Operations" and a continuing operations tax benefit of $1 .1 million for the three and six months ended June 30, 2004 ,

Note 9-Subsequent Events -

On July 2, 2004, Chiron acquired Sagres Discovery (Sagres), a privately held company headquartered in Davis, California . Sagres focuses on the discovery and validation of targets with potential application to the development of cancer therapeutics . Sagres will be part of the Biopharmaceuticals segment . Chiron acquired Sagres fora preliminary purchase price of $ 11 .8 million .

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

Overvie w

This 10-Q containsforward--looking statements regarding our expectations, hopes or intentions regarding the future, including statements relating to sales growth, product development initiatives, new product marketing, acquisitions, competition, in - and out-licensing activities and expected cost savings that involve risks and uncertainties and are subject to change . You should read the discussion below in conjunction with Part I, Item I ., "Financial Statements." of this 10-Q and Part 11, Items 7., 7A . and 8. . "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Quantitative and Qualitative Disclosures About Market Risk" and "Financial Statements and Supplementary Data, "respectively, of our Annual Report on Form 10-K for the year ended December 31, 2003 . The forward-looking statements contained in this 10--Q reflect our current beliefs and expectations on the date of this 10-Q. Actual results, performance or outcomes may differ from current expectations. Our actual performance may d yer from current expectations due to many factors . including the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, stock ,price and interest-rate volatility, and marketing effectiveness. In particular, there can be no assurance that we will increase sales of existing products, successfully develop and receive approval to market new products, or achieve market acceptance for such new products . There can be no assurance that our out-licensing activity will generate significant revenue, or that our in-licensing activities willfully protect us from claims of infringement by third parties . In addition, we may engage in business opportunities, the successful completion of which is subject to certain risks, including stockholder and regulatory approvals and the integration of operations. We have discussed the important factors, which we believe could cause actual results to differ from what is expressed in the forward-looking statements, under the caption "Factors That May Affect Future Results" in this 10-Q. Consistent with SEC Regulation FD, we do not undertake an obligation to update theforward-looking information contained in this 10-Q .

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

The blood-testing segment consists of an alliance with Gen-Probe Incorporated and our one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & .Johnson company. Our alliance with Gen-Probe is focused on developing and commercializing nucleic acid testing products using transcription-mediated amplification technology to screen donated blood and plasma products for viral infection . Our joint business arrangement with Ortho-Clinical Diagnostics is operated under a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provide supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection.

The vaccines segment consists of flu. vaccines, including Fluvirin®, a product we obtained as part of our third quarter 2003 acquisition of PowderJect Pharmaceuticals (discussed below), a meningococcaI vaccine, travel . vaccines, which include rabies and tick-borne encephalitis vaccines and two other products we obtained as part of our acquisition of PowderJect Pharmaceuticals, ArilvaxTM and DukoralTM, and pediatric and other vaccines . We sell these vaccines primarily in the U.S., Germany, Italy and the United Kingdom, as well as in other international markets . .Our vaccines segment is also involved in the development of other novel vaccines and vaccination technology .

24 The biopharmaceuticals segment consists of therapeutic products and services, with an emphasis on the treatment of cancer and infectious diseases . Our in-house capabilities span three types of therapeutics, including small molecules, therapeutic proteins and monoclonal antibodies . Our products include TO81® (tobramycin solution for inhalation) for pseudomonal lung infections in cystic fibrosis patients, Proleulcin® (aldesleukin) for cancer (metastatic melanoma and renal cell carcinoma), and Betaseronn (interferon beta-lb) for multiple sclerosis . The biopharmaceuticals segment also includes collaborations with Berlex Laboratories, Inc . and its parent company, Schering AO of Germany, related to Betaseron® interferon beta-lb .

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

On July 8, 2003, we acquired Powderlect Pharmaceuticals plc, a company based in Oxford, England that develops and commercializes vaccines . We accounted for the acquisition of this business under the purchase method of accounting and included Powderiect Pharmaceuticals' operating results in our consolidated operating results beginning July 8, 2003 . PowderJect Pharmaceuticals is part of our vaccines segment.

income from continuing operations was $32 .1 million, or $0 .17 per diluted share, and $61 .5 million or $0 .32 per diluted share, for the three months ended June 30, 2004 and 2003, respectively and $59 .0 million, or $0.31 per diluted share, and $122 .5 million, or $0 .65 per diluted share, for the six months ended June 30, 2004 and 2003, respectively. These declines were primarily due to (i) the effect of our acquisition of Powderlect, which includes amortization expense from intangible assets associated with the acquisition and (ii) the contractual decline in the BetaseronO royalty rate . As a result of our acquisition of PowderJect, which has flu sales primarily in the second half of the year, our earnings per share from continuing operations declined $0 .12 per diluted share for the three months ended June 30, 2004 and $0,23 per diluted share for the six months ended June 30, 2004 . Our earnings per share from continuing operations declined $0 .04 per diluted share for the three months ended June 30, 2004 and $0 .08 per diluted share for the six months ended June 30, 2004 as a result of the decline in the Betaseron® royalty rate.

. Total revenues were $393 .6 million and $350 .3 million for the three months ended June 30, 2004 and 2003, respectively, and $773 .3 million and $671 .3 million for the six months ended June 30, 2004 and 2003, respectively . Product sales were $295 .1 million and $245 .9 mil lion for the three months ended June 30, 2004 and 2003, respectively, and $576 .2 million and $464 .5 million for the six months ended June 30, 2004 and 2003, respectively . Our total revenues were affected by the movement in exchange rates, in particular the movements in the Euro and British Pound against the U .S . dollar. The movement in exchange rates added approximately 2% and 3% to our total revenues for the three and six months ended June 30, 2004, respectively . However, since our Euro and British Pound expenses have also increased due to the movement in exchange rates, our earnings per share from continuing operations declined $0 .01 and $0 .03 per diluted share for the three and six months ended June 30, 2004, respectively, due to higher expenses compared to revenues in Euros and British Pounds . .

For the three months ended June 30, 2004, increases in product sales were seen across all three of our business units, in particular Procieix® products, TOBI® tobramycin, travel vaccines and Proleukin®. For the six months ended June 30, 2004, increases in product sales were also seen across all three of our business units, in particular Procleix® products, TOBI®, pediatric and other vaccines, travel vaccines and Proleukin® . Revenues from the joint business arrangement, royalty and license fees, collaborative agreement revenues and other revenues were $98 .5 million and $104.3 million for the three months ended June 30, 2004 and 2003, respectivelyi and $197.1. and $206.8 million for the six months ended June 30, 2004 and 2003, respectively . For the three months ended June 30, 2004 as compared to the three months ended June 30, 2003, these revenues decreased primarily due to the decline in the Betaseront royalty rate and the timing of license fees from our intellectual property portfolio . The

<- . .::ter decrease was offset by increased profitability of the joint business arrangement and contract manufacturing activities . For the six months ended June 30, 2004 compared to the six months ended June 30, 2003, these revenues decreased primarily due to the Biogen and Serono settlements in connection with the McCormick patents owned by Schering's U .S . subsidiary, Berlex, reported in the six months ended June 30, 2003, the decline in the BetaseronO royalty rate an d i the timing of license fees from our intellectual property portfolio . This decrease was offset by increased profitability of the joint business arrangement, contract manufacturing activities and royalties from our hepatitis C virus and HIV-related patents .

Gross margins were 56% and 60% for the three months ended June 30, 2004 and 2003, respectively, and 55% and 61 % for the six months ended June 30, 2004 and 2003, respectively . For the three and six months ended June 30, 2004, gross margins decreased due to a decline in the gross margin of the vaccines business , a reduction in the royalty rate related to Betaserow) and the increased cost of producing the Betase ron® pre-filled diluent syringe .

Research and development expenses were $100.3 million and $89 .9 million for the three months ended June 30, 2004 and 2003, respectively, and $198 .7 million and $172 .0 million for the six months ended June 30, 2004 and 2003, respectively . Research and development expenses for PowderJect Pharmaceuticals were $0 .9 million and.$7 .7 million for the three and six months ended June 30, 2004 . Research and development expenses associated with PowderJect Pharmaceuticals declined for the three months ended June 30, 2004 as we completed the planned divestiture of certain research operations in Madison, Wisconsin and Oxford, England. For the three and six months ended June 30, 2004, excluding PowderJect, the main beneficiaries of this increase . include tifacogin, our meningococcal vaccines franchise, our flu cell culture program, cyclosporiae solution for inhalation, CHIR-258, a growth factor kinase inhibitor and our first small molecule oncology compound in development, and a dry powder formulation of inhaled TOB1®. These increases were partially ., offset by decreases due.to transfer of responsibility for the SILCAAT trial, discontinuance of development of tezacitabine and PA-2794 and lower costs related to the development of new manufacturing processes for Betaseron® .

Selling, general and administrative expenses were $106 .9 million and $80 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $211 .6 million and $153 .3 million for the six months ended June 30, 2004 and 2003, respectively . PowderJect Pharmaceuticals, including associated integration costs, contributed approximately $8 .0 million and $18.6 million for the three and six months ended June 30, 2004 . The remaining increase in selling, general and administrative expenses resulted from additional costs associated with increase in sales across our businesses, investment in geographic penetration,. defense of our patents and technology, increased headcount and ongoing sales and marketing programs .

The effective tax rate for the three and six months ended June 30, 2004 and 2003 was 25% of pretax income from continuing operations .

CriticalAccounting Policies and The Use of Estimates

The preparation of financial statements requires us to make estimates, assumptions and judgments . that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities . On an on-going basis, we evaluate our estimates, including those related to, investments; inventories ; derivatives; capital leases ; intangible assets ; goodwill; .purchased in-process research and development ; product discounts, rebates and returns ; bad debts; collaborative, royalty and license_arrangements; restructuring; pension and other post-retirement benefits ; income taxes ; and litigation and other contingencies, We base our estimates on historical experience and various other assumptions that we believe to be reasonable under the circumstances, the . results of which form our basis for making judgments about the carrying values of assets and liabilities that are 26 not readily apparent from other sources. Actual results may differ from those estimates under different assumptions or conditions .

Our blood-testing segment includes our one-half share in the pretax operating earnings generated by the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc ., a Johnson & Johnson company . Our joint business arrangement with Ortho-Clinical Diagnostics is a contractual arrangement and is not a separate and distinct legal entity . Through our joint business contractual arrangement with Ortho-Clinical Diagnostics, we sell a line of immunodiagnostic tests to detect hepatitis viruses and retroviruses and provide supplemental tests and microplate and chemiluminescent instrument systems to automate test performance and data collection . Prior to 2003, we had accounted for revenues relating to non-U .S . affiliate sales on a one-quarter lag, with an adjustment of the estimate to actual in the subsequent quarter. More current information of non-U .S . affiliate sales of our joint business contractual arrangement became available for the three months ended March 31, 2003, and as a result, we are able to recognize revenues relating to non-U .S. affiliate sales on a one-month lag . The effect of this change, net of tax, was an increase to net income by $3 .2 million for revenues from the joint business arrangement for the six months ended June 30, 2003 .

Our critical . accounting policies ; which incorporate our more significant judgments and estimates used in the preparation of our Condensed Consolidated Financial Statements are the same as those described in Part 11, Item 7, ."Management's Discussion and Analysis of Financial Condition and Results of Operations" in Chiron's Annual Report on Form 10--K for the year ended December 31, 2003 .

Results of Operations

Blood-testing

Product sales Our blood-testing segment recognized product sales of $67 .2 million and $53 .1 million for the three months ended June 30, 2004 and 2003, respectively, and $135 .3 million and $101 .6 million for the six months ended June 30, 2004 and 2003, respectively .

Prncleiz® On February 27, 2002, the U .S . Food and Drug Administration approved the ProcleixE HIV-IIHCV Assay . Under a collaboration agreement with Gen-Probe Incorporated, we market and sell the Procleix® HIV--1/HCV Assay and the related instrument system . In addition to selling directly in the U .S ., we also sell in various European and Asia/Pacific markets, directly and through distributors . We record revenue based upon the reported results obtained from the customer from the use of assays to screen donations or upon sale and delivery of the assays, depending on the underlying contract . In the case of equipment sales or leases, we record revenue upon the sale and transfer of the title of the instrument or ratably over the life of the lease term, respectively . For the provision of service on the instruments, we .recognize revenue ratably over the life of the service agreement.

Worldwide product sales related to tests, instruments and the provision of services we re $60 . 6 million and $46 .0 million for the three months ended June 30, 2004 and 2003, respectively, and $122.5 million and $88 . 1 million for the six months ended June 30, 2004 and 2003, respectively . The increase in product sales for the three and six months ended June 30, 2004 as compared with the three and six months ended June 30 , 2003 primari ly related to (i) the introduction of the West Nile virus as say on an investigational-use basis in the U. S. and (ii) market share gains in the U .S.' and continued penetration into several markets abroad for the Pro cleix® HIV- IlfICV Assay . In March 2003 , the U.S. Food and Drug Administration accepted an investigational new drug (IND) for the West Nile virus assay. The new assay runs on the same instrumentation platform as the currently approved Procleix® 14IV-1IHCV assay.

Ortho-Clinical Diagnostics Under the joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc., we manufacture bulk reagents an d antigens and confirmatory test kits for`

r,•f`y immunodiagnostic products . We recognized product sales under this arrangement of $6 .6 million and $7.1 million for the three months ended June 30, 2004 and 2003, respectively, and $12 .8 million and $13 .5 million for the six months ended June 30, 2004 and 2003, respectively . The decrease in product sales for the three and six months ended June 30, 2004 as compared with the three and six months ended June 30, 2003, primarily related to the timing of manufacturing services under the arrangement. We also supply bulk antigens for Ortho-Clinical Diagnostics to be included in products to be sold by Bayer under a June 2001 agreement with Ortho-Clinical Diagnostics and Bayer Corporation (see also "Royalty and license fee revenues-Bayer" below) .

We expect competitive pressures related to our blood-testing products to continue, primarily as a result of the introduction of competing products into the market, as listed in Part I, Item 1 . "Business-Competition" of out Annual Report on Form 10-K for the year ended December 31, 2003 .

Revenue from joint business arrangement Revenues from our joint business contractual arrangement with Ortho-Clinical Diagnostics, Inc, were $28 .5 million and $27 .5 million for the three months ended June 30, 2004 and 2003, respectively, and $58 .9 million and $53 .9 million for the six months ended June 30, 2004 and2003, respectively. The increase in revenues from our joint business arrangement for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 primarily resulted from (i) increased profitability of Ortho-Clinical Diagnostics' foreign affiliates and (ii) an increase in royalties. These increases were offset by the timing of Ortho-Clinical Diagnostics' shipments to third parties and an adjustment of the first quarter 2004 estimate- of revenue to actual results . The increase in revenues from our joint business arrangement for the six months ended June 30, 2004 as compared with the six - months ended June 30, 2003 primarily resulted from (i) higher profits from Ortho-Clinical Diagnostics' U .S . operations and foreign affiliates and (ii) an increase in royalties. These increases are offset by a one-time benefit for the three months ended March 31, 2003 due to a change in estimate from a three-month lag to a one-month lag relating to the Ortho-Clinical Diagnostics, Inc .'s non-U .S . affiliate sales .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Under the Ortho-Clinical Diagnostics, Inc . joint business arrangement, we conduct research and development services related to immunodiagnostic products . Our blood-testing segment recognized total collaborative agreement revenues of $2 .3 million and $2 .3 million for the three months ended June 30, 2004 and 2003 ; respectively, and $4 .4 million and $4 .3 million for the six months ended June 30, 2004 and 2003, respectively . The majority of collaborative agreement revenues recognized by our blood-testing segment related to immunodiagnostic products .

Royalty and license fee revenues Our blood-testing segment cams royalties from third parties based on their sales of immunodiagnostic and nucleic acid testing probe diagnostic products utilizing our hepatitis C virus and HIV-related patents, for use in the blood screening and plasma fractionation markets . Our blood-testing segment also earns license fees related to our hepatitis C virus and HIV-related patents for technologies used by third parties to develop products for use in the blood screening and plasma fractionation markets . The blood-testing segment recognized royalty and license fee revenues of $16 .3 million and . $23 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $32 .7 million and $38 .8 million for the six months ended June 30, 2004 and 2003, respectively. The decrease in royalty and license fees for the three months ended June 30, 2004 a s 29 compared to the three months ended June 30, 2003 as well as the six months ended June 30, 2004 compared with-the six month ended June 30, 2003 primarily related to two license agreements with Baxter A.G . for which we recognized a license fee in the second quarter 2003 .

. Hoflinann-La Roche Limited andseveral of its F. Hoffmann-La Roche settlement In October 2000, we entered into three license agreements with F affiliated companies related to the settlement of certain litigation in the U .S . and certain other countries for the use of our hepatitis C virus and HIV intellectual . See "Other-Royalty and license fee revenues" below . The third agreement for blood screening property . Two agreements relate to in vitro diagnostic products was superseded in May 2001 by two new agreements, one for each of hepatitis C virus and HIV . Revenues under these agreements were $14 .6 million and .6 million for the six months ended June 30, 2004 and $14 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $29 .6 million and $28 2003, respectively . The increase for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 related to a positive adjustment of the fourth quarter 2003 estimate to actual results . Under these new agreements, royalties continue through the lives of the hepatitis C virus and HIV-related patents covering F. Hoffrttann-La Roche's nucleic acid testing products . Currently, the applicable issued hepatitis C virus-related patents begin to expire in 2015 . An HIV-related patent was issued in the U .S . for the U ,_S_ and in 2010 for Europe . Currently, the applicable issued HIV-related patent in Europe expires in 2005 . Hoffmann-La on March 13, 2003 . This patent will expire seventeen years from the date of issuance . As permitted under the terms of its licensing agreement, F Roche instituted arbitration proceedings in regard to the application of the U .S . patent . We have deferred recognition of $5 .5 million and $ 1 . 3 million as o f June 30, 2004 and 2003, of royalty revenue, respectively . During any pending arbitration proceedings, F. Hoffmann-La Roche remains obligated to make all quarterly royalty payments, subject toa right to be reimbursed by us if it is determined in the arbitration that such royalty payments were not due .

. Bayer In June 2001, Chiron and Ortho-Clinical Diagnostics, Inc . entered into an agreement with Bayer Corporation for the clinical diagnostic market Under this agreement, Bayer manufactures and sells certain of Ortho-Clinical Diagnostics' hepatitis C virus and HIV immunodiagnostic products for use on Bayer's instrument platforms. Bayer paid us a license fee of $45 .3 million, which we deferred (due to our continuing manufacturing obligations) and began recognizing as revenue in the third quarter 2001 . We will recognize the remaining amount ratably through 2010.

BaxterA.G. In June 2003, we entered into two license agreements with Baxter A .G . related to our hepatitis C virus and HIV technology for use in the plasma fractionation market for which we recognized a license fee in the second quarter 2003 .

Royalty and license fee revenues may fluctuate based on the nature of the related agreements and the timing of receipt of license fees . Results in any one period are not necessarily indicative of results to be achieved in the future . In addition, our ability to generate additional royalty and license fee revenues may depend, in part, on our ability to market and capitalize on our technologies . We have no assurance that we will be able to do so or that future royalty and license fee revenues will not decline .

Gross profit Blood-testing gross profit as a percentage of net product sales was 42% and 46% for the three months ended June 30, 2004 and 2003, respectively, and 42% and 44% for the six months ended June 30, 2004 and 2003, respectively. The blood-testing gross profit margins for the three months ended June 30, 2003 as well as for the six months ended June 30, 2003 were positively impacted by an adjustment to cost of goods sold pursuant to our collaboration agreement with Gen-Probe lncorporated .`The blood-testing gross profit margins for the three and six months ended June 30, 2004 benefited from an amendment in November 2003 to the worldwide blood screening collaboration agreement between Chiron and Gen-Probe Incorporated in order to adopt permanent, fixed revenue shares for each party. Effective January 1, 2004, Gen-Probes share was set at 45 .75% of net revenues for assays, which include a test for the hepatitis C virus . For commercial assays, which do not test for

29 hepatitis C virus, such as the West Nile test , the agreement remains unchanged with each party retaining 50% of the net revenues after deduction of specified expenses .

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

Research and development Our blood-testing segment recognized research and development expenses of$63 million and $5 .6 million for the three months ended June 30, 2004 and 2003, respectively, and $11 .4 million and $10 . 8 million for the six months ended June 30, 2004 and 2003, respectively . The research and development spending in 2004 and 2003 related to the continued development of nucleic acid testing products and activities under the Ortho-Clinical Diagnostics joint business arrangement.

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

Selling , general , and administrative Our blood-testing segment recognized selling, general and administrative expenses of $10 .3 million an d $9.6 million for the three months ended June 30, 2004 and 2003, respectively , and S 19.6 million and $ 17.6 million for the six months ended June 30, 2004 and 2003, respectively . The increased selling, general and administrative expenses for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as for the six months ended June 30, 2004 compared with the six months ended June 30, 2003 , related to incre as ed headcount to support the expansion of our customer base for the Procleix ® HI V-1IHCV Assay in the U .S ., Europe and other international markets .

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

Vaccines

Product sales We sell flu, meningococcal , travel , pediatric , and other vaccines in the U .S ., Germany , Italy, and the United Kingdom, as well as in other international markets . Vaccine product sales were $101 .0 million and $85.6 million for the three months ended June 30, 2004 and 2003, respectively, and $ 187 .4 million and $154. 0 million for the six months ended June 30, 2004 and 2003, respectively.

Sales of our flu vaccines were $ 8 .2 million and $3 .8 million for the three months ended June 30, 2004 and2003, respectively , and $15 .9 million and $8 .0 million for the six months ended June 30 , 2004 and 2003 , respectively . Flu vaccines sales increased for the three months ended June 30, 2004 as compared with the three month ended June 30, 2003 primarily as a result of sales to South Korea . PowderJect Pharmaceuticals flu vaccine sales were $ 2 .4 million for the six months ended June 30, 2004 . Excluding PowderJect Pharmaceuticals , sales of our remaining flu vaccines increased for the six months ended June 30, 2004 compa re d with the six months ended June 30, 2003 p rimarily as a result of additional safes to South Korea and Argentina and the bene fi t of the movement in the Euro to U .S . Dollar exchange rate.

Sales of MenjugateO, our conjugate vaccine against rtieningococcal infection caused by the bacterium N . meningitidis serogro up C, were $5 .0 million and $13.7 million for the three months ended June 30, 2004 and 2003, respectively, and $9 . 6 million and $21 .2 million for the six months ended June 30, 2004 and 2003, respectively . The decrease in Menjugate ® sales for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 as well as for the six months ended June 30, 2004 compared with the six months ended June 30, 2003 was primarily driven by ( i) an Australian tender in the state of`Ncw South Wales inthe second quarter 2003, (ii) the timing of

30 outbreaks and vaccination programs in various countries and (iii) increased competition for tender sales .

Sales of our travel vaccines, comprised of tick-borne encephalitis and rabies vaccines and two products we obtained as part of our third quarter 2003 acquisition of Powderlect Pharmaceuticals, Arilvax, and Dukoral, were $40 .1 million and $23 .1 million for the three months ended June 30, 2004 and 2003, respectively, and $63 .1 million and $48 .8 million for the six months ended June 30, 2004 and 2003, respectively . The increase in travel vaccines for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 as well as the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 is primarily due to (i) increased demand for our rabies vaccines in the U.S ., primarily due to a product recall from a competitor, Europe and Asia, (ii) increased sales of out tick-borne encephalitis vaccines, which is typically sold in the first half of the year and (iii) additional sales of travel vaccine products following our acquisition of PowderJect Pharmaceuticals .

Sales of our pediatr ic and other vaccines were $47.6 million and $45.0 million for the three months ended June 30, 2004 and 2003, respectively, and . $98.8 million and $75 . 9 million for the six months ended June 30, 2004 and 2003, respectively . The increase in pediatric and other vaccines sales for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 was primarily due to increased sales following our acquisition of PowderJect Pharmaceuticals. The increase in pediatric and other vaccines for the six months ended June 30, 2004 comp ared with the six months ended June 30, 2003 was primarily due to (i), the timing of tender sales for our polio vaccines and diphthe ria, tetanus and pertussis vaccines and (ii) increased sales following our acquisition of Powderiect Pharmaceuticals , partially offset by the timing of tender sales of me as les, mumps and rubella vaccines.

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

We expect competitive pressures related to many of our vaccine products to continue into the future, primarily as a result of the introduction of competing products into the market, including, but not limited to, new combination vaccines, as listed in Part I, Item L, "Business-Competition" of our Annual Report on Form 10-K for the year ended December 31, 2003 .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Our vaccines segment recognized collaborative agreement revenues of $1 .2 million for the three months ended June 30, 2004 primarily related to increased collaboration agreement revenues following our acquisition ofPowderJect Pharmaceuticals . Our vaccines segment recognized collaborative agreement revenues of $5 .2 million for the six months ended June 30, 2004 primarily related to an agreement to supply a vaccine for meningococcal meningitis caused by the bacterium N. meningitidis serogroup B to the Ministry of Health in New Zealand and increased collaborative agreement revenues following our acquisition of PowderJect Pharmaceuticals .

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and the achievement of milestones. Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the future . In addition, the collaboration agreements typically provide for certain milestone payments and various royalties on future product sales if the collaborative partners commercialize a product using our technology . Also, our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners . 31 Royalty and license fee revenues Our vaccines segment cams royalties on third patty sales of, and license fees on, several products . The vaccines segment recognized royalty and license fee revenues of $3 .3 million for the three months ended June 30, 2003, and $2 .7 million and $6 .5 million for the six months ended June 30, 2004 and 2003, respectively . Royalty and license fee revenues for the vaccines segment for the three months ended June 30, 2004 were not material .

GlaxoSmithKline An agreement with GlaxoSmithKline plc provides for royalties on sales of certain vaccine products. Under this agreement, we recognized $1 .4 million and $3 .4 million of such royalties for the six months ended June 30, 2004 and 2003, respectively . Under this agreement, any future royalties have ceased .

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

Other revenues Our vaccines segment recognized other revenues of $5 .9 million and $3 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $9.6 million and $6.0 million for the six months ended June 30, 2004 and 2003, respectively .

Grant and contract revenues Our vaccines segment other revenues included grant and contract revenuesof$5 .1 million and $2.5 million for the three months ended June 30, 2004 and 2003, respectively, and $8 .0 million and $4 .7 million for the six months ended June 30, 2004 and 2003, respectively . We have entered into a series of agreements with the U .S . National Institutes of Health to advance our HIV vaccine program into human clinical trials . We recognized . grant and contract revenues under these arrangements of $3 .1 million and $2 .3 million for the three months ended June 30, 2004 and 2003, respectively, and $5 .5 million and $4 .1 million for the six months ended June 30, 2004 and 2003, respectively .

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

Other revenues recognized in our vaccines segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues. -

Gross profit Vaccines gross profit as a percentage of net product sales was 42% and 56% for the three months ended June 30, 2004 and 2003, respectively, and 38°/i and 52% for the six months ended June 30, 2004 and 2003, respectively . The decrease in gross, profit margins for the three months ended June 30, 2004 as compared with the'three months ended June 30, 2003 was primarily due to additional product reserves in the second quarter 2004 as well as reduced sales and margins of the Menjugate@ product . The decrease in gross profit margins for the six months ended June 3© . 2004 as compared with the six months ended June 30, 2003 was primarily due to the addition of PowderJect facilities, a portion of which traditionally is not in flu production for a significant part of the first quarter, and additional product reserves in the second quarter 2004 as well as reduced sales and margins of the Menjugate® product .

Vaccines gross profit percentages may fluctuate significantly in future periods due to product and customer mix, seasonality and ordering patterns, production yields and competitive pressures .

32 Research and development Our vaccn ..: segment recognized research and development expenses o f .. . 9 million and $26 .8 million for the three months ended June 30, 2004 and 2003, respectively, and $66 .3 million and $47 .4 million for the six months ended June 30, 2004 and 2003, respectively . The increase in research and development spending for the three months ended June 30, 2004 as compared with the three months ended June 20, 2003, as well as for the six months ended June 30, 2004 compared with the six months ended June 30, 2003, resulted mainly from the advancement of several programs in our meningococcal franchise and flu cell culture. Also, there was $0 .9 million and $7 .7 million of incremental research and development expenses for the three and six months ended June 30, 2004, respectively, following our third quarter of 2003 acquisition of PowderJect . Research and development expenses associated with PowderJect declined for the three months ended June 30, 2004 as we completed the planned divestiture of certain research operations in Madison, Wisconsin and ' Oxford, England .

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

Selling, general, and administrative Our vaccines segment recognized selling, general and administrative expenses of $35 .9 million and $24.7 million for the three months ended June 30, 2004 and 2003, respectively, and $74.9 million and $46 .8 million for the six months ended June 30, 2004 and 2003, respectively: The increase in selling, general and administrative expenses for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as the six months ended June 30, 2004 compared with the six months ended June 30, 2003 primarily related to additional expenses following our third quarter of 2003 acquisition of PowderJect . Excluding $8 .0 million and $18 .6 million of additional selling, general and administrative expenses, including integration costs, associated with Powderiect Pharmaceuticals for the three and six months ended June 30, 2004, respectively, the remaining increase in selling, general and administrative resulted from ongoing sales and marketing programs and headcount additions.

Amortization expense Our vaccines segment recognized amortization expense of.$14 .9 million and $1 .5 million for the three months ended June 30, 2004 and 2003, respectively, and $30.0 million and $2 .9 million for the six months ended June 30, 2004 and 2003 . The increase in amortization expense for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as the six months ended June 30, 2004 compared with six months ended June 30, 2003 related to the intangibles acquired following our third quarter of 2003 acquisition of PowderJect .

Biopharmaceaticals

Product sales Biopharmaceutical product sales were $126 .9 million and $107 .3 million for the three months ended June 30, 2004 and 2003, respectively, and $253.4 million and $209.0 million for the six months ended June 30, 2004 and 2003, respectively . Biopharmaceutical product sales in 2004 and 2003 consisted principally of Betaseion®, TOB1® and Proleukin® .

-$etaseron® interferon beta-lb We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc. (collectively "Schering"), under the trade names Betaseron® (in the U.S and other non-European markets) and Betaferon® (in Europe) . Boehringer ingelheitn also supplies Betaferon® to Schering for sale in Europe . For product manufactured by us, we recognize a portion of revenue for product sales upon shipment to Schering and the remainder based on a contractual percentage of sales by Scheritig, both of which we record as product sales . For product manufactured by Boehringer Ingelheim and marketed by Schering in Europe under the trade name Betaferon®, we receive royalties calculated at the same percentage of sales less the amount paid or incurred by Schering for supply costs, which we record in royalty and license fee revenues . Starting in the fourth quarter 2003, the amount we record as product sales, based on a percentage of sales by Schering, and Betaferon® royalties, declined, by five percentage points pursuant 33 to our contractual agreement with Schering . As a result, we estimate that the percentage of sales per unit on which our payments are based will decrease, reducing our per unit revenue by approximately 18% (for sales of Chiron product) and approximately 34% (for royalties from sales of Boehringer Ingetheim product) from that received prior to the decline . However, there are a number of mitigating considerations, including (i) the transitional supply agreement, discussed in "Royalty and license fee revenues-Betaferon® interferon beta-lb" below, (ii) the volume mix of Chiron product and Boehringer Ingelheim product and (iii) the launch of product upgrades with ease-of-use features . We believe these considerations will partially offset this contractual change . In order to supply Betaferon® to Schering, we continue to make capital improvements to our existing manufacturing facilities to increase capacity .

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

Betaseron® product sales were $31 .6 million and $30 .5 million for the three months ended June 30, 2004 and 2003, respectively, and $61 .8 million and $59 .8 million for the six months ended June 30, 2004 and 2003, respectively. The increase in Betaseron® product sales for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 primarily related to (i) increased sales of clinical materials, (ii) price increases and (iii) increased patient demand attributed to key marketing programs . These increases were partially offset by a decline in the royalty rate by five percentage points pursuant to our contractual agreement with Schering and by fluctuations in ordering patterns .

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

TOBI®mbramycin We sell TOBI@ directly in the U.S . and certain international markets . We recognized TOBI® sales of $51,3 million and $39.0 million for the three months ended June 30, 2004 and 2003, respectively, and $103 .9 million and $79 .7 million for the six months ended June 30, 2004 and 2003, respectively . Increased TOBI® sales for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as for the six months ended June 30, 2004 compared with the six months ended June 30, 2003, primarily related to (i) wholesaler ordering patterns, (ii) increased patient demand in the U.S ., (iii) price increases and (iv) the benefit of the movement in the Euro to U .S . Dollar exchange rate.

ProleukinO (aldesleukin) Sales were $35.1 million and $29.4 million for the three months ended June 30, 2004 and 2003, respectively, and $66 .9 million and $55 .4 million for the six months ended June 30, 2004 and 2003, respectively . The increase in Proleukin(g> product sales for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 is primarily related to (i) wholesaler ordering patterns, (ii) price increases and (iii) the benefit of the movement in the Euro to U .S . Dollar exchange rate .

The balance of product sales recognized in our biopharmaceuticals segment consisted of various other products, which individually were . not material .

Wholesale ordering patterns, reimbursement and government pressures, competition, foreign currency exchange rates and the level of rebates may influenc e future biopharmaceutical sales . We expect competitive pressures related to many of our biopharmaceutical products to continue into the future, primarily as a result of the introduction of competing products into the market, as listed i n r

34 Part 1, Item I., "Business-Competition" of our Annual Report on Form 10-K for the year ended December 31, 2003 .

Collaborative agreement revenues We recognize collaborative agreement revenues for fees received as we perform research services and achieve specified milestones . Our biopharmaceuticals segment recognized collaborative agreement revenues of $03 million and $1 .1 million for the three months ended June 30, 2004 and 2003, respectively, and $0.8 million and $3 .3 million for the six months ended June 30, 2004 and 2003, respectively . The decline for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 is due to the near completion of our fourth quarter 2002 collaboration activities under our collaboration agreement and license agreement with GlaxoSmithKline plc related to certain of our MC-4R compound patents . The decline for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 is due to the near completion of our fourth quarter 2002 collaboration activities under our collaboration agreement and license agreement with GlaxoSmithKline plc related to certain of our MC-4R compound patents and due to completion in the first quarter 2003 of our 2001 collaboration agreement with Taisho Pharmaceuticals Co . Ltd . to target macrolide mediated gene discovery . -

Collaborative agreement revenues tend to fluctuate based on the amount and timing of research services performed, the status of projects under collaboration and our achievement of performance milestones . Due to the nature of our collaborative agreement revenues, results in any one period are not necessarily indicative of results to be achieved in the future . In addition, the collaboration agreements typically provide for certain milestone payments and various royalties on future product sales if the collaborative partners commercialize a product using our technology . Also, our ability to generate additional collaborative agreement revenues may depend, in part, on our ability to initiate and maintain relationships with potential and current collaborative partners.

Royalty and license fee revenues Our biopharmaceuticals segment cams royalties on third party sales of several products, including Betaferon® and recombinant insulin and glucagon products. Our biophannaceuticals segment also earns license fees for technologies, such as hepatitis C virus-related patents, used by third parties to develop therapeutic products . The biopharmaceuticals segment recognized royalty and license fee revenues of$ 15.2 million and .6 million for the six months ended June 30, 2004 and $20 .8 million for the three months ended June 30; 2004 and 2003, respectively, and $32 .5-million and $38 2003, respectively .

Betaferon® interferon beta-lb We manufacture interferon beta-lb which is marketed by Schering AG and its affiliates, including Berlex Laboratories, Inc. (collectively "Schering"), under the trade names Betaserone (in the U .S and other non- European markets) and Betaferon® (in Europe) . . Boehringer Ingelheim also supplies BetaferonO to Schering for sale in Europe . For product manufactured by Boehringer Ingelheim, we receive . royalties calculated as a percentage of sales less the amount paid or incurred by Schering for supply costs, including Schering's cost to purchase product from Boehringer Ingelheim.

For the three months ended June 30, 2004 and 2003, we recognized Betaferon@ royalties of $11 .6 million and $17.2 million, respectively, andfor the six months ended June 30, 2004 and 2003, we recognized 13etaferon® royalties of $25 .4 million and $31 .1 million, respectively, under this arrangement : Betaferon® royalties decreased for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003 as well as for . the six months ended June 30, 2004 as compared with the six months ended June 30, 2003 primarily due to a decline in the royalty rate by five percentage points, pursuant to our contractual. agreement with Schering, partially offset by (i) an increase in demand, (ii) the benefit of the movement in the Euro to U .S . Dollar exchange rate and (iii) the benefit of a reduction of the allocated cost under a three-year limited cost sharing arrangement under the transitional supply agreement with Schering .

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

Novo Nordisk We earn royalty revenues on insulin and glucagon product sales by Novo Nordisk AS . We recognized $0 .9 million and $1 .9 million for the three months ended June 30, 2004 and 2003, respectively, and $2.3 million and S3 .9 million for the six months ended June 30, 2004 and 2003, respectively, under this arrangement . Patents related to the production of insulin and glucagon began expiring in late 2003 and as a result, royalty revenues recognized under this arrangement are declining significantly .

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

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

Other revenues Our biopharmaceuticals segment recognized other revenues of $4 .8 million and $3 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $7.9 million and $18 .8 million for the six months ended June 30, 2004 and 2003, respectively .

Contract manufacturing revenues Our biopharmaceuticals segment recognized contract manufacturing revenues of $4.7 million and $3 .0 million forthe three months ended June 30, 2004 and 2003, respectively, and $7.5 million and $3 .1 million for the six months ended June 30, 2004 and 2003, respectively . The fluctuation resulted from the level of activity an d the timing of contract manufacturing activities .

Btogen and Serono settlements A U .S . Court of Appeals partially reversed a District Court ntling in connection with certain patents owned by Chiron and licensed exclusively to Schering AG's U. S . subsidiary, Berlex Laborato ri es. As a resultof the ruling and prior agreements between Biogen and Berlex , Biogen was required to make a settlement payment to Schering. In accordance with an earlier contract between Chiron and Berlex, we recognized approximately $13 .0 million during the six months ended June 30, 2003, which represented our share of this settlement payment. In addition, there was a similar settlement between Berlex and Serono of which we recognized approximately $ 1 .4 million during the six months ended June 30, 2003 .

The balance of other revenues recognized in out biopharmaceuticals segment consisted of various other arrangements, which individually were not material .

36 Other revenues recognized in our biopharmaceuticals segment may fluctuate due to the nature of the revenues recognized and the timing of events giving rise to these revenues. We cannot guarantee that we will be successful in obtaining additional revenues or that these revenues will not decline .

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

Biopharmaceutical gross profit percentages may fluctuate significantly in future periods due to production yields, increased cost to produce the Betaseron® pre-filled diluent syringe, the decline in Betaseron® product sales, based on a percentage of sales by Schering, by five percentage points pursuant to our contractual agreement with Schering and as the biopharmaceutical product and customer mix changes .

Research and development Our biopharmaceuticals segment recognized research and development expenses of $61 .8 million and $57 .4 million for the three months ended June 30, 2004 and 2003, respectively, and $120 .4 million and $113 .7 million for the six months ended June 30, 2004 and 2003, respectively .

The increase in research and development spending for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003, primarily related to activities related to the development of (i) tifacogin, as discussed below,(ii) CHIR-258, a growth factor kinase inhibitor and our first small--molecule oncology compound in development , (iii) cyclosporine solution for inhalation, a therapy under evaluation for the treatment of rejection and reduction of mortality in lung transplant patients, and (iv) a dry powder formulation of inhaler, TOBI® . These increases were partially offset by (i) the discontinuance of development of tezacitabine in the first quarter of 2004 based on an analysis of the data from a Phase II trial in patients with gastroesophageal cancer, (ii) decline in spending due to discontinuance of development of PA-2794, (iii) decrease in spending on development of manufacturing processes for BetaseronO, and (iv) decrease in spending on the SILCAAT trial, as described below.

In the fourth quarter 2002, we reached an agreement in principle to transfer responsibility for the SILCAAT (referred to-also as Proleukin® (aldesleukin) for HIV) trial, a Phase III study for recombinant human interleukin-2 (IL-2, aldesleukin), to the National Institutes Allergy and Infectious Disease (NIAID) and the University of Minnesota. Responsibility for the SILCAAT study was transferred to NIA1D and University of Minnesota effective February 14, 2003 . Our research and development expenses related to the SILCAAT trial are expected to decrease in 2004 as a result of the transfer . Under the agreement, we are obligated to fund a maximum of $18 .0 million over the lifetime of the trial and to supply clinical materials and certain other support services of which $9.0 million has been paid through-June 30, 2004.

In October 2003, we acquired all of Pfizer, Inc .'s, formerly Pharmacia Corp.'s, interest in tifacogin, in return for which Pfizer will receive royalties on future sales of tifacogin . In the second quarter 2004, we began e nrolling patients in our Phase III trial for tifacogin as a treatment for patients with severe community-acquired pneumonia.

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

Selling, general , and administrative Our biopharmaceuticals segment recognized selling, general and administrative expenses of$33 .2 million and $28 .7 million for the three months ended June 30, 2004 and 2003, respectively, and $65 .2 million and $54.9 million for the six months ended June 30, 2004,and 2003, respectively. The increase in selling, general and administrative expenses for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, as well as the six months ended June 30, 2004 compared with six months ended June 30, 2003, related to increased expenses for programs . and headcount in support of TOBI8 and Proleukin®, and the Euro to U.S . Dollar exchange rate fluctuation, partially offset by lower consulting costs to enhance business processes.

Amortization expense Our biopharmaceuticals segment recognized amortization expense of $6 .2 million for each of the three months ended June 30, 2004 and 2003, respectively, and $12 .5 million and $12.4 million for the six months ended June 30, 2004 and 2003, respectively .

Other

Royalty and license fee revenues Our other segment cams royalties on third party sales of, and license fees on, several products . Our other segment recognized royalty and license fee revenues of $23 .7 million and $19 .6 million for the three months ended.June 30, 2004 and .2003, respectively, and $42 .1 million and $36 .4 million for the six months ended June 30, 2004 and 2003, respectively . The majority of royalty and license fee revenues related to the use of our hepatitis C virus and HIV-related patents for diagnostic testing purposes by various third parties .

F. Hofmann-La Roche settlement In October 2000, we entered into three license agreements with F . Hoffmann-La Roche Limited related to the settlement of litigation in the U .S . and cert ain other count ries for use of our hepatitis C virus and HIV nucleic acid testing intellectual property for use in cl inical diagnostics .

Under the hepatitis C virus agreement, we received $85 .0 million, of which we recognized $40 .0 million in the fourth quarter 2000 . We deferred the remaining $45 .0 million, which becomes nonrefundable ratably through 2005. In the first quarter 2001, we began recognizing portions of the $45 .0 million based upon the greater of (i) the scheduled quarterly minimum non-refundable amount or (ii) the actual earned credits as royalties on future sales related to F . Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products. The agreement also provides for royalties on future sales related to F. Hoffmann-La Roche's use of our hepatitis C virus-related patent in its in vitro diagnostic products, which commenced in the first quarter 2001 . Royalty revenues increased for the three months ended June 30, 2004 as compared to the three months ended June 30, 2003 as well as for the six months ended June 30, 2004 as compared with the six months ended June 30, 2003, primarily as a result of an increase in quarterly minimum amounts we recognize under this agreement, an increase in the positive adjustment of estimated to actual royalty revenue recorded in the subsequent quarter and increased product sales recognized by F. Hoffman-La Roche.

The HIV agreement also provides for royalties on future sales related to F. Hoffmann-La Roche's use of our IilV-related patent in its in vitro diagnostic products, which commenced in the first quarter 2001 when the European Patent Office Board of Technical Appeals upheld our HIV-related patent . Royalty revenues recognized under this agreement for the three and six months ended June 30, 2004 were consistent with the three and six months ended June 3 0 , 2003, respectively.

38 Currently, the applicable issued HIV-related patent in Furope expires in 2005 . An HIV-related patent directed to nucleic acid testing methods for HIV-1 was issued in the U.S. on March 13, 2003 . This patent will expire seventeen years from the date of issuance . The issuance of the patent triggered a milestone payment to Chiron of $10.0 million from F_ Hoffrnarm-La Roche, which was received in April 2003 . As permitted under the terms of its licensing agreement, F . Hoffmann-La Roche has decided to institute arbitration proceedings in regard to the application of the U .S . patent . We have deferred recognition of thi s $10.8 million milestone payment and interest as of June 30, 2004 and $16 .3 million and $3 .8 million of royalty revenue as of June 30, 2004 and 2003, respectively. ]During any pending arbitration proceedings, F. Hofftnanm-La Roche remains obligated to make all quarterly royalty payments, subject to a tight to be reimbursed by Chiron if it is determined in the arbitration that such royalty payments were not due .

Bayer A cross-license agreement provides for royalties to us on HIV and hepatitis C virus products sold by Bayer, which increased for the three months ended June 30, 2004 as compared with the three months ended June 30, 2003, due to increased donations, The six months ended June 30, 2004 as compared with the six months ended June 30, 2003 increased primarily due to (i) additional royalties under the HIV--related patent issued in the U .S . in March 2003, discussed above, .(ii) increased royalty rates and (iii) increase donations.

The balance of royalty and license fee revenues consisted of various other agreements , which individually were not mate ri al.

Selling, general, and administrative Our other segment recognized selling, general and administrative expenses of $27 .4 million and $17 .2 million for the three months ended June 30, 2004 and 2003, respectively, and $52.0 million and $34 .0 million for the six months ended June 30, 2004 and 2003, respectively. The increases in selling, general and administrative for the three and six months ended June 30, 2004 as compared with the three and six months ended June 30, 2003 were primarily due to higher litigation costs related to the defense of our patents and technology, higher facility related costs, .higber employee related expenses and higher consulting expenses .

Interest expense We recognized interest expense of $6 .5 million and $2 .8 million for the three months ended June 30, 2004 and 2003, respectively, and $12 .4 million and $6 .3 million the six months ended June 30, 2004 and 2003, respectively . The increase in interest expense for the three and six months ended . June 30, 2004 as compared with the three and six months ended June 30, 2003 primarily related to interest expense recognized on the $500 .0 million convertible debentures that were issued on July 30, 2003.

Interest and other income, net Interest and other income, net, primarily consisted of interest income on our cash and investment balances and other non-operating gains and losses. We recognized. interest income of $5 .8 million and $6 .3 million for the three months ended June 30, 2004 and 2003, respectively, and $10.9 million and $13.3 million for the six months ended June 30, 2004 and 2003, respectively . The decreases in interest income for the three and six months ended June 30, 2004 as compared with the three and six months ended June 30, 2003 were primarily due to lower average cash and investment balances following the acquisition of PowderJect Pharmaceuticals.

39 We recognized gains of $14 .3 million and $4 .8 million for the three months ended June 30, 2004 and 2003, respectively, and $24.0 million and $9.4 million for the six months ended June 30, 2004 and 2003, respectively, related to the sale of certain equity securities.

On December 31, 1998, we completed the sale of our 30% interest in General Injectibles & Vaccines, Inc., a distribution business, to Henry Schein, Inc . and received payment in full of certain advances we made to General Injectibles & Vaccines . The agreement also provided for us to receive additional payments, calculated as a pre-determined percentage of Henry Schein's gross profit, through 2003 . We received $3 .5 million for 2003 and $2 .0 million for 2002 during the six months ended June 30, 2004 and 2003, respectively .

Income taxes The effective tax rate for the three and six months ended June 30, 2004 and 2003 was 25% of pretax income from continuing operations . The effective tax rate may be affected in . future periods by changes in management's estimates with respect to our deferred tax assets and other items affecting the overall tax rate.

Discontinued operations During the three months ended June 30, 2004, Chiron and the IRS entered into a settlement agreement closing the open tax years 1996 to 1998 . Pursuant to this settlement agreement we recognized for the three months ended June 30, 2004 a tax benefit of $12 .5 million for discontinued operations.

Chiron and Bayer were involved in a dispute with respect to their respective rights to certain royalty refunds receivable for which a settlement was reached in 2004. Under this settlement agreement, we made a payment to Bayer in 2004 . This settlement includes an .agreement that all outstanding items with Bayer related to the sale of Chiron Diagnostics are resolved and no future indemnity obligations are .required. We released previously established reserves in excess of the required payments for the indemnity obligations in the first quarter of 2004. This settlement resulted in a benefit of $0 .3 million and an income tax benefit of $12 .5 million, resulting in a net gain of $12 .8 million, which was reported as a "Gain from discontinued operations" for the six months ended June 30, 2004 .

During the three months ended June 30, 2003, we reversed approximately $0 .5 million related to unutilized reserves of Chiron Diagnostics and Chiron Vision, which were recorded as a "Gain from discontinued operations" for the three months ended June 30, 2003 .

During the three months ended March 31, 2003, Chiron and Bayer Corporation reached a settlement agreement relating to certain claims raised by Bayer under the Stock Purchase Agreement dated September 17, 1998, between Chiron and Bayer for Chiron Diagnostics . Under this settlement agreement, we were required to make a payment to Bayer during the first quarter 2003 . Pursuant to this settlement, we recorded a charge, net of adjustment to our previously provided reserve for indemnity obligations, of$7 .6 million, offset by an income tax benefit of $9 .0 million, resulting in a net gain of $1 .4 million, which was reported as a "Gain from discontinued operations" for the six months ended June 30, 2003 .

Liquidity and Capital Resources

40 instruments, corporate notes and bonds, government or government agency securities and other debt securities issued by financial institutions and other issuers . Investments are generally not collateralized and primarily with strong credit ratings . By policy, the amount of credit exposure to any one institution is limited mature within three years .

On June 12, 2004, certain Liquid Yield Option Notes (LYONs) holders, at their option, tendered $649 .9 million in aggregate principal amount at maturity of . The aggregate LYONs, which were purchased by us . The purchase price for the LYONs was $584 .31 in cash per $1,000 in principal amount at maturity purchase price for all the LYONS validly surrendered for purchase was 5379.7 million. At June 30, 2004, there remains $80 .1 million in aggregate principal amount at maturity and an accreted balance of $46 .8 million for the LYONs .

On June 22, 2004, we issued $385 .0 million aggregate principal amount of convertible debentures, which mature on June 30, . 2034 . The convertible . The debentures are debentures accrue interest at a rate of 2.75% per year and interest is payable on June 30 and December 30 commencing December 30, 2004 senior, unsecured obligations and rank equal in right of payment with all of our existing and future unsecured and unsubordinated indebtedness .

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

at June 30, 2004 and 2003, respectively. Sources and uses of cash We had cash and cash equivalents of $595 .0 million and $876 .0 million

.7 million as compared with $112.7 million Operating activities For the six months ended June 30, 2004, net cash provided by operating activities was $74 for the six months ended June 30, 2003 . The decrease in cash provided by operating activities primarily was due to lower income from continuing operations before depreciation and amortization and non-cash charges mainly from higher costs in our vaccines segment related to the effect of our acquisition of . In PowderJect. This was partially offset by higher royalty payments received under the Roche royalty arrangements for the six months ended June 30, 2004 addition, the cash provided by operations for the six months ended June 30, 2003 was negatively impacted by tax payments and a payment to Bayer Corporation as a result of a settlement agreement relating to certain claims raised by Bayer in connection with the Stock Purchase Agreement-dated September 17, 1998 and positively impacted by $14.4 million of cash received as a result of the Biogen and Serono settlements in connection with the McCormick patents during the six months ended June 30, 2003 .

Investing activities Pot the six months ended June 30, 2004, net cash provided by investing activities consisted of proceeds from sales and maturities of investments in marketable debt securities of $508 .1 million, proceeds from the sale of equity securities and interests in affiliated companies of $16.3 million and .8 million, other proceeds of $0, 8 million. Cash provided by investing activities was offset by purchases of investments in marketable debt securities of $218 capital expenditures of $93 .8 million, cash paid for acquisitions, net of cash acquired of $19 .5 million, which consists of $15 .5 million of cash delivered on the divestiture of certain research operations in Madison, Wisconsin and Oxford, England and certain vaccines operations in Sweden and $4 .0 million for previously accrued costs in connection with the acquisition of PowderJect, purchases of equity securities and interests in affiliated companies of $4 .3 million .

In 2003, our Board of Directors approved $ 50 .7 million in expenditures for a 25-year lease for buildings and $42.2 million for capital improvements, both he new manufactu ring facility will replace of which are part of a $97 .0 million project for a new flu vaccines manufacturing facility in Liverpool , England. T existing flu vaccines m anufacturing facilities in Liverpool , England. In December 2003, we

41 entered into a 25--year lease for these buildings . As of June 30, 2004, we have incurred $6 .3 million for these capital improvements.

For the six months ended June 30, 2003, net cas h provided by investing activities consisted of proceeds from sales and maturities of investments in marketable debt secu rities of $917.8 million and proceeds fr om the sale of equity securities and interests in affiliated companies of $7 .4. million. Cash provided by investing activities was offset by purchases of investments in m ar ketable debt securities of $277 .5 million, capital expenditures of $52 .4 million, purchases of equity securi ties and interests in affiliated companies of $36 . 9 million, cash paid for acquisi tions, net of cash acquired of $1 .2 million and other uses of cash of $0 .8 million.

Financing activities For the six months ended June 30, 2004, net cash used in financing activities consisted of $380 .0 million for the repayment of debt and capital leases, $71 .7 million for the acquisition of treasury stock and $7 .8 million for the payment of debt issuance costs. Cash used in financing activities was offset by $385 .0 million of proceeds from issuance of convertible debentures, $45 .0 million of proceeds from the reissuance of treasury stock an d $2 .3 million of proceeds from the issuance of debt .

Our Board of Directors has authorized the repurchase of our common stock on the open market . In December 5, 2003, the Board of Directors granted authority to buy 5 .0 million shares and authorized the repurchases through December 31, 2004 . From January 1, 2004 through June 30, 2004, 1 .5 million shares were repurchased .

For the six months ended June 30 , 2003, net cash used in financing activities consisted of $68 . 1 million for the acquisition of treasury stock, $0 . 1 million for the net repayment of short-- term borrowings and $0 .1 million for the repay ment of debt . Cash used in financing activities was offset by $24 .5 million of proceeds from the reissuance of treasury stock (related to stock option exercises ), and $2 .1 million of proceeds from put options.

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

Borrowing arrangements Under a revolving, committed, uncollateralized credit agreement with a major financial institution , we can borrow up to $100.0 million in the U .S . This credit facility is guaranteed by Novartis. AG under a November 1994 Investment Agreement, provides various interest rate options and .matures in February 2006 . There were no borrowings outstanding under this credit facility at June 30, 2004 and December 31, 2003 . In December 1999, Chiron and Novartis amended the November 1994 Investment Agreement to reduce the maximum amount of our obligations .that Novartis would guarantee from $725 .0 million to $702 .5 million .

As of June 30, 2004, Novartis had also guaranteed $173 .3 million of Chiron's lease commitments for a six-year lease to rent a research facility in Emeryville, California.

Factors That May Affect Future Results

As a global pharmaceutical, company, we are engaged in a rapidly evolving and often unpredictable business . The forward-looking statements contained in this l0--Q and in other periodic reports, press releases and other statements issued by us from time to time reflect our current beliefs and expectations concerning objectives, plans, strategies, future performance and other future events . The following discussion highlights some of the factors, many of which are beyond our control, which could cause actual results to differ .

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

We focus our research and development activities on areas in which we have particular strengths and on technologies that appear promising . These technologies often are on the cutting edge of modern science . As a result, the outcome of any research or development program is highly uncertain . Only a very small fraction of these programs ultimately result in commercial products or even product candidates. Product candidates that initially appear promising often fail to yield successful products . In many cases, preclinical or clinical studies will show that a product candidate is not efficacious (that is, it lacks the intended therapeutic or prophylactic effect), or that it raises safety concerns or has other side effects, which outweigh the intended benefit. Success in preclinical or early clinical trials (which generally focus on safety issues) may not translate into success in large-scale clinical trials (which are designed to show efficacy), often for reasons that are not fully understood. Further, success in clinical trials will likely lead to increased investment, adversely affecting short-term profitability, to bring such products to market . And even after a product is approved and launched, general usage or post-marketing studies may identify safety or other previously unknown problems with the product which may result in regulatory approvals being suspended, limited to narrow indications or revoked, or which may otherwise prevent successful commercialization.

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

An important part of our business strategy depends upon collaborations with third parties, including research collaborations and joint efforts to develop and commercialize new products . As circumstances change, Chiron and our strategic partners may develop conflicting priorities-or other conflicts of interest . We may experience significant delays and incur significant expenses in resolving these conflicts and may not be able to resolve these matters on acceptable terms . Even without conflicts of interest, we may disagree with our strategic partners as to how best to realize the value associated with a current product or a product in development. In some cases, the strategic partner may have responsibility for formulating and implementing key strategic or operational plans . In addition, merger and acquisition activity within the pharmaceutical and biotechnology industries may affect our strategic partners, causing them to reprioritize their efforts related to the research collaborations and other joint efforts with us . Decisions by corporate partners on key clinical, regulatory, marketing (including pricing), inventory management and other issues may prevent successful commercialization of the product or otherwise impact our profitability .

If we fail to obtain or maintain the regulato ry approvals we need to market our products, our business will suffer.

We must obtain and maintain regulatory approval in order to market most of our products . Generally, these approvals are on a product-by--product and country-by-country basis. In the case of therapeutic products, 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 clinical trials often are susceptible to varying - interpretations that may delay, limit or prevent approval or result in the need for post--marketing studies . In addition, regulations may be amended from time to time, Revised regulations may require us to reformulate products on a country or regional basis, obtain additional regulatory approvals, or accept additional risks that our products will not maintain market acceptance or be eligible for third party insurance coverage . Increased regulatory scrutiny and restrictions regarding marketing practices for products that are subject to government reimbursement may impact the sales of such products . There is no guarantee that we will be able to satisfy these new regulatory requirements and may suffer a loss of revenue as a result .

-1 Our products are complex and difficult to manufacture on a large-scale basis, which could cause us to delay product launches, experience shortages of products or prevent us from offering products on a volume basis.

Most of our products are biologics . Manufacturing biologic products is complex . Unlike chemical pharmaceuticals, a biologic product generally cannot be sufficiently characterized (in terms of its physical and chemical properties) to rely on assaying of the finished product alone to ensure that the product will perform in the intended manner. Accordingly, it is essential to be able to both validate and control the manufacturing process, that is, to . show that the process works and that the product is made strictly and consistently in compliance with that process . Slight deviations anywhere in the manufacturing process, including quality control, labeling and packaging, may result in unacceptable changes in the products that may result in lot failures or product recalls, or liability to a third party to the extent we are contract manufacturing products in our facilities for such third party . Manufacturing processes which are used to produce the smaller quantities of material needed for research and development purposes may not be successfully scaled up to allow production of commercial quantities at reasonable cost or at all . All of these difficulties are compounded when dealing with novel biologic products that require novel manufacturing processes . Additionally, manufacturing is subject to extensive government regulation . Even minor changes in the manufacturing process require regulatory approval, which, in turn, may require further clinical studies . For some of our products, we rely on others to supply raw materials and to manufacture those products according to regulatory requirements.

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

Ourmishandling of hazardous materials could result in substantial costs and harm to our business.

In connection with our research and manufacturing activities', we utilize some hazardous materials . We believe we take great care to ensure we have appropriate procedures and permits in place for storing and handling such hazardous materials . We could be subject to loss of our permits, government fines or penalties and/or other adverse governmental action if such hazardous materials are stored, handled or released into the environment in violation of law or any permit . A substantial fine or penalty, the payment of significant environmental remediation costs or the loss of a permit or other authorization to operate or engage in our ordinary course of business could result in material, unanticipated expenses and the possible inability to satisfy customer demand .

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

We use raw materials and other supplies that generally are available from multiple commercial sources . Certain manufacturing processes, however, use materials that are available from sole sources, or that are in short supply, or are, difficult for the supplier to produce and certify in accordance with our specifications. From time to time, concerns are raised with respect to potential contamination of biological materials that are supplied to us . These concerns can further tighten market conditions for materials that may be in short supply. or available from limited sources . Moreover, regulatory approvals to market our products may be conditioned upon obtaining certain materials from specified sources . Our ability to substitute material from an alternate source may be delaye d } pending regulatory approval of such alternate source . Although we work to mitigate the risks associated with relying on sole suppliers, there is a possibility that material shortages could impact production .

44 We purchase bulk powdered tobramycin, the primary basic raw material in TOB1® tobramycin, from two of the principal worldwide suppliers of the drug . We anticipate that either one of these suppliers alone will be able to supply sufficient quantities to meet current needs ; however, there can be no assurance that these suppliers will be able to meet future demand in a timely and cost-effective manner . As a result, our operations could be adversely affected by an interruption or reduction in the supply of bulk-powdered tobramycin .

We have entered into contracts with third patties for the production and packaging of TOBI®. Over time, we can use alternative production and packaging sources . However, if the contracted third patties become unable to produce or package sufficient quantities of TOBI() due to work stoppages or other factors, our operations could be disrupted until alternative sources are secured .

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

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

We are a key provider for the blood screening field of nucleic and testing and immunodiagt ostics . In nucleic acid testing, we rely on our collaborative partner, Gen-Probe, to manufacture the West Nile virus assay, currently in use on an investigational-use basis in the U .S . and the Procleix® HIV-I/HCV Assay, We currently source the related instrument system from third party suppliers. Currently, Gerr-Probe is the only manufacturer of nucleic acid testing products using Transcription-Mediated Amplification technology . In immunodiagnostics, under the Ortho-Clinical Diagnostics, Inc . contract, we manufacture bulk reagents and antigens and confirmatory test kits sold in the clinical diagnostics and blood screening fields . While we and our partners work to mitigate the risks associated with being a key provider, there can be no assurance that our partner, Gen-Probe, will be able to provide sufficient quantities of the Procleix® HIV-l/HCV Assay or that we will be able to manufacture sufficient bulk reagents and antigens and confirmatory test kits for immnnodiagnostic products. Our difficulties or delays or those of our partners' could cause a public health concern for the, blood supply, as well as increase costs and cause loss of revenue or market share.

Ifwe cannot obtain necessa ry licenses to (hi rd party patents for the manufacture or sale of our products, the may have to withdraw from the market or delay the introduction of the affected product.

Third parties, including competitors , have patents and patent applications in the U.S . and other significant markets that may be useful or necessary for the manufacture , use or sale of certain products and products in development by our strategic partners and us. It is likely that third parties will :obtain these patents in the future . Certain of these patents may be broad enough to p revent or delay us and our strategic partners from manufacturing or marketing products important to our curr ent and future business. We cannot accurately predict the scope, validity and enforceability of these patents ,if granted , the extent to which we may wish or need to obtain licenses to these patents, and the cost and availability of these licenses . If we do not or cannot obtain these licenses, products may be withdrawn from the market or delays could be encountered in market introduction while an attempt is made to design around these patents, or we could find that the development, manufacture or sale of such products is foreclosed. We could also incur substantial costs in licensing or challenging the validity and scope of these patents . 45 Because most of our products are based on tecu . . gies that are unfamiliar to the healthcare community, they . . jot be accepted by healthcare providers an d patients, which could harm our business .

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

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

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

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

If we are unable to successfully compete in the highly competitive healthcare industry, our business could be harmed

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

• The possibility that the competitor may have launched its product first;

• The competitor may have greater access to certain raw materials;

• The competitor may have . more efficient manufacturing processes ;

The competitor may adapt more quickly to technological change ;

• The competitor may have greater marketing capabilities ;

The competitive product may have therapeutic or other advantages ; or

New competitors may enter into markets where we currently have significant competitive advantage .

46 Our patents may not prevent competition or generate revenues ,

We seek to obtain patents on many of our inventions . Without the protection of patents, competitors maybe able to use our inventions to manufacture and market competing products without being required to undertake the lengthy and expensive development efforts made by us and without having to pay royalties or otherwise compensate us for the use of the invention . We have no assurance that patents and patent applications owned or licensed to us will provide substantial protection . Important legal questions remain to be resolved as to the extent and scope of available patent protection for biotechnology products and processes in the U .S . and other important markets . We do not know how many of our pending patent applications will be granted, or the effective coverage of those that are granted . In the U.S. and other important markets, the issuance of a patent is neither conclusive as to its validity nor the enforceable scope of its claims . We have engaged in significant litigation to determine the scope and validity of certain of our patents and expect to continue to do so . An adverse outcome of litigation could result in the reduction or loss of royalty revenues . Engaging in patent litigation against one party may place significant royalty revenues received or to be received from other parties at risk . Even if we are successful in obtaining and defending patents, there can be no assurance that these patents will provide substantial protection . The length of time necessary to resolve patent litigation successfully may allow infringes to gain significant market advantage . Third parties may be able to design around the patents and develop competitive products that do not use the inventions covered by our patents . Many countries, including certain countries in Europe, have compulsory licensing laws under which a patent owner may be compelled to grant licenses to third parties (for example, the third party's product is needed to meet a threat to public health or safety in that country, or the patent owner has failed to "work" the invention in that country, or the third party has patented improvements) . In addition, most countries limit the enforceability of patents against government agencies or government contractors . In these countries, the patent owner may be limited to monetary relief and may be unable to enjoin infringement, which could materially diminish the value of the patent . In addition, royalty revenues may decline as patents expire.

Sales ofour products maybe adversely affected by the availability and amount ofreimbursement to the user of our products from thirdparties, such as the government and insurance companies.

In the U .S . and other significant markets, sales of our products may be affected by the availability of reimbursement from the government or other third . parties, such as insurance companies. It is difficult to predict the reimbursement status of newly approved, novel biotechnology products, and current reimbursement policies for existing products may change. In certain foreign markets, governments have issued regulations relating to the pricing and profitability of pharmaceutical companies . There have been proposals in the U .S . (at both the federal and state level) to implement such controls, If the United States Congress enacts legislative proposals addressing parallel . importation currently being deliberated, revenues from certain products may be affected by this change . in U.S . policy . The growth of managed care in the U.S . also has placed pressure on the pricing of healthcare products . These pressures can be expected to continue .

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

As part of our business strategy , we expect to continue to grow our business through in -licensing, collaborations or acquisitions of products or companies . The failure to adequately address the financial , operational or legal risks raised by such transactions , could harm our business. Financial aspects related to these transactions may alter our fi nancial position, repo rted operating re sults or stock price, and include :

Use of cash resources ;

Potentially dilutive issuances of equity securities;

47 The incurrence of debt andconttiingent liabilities , impairment losses or restructuring charges ; .

Large write-offs and difficulties in assessment of the relative percentages of in-process research and development expense that can be immediately written off as compared to the amount which must be amortized over the appropriate life of the asset ; and

Amortization expenses related to other intangible assets ,

Operational risks that could harm our existing operations or prevent realization of anticipated benefits from such transactions include :

Challenges associated with managing an increasingly diversified business ;

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

Diversion of management's attention from other business concerns ;

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

The assumption of known and unknown liabilities of the acquired company, including intellectual property claims ; and

Subsequent loss of key personnel .

Legal risks may include re quirements to obtain the consent of our stockholders or a third party, or the approval of various regulatory authorities.

If such efforts to integrate acquired or licensed businesses or technologies into our business are not successful, our business could be harmed .

!f we cannot initiate and maintain revenue-generating relationships with third parties, we may not be able to grow our revenues in the near to medium term .

Many products in our current pipeline are in relatively early stages of research or development . Our ability to grow earnings in the near- to medium-term may depend, in part, on our ability to initiate and maintain other revenue generating relationships with third parties, such as licenses to certain of our technologies, and on our ability to identify and successfully acquire rights to later-stage products from third parties . We may fail to establish such other sources /i of revenue .

Fluctuations in interest rates and foreign currency exchange rates could harm our business.

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

Our-level of debt could limit cash flow available for our operations and could adversely affect our ability to service our debt or obtain additional f nancing, if necessary.

As of June 30, 2004, our total debt was $938 .0 million. Our level of debt could restrict our operations and make it more difficult for us to satisfy our obligations under the 2033 and the 2034 convertible debentures ("the debentures") . Among other things, our level of debt may :

Limit our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions and general corporate purposes ;

1 Require us to dedicate all or a substantial portion of our cash flow to service our debt, which will reduce funds available for other business purposes, such as capital expenditures or acquisitions ;

Limit our flexibility in planning for or reacting to changes in the markets in which we compete ;

Place us at a competitive disadvantage relative to our competitors with less leverage ;

Render us more vulnerable to general adverse economic and industry conditions ; an d

Make it more difficult for us to satisfy our financial obligations, including those relating to the debentures and our other debt obligations .

We and our subsidiaries may still be able to incur substantially more debt . The terms of our credit facility, the indentures governing the debentures and the agreements governing our other debt permit additional borrowings . Our incurrence of additional debt could further exacerbate the risks described above .

Our ability to satisfy our obligations under the debentures and our debt agreements will depend on our future operating performance, which will be subject, in part, to factors beyond our control, including general economic and business conditions . If we are unable to generate sufficient cash flow to service our debt, we maybe required to refinance all or a portion of our debt, including the debentures, obtain additional financing, sell some of our assets or operations, reduce or delay capital expenditures, or revise or delay our strategic plans. If we are required to take any of these actions, it could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure you that we would be able to take any of these actions, that these actions would enable us to continue to satisfy our capital requirements or that these actions would be permitted under the terms of our various debt instruments, including the indentures governing the debentures.

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

We have an alliance with Novartis AG, a life sciences company headquartered in Basel, Switzerland . Under a series of agreements between Chiron and Novartis, and as a result of subsequent stock issuances by Chiron, Novartis' ownership interest in Chiron was approximately 42% as of June 30, 2004: The governance agreement between Chiron and Novartis contains provisions that require the .approval of Novartis before we enter into certain corporate transactions . These transactions generally include significant debt or equity issuances, debt or equity repurchases, most mergers and acquisitions, the payment of cash dividends, amendments to Chiron's certificate of incorporation or by-laws, and other transactions that would adversely impact the rights of Novattis, or discriminate against Novartis, as a Chiron stockholder. In addition, a majority of the independent directors must approve any material transactions between Chiron and Novartis . These provisions may limit our ability to enter into transactions with third parties otherwise viewed as beneficial to Chiron . All of our shares owned by Novartis are eligible for sale in the public market subject to compliance with the applicable securities laws . We have agreed that, upon Novartis' request, we will file one or more registration statements under the Securities Act in order to permit Novartis to offer and sell shares of our common stock . Sales of a substantial number of shares of out common stock by Novartis in the public market could adversely affect the market price of our common stock .

49 Volatility of our stock price could negatively impact our prof tability.

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

Fluctuations in earn ings from period to period ;

Results of clinical trials conducted by us or by our competitors ;

Announcements by us or our competitors regarding product development efforts, including the status of regulatory approval applications ;

The outcome of legal proceedings, including claims filed by us against third parties to enforce our patents and claims filed by third parties against us relating to patents held by the third parties ;

The launch of competing products ;

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

Corporate restructuring by us;

The sale of a substantial number of shares held by our existing stockholders ;

Licensing activities by us; and

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

In connection with our research and development collaborations, from time to time we may invest in equity securities of-our strategic partners . The price of these securities also is subject to significant volatility and maybe affected by, among other things, the types of events that affect our stock . Changes in the market- price of these securities may impact our profitability .

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

We pay taxes principally in the U .S ., Germany, Italy, The Netherlands and, with the acquisition of Powderlect, theUnited .Kingdom . All of these jurisdictions have in the past and may in the future make changes to their corporate tax rates and other tax laws, which could increase our future tax provision . We have negotiated a number of rulings regarding income and other taxes that are subject to periodic review and renewal . If such rulings are not renewed or are substantially modified, income taxes payable in particular jurisdictions could increase. While we believe that all material tax liabilities are reflected properly in our balance sheet, we are presently under audit in several jurisdictions and may be subject to further audits . in the future, and we have no assurance that we will prevail in all cases in the event the taxing authorities disagree with our interpretations of the tax law . In addition, we have assumed liabilities for all income taxes incurred prior to the sales of our former subsidiaries, Chiron Vision (subjecfto certain limitations) and Chiron Diagnostics . Future levels of research and development spending, capital investment and export sales will impact our entitlement to related tax credits and benefits which have the effect of lowering our effective tax rate .

Volatility of earnings could negatively impact our business .

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

Inventory management practices, including wholesale ordering pattern s ;

The level of pre-clinical and clinical trial-related activities ;

50 Seasonality of certain vaccine products ;

The tender driven nature of certain vaccine products;

The nature of our collaborative, royalty and license arrangements and other revenue sources ;

Foreign currency exchange rate fluctuations ; and

The level of product reserves due to various issues, including seasonality patterns, excess and obsolete inventory, and production yields .

Our results in any one quarter are not necessarily indicative of results to be expected for a full year .

We must follow accounting standards, financial reporting and corporate governance requirements and tax laws set by the governing bodies and lawmakers in the U.S . and other countries where we do business . From time to time, these governing bodies and lawmakers implement new and revised rules and laws . These new and revised accounting standards, financial reporting and corporate governance requirements and tax laws may require changes to our financial statements, the composition of our board of directors, the composition, the responsibility and manner of operation of various board-level committees, the information filed by us with the governing bodies and enforcement of tax laws against us . Implementing changesrequired by such new standards, requirements or laws likely will require a significant expenditure of time, attention and resources, especially by our senior management . It is impossible to predict the impact, if any, on Chiron of future changes to accounting standards, financial reporting and corporate governance requirements and tax laws . In addition, it is possible that the application of certain current accounting standards may change due to environmental factors, which may necessitate a change in out standard practice related to these accounting standards .

Item 3. Quantitative and Qualitative Disclosures About Market Ris k

Market risk management Our cash flow and earnings are subject to fluctuations due to changes in foreign currency exchange rates, changes in interest rates and changes in the fair value of equity securities held for sale . We attempt to limit our exposure to some or all of these market risks through the use of various financial and derivative instruments . During the second quarter of 2004, we issued $385 .0 million of new convertible debentures to replace the LYONs tendered for cash of $379 .7 million by certain holders of our LYONs . The new convertible debentures carry a coupon rate of 2 .75% and were issued at par. Future changes in interest rates will not affect interest expense incurred on our outstanding convertible debentures and remaining outstanding LYONs because these obligations bear interest at fixed rates. We seek to manage our exposures to market risks as discussed in further detail in Part 11, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk" in our annual Report on Form 10-K for the year ended December 31, 2003 .

Item 4. Controls and Procedure s

(a) Evaluation of disclosure controls and procedures As of the end of the period covered by this report, Chiron carried out an evaluation under the supervision and With the participation ofChiron's management, including Chiron's CEO and CFO, of the effectiveness of Chiron's disclosure controls and procedures pursuant to Exchange Act Rule 1'3a-15(e) or 15d-15(e) . Based on that evaluation, Chiron's management, including the CEO and CFO, concluded that Chiron's disclosure controls and procedures were effective in timely alerting them to material information relating to Chiron required to be included in Chiron s periodic SEC filings . . Sl Changes in internal controls There have been no changes in Chiron's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect internal controls over financial reporting during the most recent fiscal quarter .

(c) Limitations on the effectiveness of controls It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met . In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions .

I PART II

Item I . Legal Proceeding s

We are party to certain lawsuits and legal proceedings, which are described in Part I, Item 3 . "Legal Proceedings" of our Annual Report on Fonn 10--K for the year ended December 31, 2003 . The following is a description of material developments during the period covered by this Quarterly Report and should be read in conjunction with the Annual Report on Form 10-K for the year ended December 31, 2003 .

F. Hoffmann- La Roche Ltd. and Roche Molecular Systems, Inc.-HI V

On March 11, 2003, the U .S. Patent and Trademark Office issued Chiron's U .S, Patent No. 6,531,276 (addressed to Methods For Detecting Human Immunodeficiency Virus Nucleic Acid) (the "276 Patent") . Chiron asserts that under its October 10, 2000 HIV Probe License Agreement and January 1, 2001 HIV Blobd Screening Agreement (the "License Agreements") with F . Hoffman-La Roche Ltd, and Roche Molecular Systems (collectively, "Roche"), Roche is obligated to pay certain licensing fees and ongoing royalties for the sale of certain Roche HIV nucleic acid tests which infringe the "276 Patent . Roche disputes these obligations on a variety of grounds including a limited claim of non-infringement and invalidity . Roche initially contested the rate at which royalties must be paid if in fact its produets.are covered by the License Agreements, but later withdrew this claim . In November 2003 ; Chiron initiated an arbitration against Roche pursuant to the rules of the CPR Institute for Dispute Resolution. The arbitration was held in June 2004 and the arbitrator is expected to render an award during the third quarter of this year .

Chiron does not know the basis upon which this matter will be resolved .

Dade Behring Marburg GmbH and Dade Gehring S.p.A.

In January 2001 , Dade Behring Marburg GmbH and Dade BeIs ing S . p .A . (collectively , " Dade Behring") filed suit in the Court of Milan, Italy against Chiron seeking a pan European declaration that its Enzygnost ® HIV 1/2 plus immunoassay kit does not infringe Chiron' s European Patent No . 0 181 150 (the "'150 patent ") relating to HIV technology , and to nullify the Italian portion of the'150 patent . In April 2001 , Chiron filed a counterclaim seeking a declaration of infringement of the Italian portion of the '150 patent by the Enzygnost ® HIV 1/2 plus kit and related damages . In June 2002 , the Court of Milan declared that it lacked jurisdiction over the non-Italian part s of the'150 patent, thereby limiting the lawsuit to issues involving only the Italian portion of the ' 150 patent. I n May 2004, the parties entered into a cross-license agreement pursuant to which the parties agreed, inter aiia, to dismiss the matters discussed above . The matter is thus concluded.

Item 2 . Changes in Securities and Use of Proceed s

(e) Our Board of Directors autho ri zed the repurchase of our common stock on the open market to offset the dilution associated with the issuance of new shares under the stock option and stock purchase pl ans and the granting of share rights . On December 5, 2003, the Board of Directors granted authority to buy 5 million shares of Chiron common stock and authorized such repurchases through December 31, 2004 under the stock repurchase program .

53 Our stock repurchases under the above pla. summarized below ( shares in millions) :

Maximu m Total Number Number of oiShares shares tha t Total Number Purchased as May Yet B e of Share s Average Price Part of Publicl y Purchased Period Purchased Paid per Share Announced Plan Under Plan

April 1, 2004-April30, 2004 $ May 1, 2004- May 31, 2004 1 .2 $ 43 .68 . 1-2 3 . 8 June I, 2004 -- June .30, 2004 . 0 .3 $ .45 .17 . . 0 .3 3 . 5

Total 1-5 $ 43 .95 1-5

Item 4 . Submission of Matters to a Vote of Security Holder s

(a) Chiron held its Annual Meeting of Stockholders on May 27, 2004 .

(b) Omitted pursuant to Instruction 3 to Item 4 of Form 10-Q .

(c) The three matters voted upon at the-meeting were : (i) election of three directors to hold office for the terms indicated ; (ii) amendment and restatement of the Chiron 1991 Stock Option Plan, renamed the Chiron 2004 Stock Compensation Plan ; and (iii) ratification of the appointment of Ernst & Young LLP as Chiron's independent auditors for the year ending December 31, 2004- The three directors, Mr . Vaughn D . Bryson, Mr. Pierre E . Douaze and Dr. Edward E . Penhoet, were serving as directors and were nominated for election to the Board for a three-year term expiring in 2007 .

(i) The following votes were cast for or were withhold with respect to each of the nominees for director:

DIRECTORS FOR WITHHELD

. . Class ef2007 , ~ . Vaughn D Bryson 165,892,843 6,831,004 Pierre'E Doiiaze 169739784, 2;984,063 Edward E . Penhoet 169,556,989 3,166,85 8 All nominees were declared to have been elected as directors to hold their respective offices until the Annual Meeting of Stockholders in the year 2007 as noted above . No abstentions or broker non--votes were cast for the election of directors .

The following directors shall continue in office after Chiron's Annual Meeting of Stockholders held on May 27, 2004 : Lewis W . Coleman, J. Richard Fredericks, Paul L. Healing and Howard H. Pien until the Annual Meeting of Stockholders in the year 2005, and Raymund Breu, Denise M . O'Leary and Pieter J. Strijkert until the Annual Meeting of Stockholders in the year 2006 .

(ii) With respect to the proposal to approve the amendment and restatement of the Chiron 1991 Stock Option Plan, renamed the Chiron 2004 Stock Compensation Plan (the "Stock Plan"), 110,380,017 votes were cast for the proposal, 40,308,665 votes were cast against'the proposal, and 1,369,878 votes abstained. No broker non-votes were cast in connection with this proposal. The approval of the Chiron Stock Plan was declared to have been approved .

(iii) With respect to the proposal to ratify the appointment of Ernst & Young LLP as Chiron'. independent auditors, 170,960,642 votes were cast for the proposal, 496,385 votes were cast against the proposal, and 1,266,820 votes abstained- No broker non-votes were cast in connection with the. proposal . The selection of Ernst & Young LLP as the Chiron's independent auditors for the year ending December 31, 2004 was declared to have been ratified .

54 Item 6 . Exhibits and Reports on Form 8-K

(a) Exhibit s

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 .

3.03 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 3 .04-of Chiron's report on Form 10--K for fiscal year 2003 .

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 l0-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-I 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., Bane of America Securities LLC and BNP Paribas Securities Corp ., incorporated by reference to Exhibit 4 .3 ofCliyroti'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 .

4.08 Registration Rights Agreement dated as of June 22, 2004, between Chiron, Credit Suisse First Boston, LLC and Morgan Stanley & Go .

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 the period ended June 30, 2004) issued on June 22, 2004 .

55 10 .102 Amended and Restated Revolving Credit Agreement, dated as of August 13, 2002, by and between Chiron and Bank of America, N .A ., and exhibits thereto, incorporated by reference to Exhibit 10 .102 of Chiron's report on Form l0-Q for September 30, 2002 .

10.501 Chiron 2004 Stock Compensation Plan . *

10 .508 Form of Performance Share Rights Agreement (Executive Officers) .*

10.519 Corporate Governance Guidelines, as amended and restated ,

10.520 Finance Committee Charter.

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 I3a-I4(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 pursuan t to 18 U .S .C . Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 .

Management contract, compensatory plan or arrangement .

(b) Reports on Form 8-K

On April 21, 2004, Chiron filed a current report on Form 8-K, furnishing under Item 12, Chiron s preliminary results for its first quarter ended March 31, 2004 via a press release.

On May 14, 2004, Chiron filed a current report on Form 8-K, filed under Item 5, announcing that it had filed a Tender Offer Statement on Schedule TO--1 with the Securities and Exchange Commission (the "Commission") relating to Chiron 's repurchase offer of its 30-year Liquid Yield OptionTM Notes due 2031 (Zero Coupon-Senior) [the "LYONS"] at a purchase price of $584.31 per $1,000 principal amount at maturity outstanding.

On May 18, 2004, Chiron filed a current report on Form 8-K, filed under Item 5, announcing that : (i) Chiron had sold all of the shares of its subsidiary, SBL Vaccin AB, to the management team of SBL Vaccin AB, and (ii) disposed of its needle-free particle mediated delivery technology and related DNA vaccine development programs through the sale of its shares of PowderJect Vaccines, Inc . and substantially all the assets held by two Chiron subsidiaries, Powderlect Research Limited and PowderJect Technologies Limited, to PowderMed Limited, a U .K. company .

On June 15, 2004, Chiron filed a current report on Form 8-K, filed under Item 5, announcing that it had filed an amendment to its Tender Offer Statement on Schedule TO/A with the Commission to report the results of its offer to purchase the LYONS, which repurchase offer expired at 5 :00 p.m . New York City time on June 14, 2004, as more fully described in Chiron's Schedule TO/A.

On June 17, 2004, Chiron filed a current report on Form 8-K, filed under Item 5, announcing that it had agreed to the sale of 30-year convertible debentures to qualified institutional buyers. The debentures are convertible under certain circumstances into cash and, if applicable, Chiron common stock .

56 CIHIRON CORPORATION June 30, 2004

SIGNATURES

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

CHIRON CORPORATION

DATE: August 9, 2004 By : Is! HOWARD H . PIEN

Howard H . Pie n President and Chief Executive Officer

DATE: August 9, 2004 Hy : /s! DAVID V_ SMIT H

David V . Smith Vice President and Chief Financial-0fcer

1r` . g :.

3 EXHIBIT F Chiron News Page 1 of 9 Lu

Chiron Reports 2003 Second-Qua rter Pro-Forma income of 35 Cents Per Share 17 Percent Increase in Revenues Over 2002

EMERYVILLE, Calif., July 23 /PRNewswire -FirstCall! - Chiron Corporation ( Nasdaq : CH1R) today reported pro-forma income from continuing operations of $67 million, or $0 .35 per share, for the second quarter of 2003, compared to $56 million, or $0 .29 per share, for the second qua rter of 2002. (Chiron management uses pro-forma financial statements to gain an understanding of the company 's operating pe rformance on a comparative basis. Pro-forma results exclude special items relating to certain acquisitions and revenues . which may not be relevant.to gaining an understanding of the company's trends or potential future pe rformance. Please refer to the a ttached tables at the end of this document for more detail on these items and-a reconciliation to GAAP financial statements.) On a GAAP basis, Chiron's income from continuing operations was $61 million, or $0.32 per share, for the second quarter of 2003 , compared to $50 million, or $0.26 per share, for the second quarter of 2002 . (All references to per-share amounts are per diluted share .) Foreign exchange rates . an a pro-forma basis, resulted in a $0 .01 increase in earnings per share.

"Chiron made several important advances that demonstrate our momentum as a global biopharmaceutical company and that will help drive growth from the immediate to the long term, increasing shareholder value," said Howard Pien, Chiron's president and CEO. "Prominent among these was our acquisition of PowderJect, which makes us the second-largest flu vaccines manufacturer worldwide and adds a U .S . complement to our strong global vaccines business . The PowderJect acquisition, after integration costs, will be EPS neutral or better this year and accretive in 2004, and we are affirming our 2003 pro-forma guidance to be toward the upper end of the previously stated range of $1 .40 to $1 .50.

"Our Blood Testing business also saw notable milestones, including the introduction of the Procleix(R) West Nile Virus Assay, which is now used to test more than 80 percent of the U .S. blood supply under an IND . Our SioPharmaceuticals business continues its strategic advancement with expanded leadership and positive clinical data," added Pien . 'ogether, Chiron's businesses continue to increase the company's profound impact on .human health worldwide ."

Overall Revenue s

Total revenues in the second quarter of 2003 were $350 million, an increase of approximately 17 percent from $299 million in the second quarter of 2002 . Foreign exchange rates resulted in an 8 percent increase in revenues . Net product sales increased 16 percent in the second quarter of 2003, to $246 million from $211 million in the second quarter of 2002.All. other revenues increased 19 percent in the second quarter of 2003, to $104 million from $88 million in the second quarter of 2002 .

BioPharmaceuticals

The Biopharmaceuticals division reported net product sales and Betaferon(R) interferon beta-lb royalties of $124 million in the second quarter of 2003, compared to $115 million in the second quarter of 2002 . The gross profit margin on biopharmaceutical products sold during the second quarter of 2003 was 71 percent, compared to 72 percent in the second quarter-of 2002 .

-- TQBI(R) tobramycin solution for inhalation sales in the second~quarter of 2003 were $39 million, . compared to $34 million in the second quarter of 2002, primarily due to greater product penetration in Europe , increased patient demand and compliance in the United States, and price increases in both the United States and Europe, which were partially offset by wholesale ordering patterns . -- Sales of Betaseron(R) interferon beta-lb, marketed in Europe as Betaferon, to Berlex Laboratories, Inc . (and its parent company Schering AG) for marketing and resale were $31 million in the second quarter of 2003, compared to $34 million in the second quarter of 2002 . The decrease was due to wholesale ordering patterns resulting from last year's launch of the room-temperature stable formulation, partially offset by price increases . Royalties from Schering AG's European sales of Betaferon were $17 million in the second quarter of 2003, compared to $11 million in the second quarter of 2002 . - Proleukin(R) (aldesleukin) interleukin-2 sales were $29 million in the second quarter of 2003, compared to $28 million in the second quarter of 2002, due primarily to price increases .

Vaccine s

Vaccines net product sales in the second quarter of 2003 were $86 million, compared to $73 million in the second quarter of

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2002. The gross profit margin on vaccines products for the second quarter of 2003 was 56 percent, compared to 61 percen t in the second quarter of 2002 .

sales of Menjugate(TM) conjugate vaccine against meningococcal C disease totaled $14 million in the second quarter of 2003, compared to $10 million in the second quarter of 2002, with the increase due primarily to sales made under an Australian tender in the state o f New South Wales . Sales from Chiron's travel vaccines'-- the tick-borne encephalitis vaccine Encepur{TM) and the rabies vaccine RabAvert(R) -- were $23 million in the second quarter of 2003, consistent with the second quarter of 2002 . Typically, the first half of the year is the prithe season for Encepur ; overall, the product has seen a seasonal increase of 17 percent year over year . Sales of Chiron's pediatric, flu and other vaccines products were $49'million in the second quarter of 2003, compared to $40 million in the second quarter of 2002, with the increase primarily . due to tender sales of pediatric vaccines .

Blood Testing

Total Blood Testing revenues in the second quarter of 2003 were $106 million, compared to $77 million in the second quarter of 2002. Blood Testing revenues primarily include revenues from the sales of products related to Chiron's Procleix(R) HIV- 1/HCV Assay; revenues related to Chiron's joint immunodiagnostic business with Ortho-Clinical Diagnostics, Inc . (Ortho), a Johnson & Johnson company; royalties paid by F. Hoffmann-La Roche (Roche) related to nucleic acid testing (NAT) blood screening ; and new license fees related to NAT plasma fractionation .

-- Sales related to Procleix were $46 million in the second quarter of 2003, compared to sales of $29 million in the second quarter of 2002 . Product revenues recognized in the second quarter of 2003 include a full quarter of commercial pricing in the United States, market share gains in the United States, and continued penetration into several markets abroad . - Revenues recorded in earnings from Chiron's unconsolidated joint business with Ortho were $27 million in the second quarter of 2003, comparable with $27 million in the second quarter of 2002 . - Royalties paid by Roche related to NAT blood screening were $14 million in the second quarter of 2003, compared to .$1 .1 million in the second quarter of 2002 .

Pipeline and Products Updat e

Chiron has a diverse and robust array of clinical programs and product franchises with a focus on cancer and infectious disease . The company is committed to expanding its franchises through geographic and market expansion ; new indications, and new products. Chiron expects to continue to see advances in franchises across all three business units in 2003 .

BioPharmaceuticals: TOBI(R) Tobramycin Solution for Inhalatio n

Chiron is further developing TOBI, .used by cystic fibrosis (CF) patients with chronic pseudomonal lung infection, through new formulations, new delivery systems and expanded indications .

-- The FAA has accepted the IND for the dry-powder formulation and hand-held device for TOSI, which Chiron is developing in collaboration with Nektar Therapeutics . Chiron initiated Phase I testing with this product, which will increase ease of use for patients ; last week . - At the 26th European Cystic Fibrosis Conference in Belfast in June, Chiron presented the results of a 184-patient open-label study that showed that subjects undergoing TORT treatment in conjunction with routine care were significantly less likely to be hospitalized for respiratory symptoms or to be treated with oral antibiotics than those undergoing routine care alone . - Chiron also saw recent positive data on TOBI's efficacy in decreasing Pseudomonas aeruginosa (Pa) in pediatric patients, which was published Chiron News Page 3 of 9

in the March 15, 2003, American Journal of Respiratory and Critical Care medicine, as well as data on TOBIIs potential role in treating chronic bronchiectasis, which was presented at the American Thoracic Society meeting in Seattle in May . At the and of 2003, Chiron intends to initiate the ELITE (EarLy Intervention TOBI Eradication) trial in Europe to further study the benefits of TOBI in treatment of early onset Pa in CF patients .

Biopharmaceuticals : Betaseron(R) Interferon Beta-l b

Betaseron continues to distinguish itself in the multiple sclerosis (MS) market through its strong clinical results and expanded labeling . Convenience features and new studies will help drive Betaseron growth .

Upcoming product enhancements include a pre-filled diluent syringe for the U .S_ market to increase ease of use . At the European Neurological Society annual meeting in Istanbul in June, Chiron's marketing partners, Berlex and Berlex's parent Schering AG, presented data from a 64-patient blinded, controlled study showing that Betaferon/Betaseron as compared with Rebif(R) was associated with less pain and fewer skin reactions at the injection site . -- Schering AG also announced the completion of recruitment . for its Phase III BENEFIT study, the first long-term MS-trial to assess a high-dose, frequently administered beta interferon therapy in patients with early signs of MS . More than 450 . patients from 96 centers in 20 countries have been randomized and started treatment in the two-year study, the "final results of which will be available by mid-2005 .

Biopharmaceuticals : Oncolog y

Chiron's anticancer franchise has three dimensions : immune-based therapies, monoclonal antibodies and novel cancer . agents.

- Chiron currently has four clinical trials underway -- two in Phase II and two in Phase I -- to .evaluate the . potential of Proleukin(R) (aldesleukin) interleukin-2 and its second-generation liquid formulation to increase the clinical benefit of rituximab or trastuzumab in cancer treatments- Chiron anticipates having sufficient data to decide next .steps in several of these trials by the end of . 2003 . - Chiron has two Phase II trials underway to study the potential, of tezacitabine, Chiron's next-generation nucleoside analog . The current . trials in colorectal cancer and gastroesophogeal cancer are part of a program to determine the specific tumor types that the compound is most effective in treating . Chiron expects to see preliminary data from the . current Phase II trials in 2004 . . .

Vaccine s

Chiron is the fifth-largest vaccines business in the world and markets more than 30 novel and conventional vaccines for adults and children . The company is investing in the vaccines business,to develop new products with significant growth potential.

- As previously announced, Chiron acquired Powderiect Pharmaceuticals, solidly positioning Chiron as the second-largest manufacturer of flu vaccines in the world . The two companies were geographic complements, and the acquisition provides Chiron with a strong U .S . flu vaccines business and an excellent platform to launch new vaccines products in the United States . Chiron will begin incorporating PowderJect results in the third quarter . - In the second quarter, Chiron saw progress in its development of vaccines for the five primary serogroups that cause meningococcal disease . * Enrollment is continuing in Chiron's Phase III trial in the United States for Menjugate(TM) conjugate vaccine . Chiron expects to Y Chiron News Page 4 of 9

complete Phase III and present data to the FDA in 2004 . * Chiron's combination ACYW vaccine candidate showed favorable safety and immunogenicity results in Phase I testing and has advanced to Phase II . Enrollment for this trial is on track, and Chiron expects results from the study later this year- Positive proof-of-concept data from the Phase I trial for Chiron's first-generation, broad-coverage meningococcal B vaccine raised the company's confidence in the potential of its second-generation vaccine candidate, which is expected to enter Phase I testing in 2004 and show stronger immunogenicity .

Blood Testing : Procleix(R) System

Chiron is a leader in blood testing and making the blood supply safer . Through its NAT collaboration with Gen-Probe incorporated, the company expects to expand its leadership through new geographies, greater market penetration, additional assays and enhanced automation of the Procleix instrument system .

74 Chiron and its collaborator Gen-Probe Incorporated introduced the Procleix(R) West Nile Virus Assay on a cost-recovery basis under an IND to customers in the United States, meeting the deadline requested by federal health authorities . -- Chiron's Procleix(R) Ultrio(TM) Assay, which adds a hepatitis B virus assay to the current Procleix(R) HIV-f/HCV Assay, is on track for approval of CE marking in Europe by the end of the year, followed by commercial launch . Chiron also expects to file an IND and begin clinical trials in the United States for Ultrio this year . - Chiron saw the resolution of the Commission of the .European Communities inquiry with a joint settlement proposal made by Chiron and Roche, which preserves Chiron's NAT per-donation royalty structure and recognizes the value of the company's intellectual property while potentially expanding the number of Chiron licensees and licensed products serving the European blood-screening marketplace . - Chiron licensed its 14IV and hepatitis C virus (HCV) intellectual property to Baxter AG, a subsidiary of Baxter International, for use in screening plasma in combination with Baxter's own technology in Europe, representing the first license of Chiron's intellectual property for use in plasma fractionation .

Other Recent Business Milestone s In other recent business milestones, Chiron :

` ~' -- Appointed Kenneth W . Bair, Ph .D ., as senior vice president, head of BioPharma research, Chiron Biopharmaceuticals, and Carl Pelzel as senior vice president, BioPharma commercial operations, Chiron BioPharmaceuticals . Dr . Bair was formerly vice president, discovery oncology, Pharmacia Corporation, and Mr . Pelzel was most recently president and CEO of Invenux, a privately held drug discovery company . { 2003 Earnings Conference Cal l

Chiron will hold a conference call and webcast on Wednesday, July 23, 2003, at 4 :45 p .m . Eastern Daylight Time (EDT) to: . review its second-quarter 2003 results of operations and business highlights . In addition, the company may address forward- looking questions concerning business, financial matters and trends affecting the company .

To access either the live webeast or the one-week archive, please log onto http ://www.chiron.com/webcast . Please connect to the website at least 15 minutes prior to the conference call to ensure adequate time to download any necessary software . Alternatively, please call 1-800-374-0907 (U .S.) or 706-643-3367 (international) . Replay is available approximately two hours after the completion of the call through 11 :59 p .m . EDT, Wednesday, July 30, 2003 . To access the replay, please call 1-800- 642-1687 (U .S.) or 706-645-9291 (international) . The conference ID number is 1582120 .

About Chiro n

Chiron Corporation, headquartered in Emeryville, California, is a global pharmaceutical company that leverages a diverse business model to develop and commercialize high-value products that make a difference in people's lives . The company Chiron News Page 5 of 9

has a strategic focus on cancer and infectious disease . Chiron applies its advanced understanding of the biology of cancer and infectious disease to develop products from its platforms in proteins . small molecules and vaccines . The company commercializes its products through three business units : Biopharmaceuticals, Vaccines and Blood Testing . For more information about Chiron, visit the company's website at www .chiron .com .

This news release contains forward-looking statements, including statements regarding sales growth . product development initiatives, new product indications . new product marketing, acquisitions . and in- and out- licensing activities, that involve risks and uncertainties and are-subject to change . A full discussion of the company's operations and financial condition, including factors that may affect its business and future prospects, is contained in documents the company has filed with the SEC, including the form 10-Q for the quarter ended March 31, 2003, and the form 10- K for the year ended December 31 . 2002, and will be contained in all subsequent periodic filings made with the SEC . These documents identity important factors that could cause the company's actual performance to differ from current expectations . including the outcome of clinical trials, regulatory review and approvals, manufacturing capabilities, intellectual property protections and defenses, stock-price and interest-rate volatility, and marketing effectiveness . In particular, there can be no assurance that Chiron will increase sales of existing products, successfully develop and receive approval to market new products, or achieve market acceptance for such new products. There can be no assurance that Chiron's out-licensing activity will generate significant revenue, nor that its in- licensing activities will fully protect it from claims of infringement by third parties . In addition, the company may engage in business opportunities, the successful completion of which are subject to certain risks, including shareholder and regulatory approvals and the integration of operations .

Consistent with SEC Regulation FD, we do not undertake an obligation to update the forward-looking information we are giving today .

NOTE, Encepur, Menjugate , Procleix, Proleukin, RabAvert, TOBI and Ultrio are trademarks of Chiron Corporation . Betaseron and Betaferon are trademarks of Schering AG. Rebif is a trademark of Serono, Inc .

CHIRON CORPORATIO N CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited ) (In thousands, except per share data ) Three Months Ended June 30, 200 3 Pro Forma Pro Forma Adjusted(A) Adjustments . Actual Revenues ; Product sales, ne t $245,928 $-'- $245,92 8 Earnings of unconsolidated joint businesse s 27,475 27 ;475 Collaborative agreement revenues 3,62 4 - 3,62 4 Royalty and license fee revenues 66,876 66,876 Other revenue s 6,369 6,369

Total revenue s 350,27 2 350,27 2

Operating expenses : Cost of sale s 97,420 97,420 Research and development . 89,915 89,915 Selling, general and administrative 79,70 7 79,70 7 Amortization expens e (7,701) 7,70 1 Restructuring and reorganization charge s 519 51 9 Other operating expenses 1,25 9 -- 1,25 9

Total operating expense s 268,820 (7,701) 276,52 1

Income from operation s 81,452 7,701 73,75 1

Interest expense (2,839) (2,839 ) Other income, net 11,61 3 - 11,61 3 Minority interes t (581) (581 )

Income from continuing operations before income taxe s 89,645 7,701 81,94 4 Provision for income taxes 22,412 1,927 20,485

ht+, - //V,- . . . .~~ a . ..-,,,.a1-I- -- =- -y -In - ,~~ .,~ . ., . Chiron News Page 6 of 9

Income from continuing operations 67,233 5,774 61,45 9

Gain on disposal of discontinue d operations 538 -- 53 8

Net income $67,771 $5,774 $61,99 7

Basic Earnings per share ; Income from continuing operations $0 .36 $0 .3 3 Net Income $0 .36 $0 .3 3 Diluted Earnings per share :. Income from continuing . operations $0 .35 $0 .3 2 Net Income $0 .36 $0 .33

Shares used in calculating basi c earnings per share 186,408 186,40 8 Shares used .in calculating dilute d earnings per share 195,191 189,96 3

Three Months Ende d June 30, 200 2 Pro Forma . Pro Forma Adjusted (B) Adjustments Actua l

Revenues : Product sales, net $211,293 $-- $211,29 3 Earnings of unconsolidated join t businesses 27,394 -- 27,39 4 Collaborative agreement revenues 6,602 -- 6,60 2 Royalty and license fee revenues 45,494 . -- 45,49 4 Other revenues 8,495 -- 8,49 5

Total revenues 299,278 -- 299,27 8

Operating expenses ; Cost of sales 76,225 -- 76,22 5 Research and development 83,530 -- 83,53 0 Selling, general and administrative 71,093 -- 71,09 3 Amortization expense -- (7,446) 7,44 6 Restructuring and reorganization charges - - Other operating expenses 899 89 9

Total operating expenses 231,747 (7,446) 239,19 3

Income from operations 67,531 7,446 60,08 5

Interest expense (3,133} . - (3,133 ) Other income, net 12,613 -- 12,61 3 Minority interest (464) -- (464 )

Income from continuing operation s before income taxes 76,547 7,446 69,10 1 Provision foi income taxes 20,668 2,011 18,65 7

Income from continuing operations 55,879 5,435 50,44 4

Gain on disposal of discontinue d operations - -

Net income $55,879 $5,435 $50,44 4

Basic Earnings per share : Income from continuing operations . $0 .29 $0-27 Net Income $0 .29 $0 .27 Chiron News Page 7 of 9

Diluted Earnings per share : Income from continuing operations 50 .29 $0 .26 Net Incom e $0 .29 $0 .2 6

Shares used in calculating basic earnings per share 189,579 189,579 Shares used in calculating diluted earnings per share 192,925 192,92 5

(A) Pro Forma Adjusted amounts exclude the amortization expense on acquired intangible assets related to the acquisitions of PathoGenesis, Chiron Behring"and Pulmopharm .

(B) Pro Forma Adjusted amounts exclude the amortization expense on acquired intangible assets related to the PathoGenesis acquisition and the Chiron Gehring acquisition .

CHIRON CORPORATIO N CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited ) (In thousands, except per share data ) Year to Dat e June 30, 200 3 Pro Forma Pro Form a Adjusted (C) Adjustments Actual . Revenues : Product sales, ne t $464,548 $-- $464,54 8 Earnings of unconsolidated joint businesse s 53,927 -- 53,92 7 Collaborative agreement revenues 7,738 7,73 8 Royalty and license fee revenues 120,300 -- 120,300. Other revenue s 10,381 (14,413) 24,79 4

Total revenues 656,894 (14,413) 671,30 7

Operating expenses : Cost of sale s 183,009 -- 183,00 9 Research and developmen t 172,045 -- 172,04 5 Selling, general and administrative 152,749 -- 152,74 9 Write-off of purchased in-process technologie s Amortization expense - (15,314) 15,31 4 Restructuring and reorganization, charge s 675 -- 67 5 Other operating expenses 2,754 -- 2,79 4

Total operating expenses 511,272 (15,314) 526, 586

Income from operations 145,622 901 144,72 1

Interest expense (6,303) (6,301 ) Other income, net 25,931 -- 25,93 1 Minority interes t (981) -- (981 )

Income from continuing operations before income taxe s 164,271 901 163,37 0 Provision for income taxes 41,069 227 40,84 2

Income from continuing operations 123,202 674 122,52 8

Gain on disposal of discontinued operations 1,964 -- 1,96 4 Chiron New s Page 8 of 9

Net income $125,166 $674 .$124,49 2

Basic earnings per share : Income from continuing operations $0 .66 $0 .66 Net incom e $0 .67 $0 .6 7 Diluted earnings per share : Income from continuing operations $0 .65 $0 .6 5 Net incom e $0 .66 $0 .6 6

Shares used in calculating basic earnings per shar e 186,584 186,58 4 Shares used in calculating diluted earnings per shar e 189,881 1891 .88 1

Year to Date June 30, 200 2 Pro Forma Pro Forma Adjusted (D) Adjustments Actual Revenues : Product sales, ne t $384,877 $-- $384,877 Earnings of unconsolidated joint businesse s 46,192 -- 46,192 Collaborative agreement revenues 12,809 -- 12,809 Royalty and license fee revenues 90,372 -- .90,372 Other revenue s 17,225 -- 17,22 5

Total revenues S51,475 -- 551,475

Operating expenses : Cost of sale s 142,391 -- 142,39 1 Research and developmen t 162,303 -- 162,30 3 Selling, general and administrative 133,863 -- 133,863 ' `>a write-off of purchased in-process technologie s (54,781) 54,78 1 Amortization expense - (14,824) 14,82 4 Restructuring and reorganization charges Other operating expenses 5,482 -- 5,48 2

Total operating expenses 444,039 (69,605) 513,64 4

Income from operation s 107,436 69,605 37,83 1

Interest expense (6,288) -- (6,288 ) Other income, net 32,760 -- 32,76 0 .Minority interes t (883) (883 )

Income from continuing operations before income taxe s 133,025 69,605 63,42 0 Provision for income taxe s 35,917 4,004 31,91 3

Income from continuing operations 97,108 65,601 31,50 7

Gain on disposal of discontinued operations

Net income $97,108 $65,601 $31,50 7

Basic earnings per share : Income from continuing operations $0 .51 $0 .1 7 Net incom e $0 .51 $0 .1 7 Diluted earnings per share : Income from continuing operations $0 .50 $0 .1 6 Net income $0 .50 $0 .1 6

1 _ _, . 1 , , . t , , . , r. y ~ r ~ .~ ,. n , . r ... n _ .-. ~ ~ ...... +. ~. , .~ .•. .. _ Chiron News Page 9 of 9

Shares used in calculating basi c earnings per share 189,536 189,536 Shares used in calculating dilute d earnings per share 193,209 193,20 9

(C) Pro Forma Adjusted amounts exclude : (a) amortization expense on acquired intangible assets related to the acquisitions of PathoGenesis, Chiron Behring and Pulmopharm and (b) the Biogen and Serono settlements in connection with the McCormick patents owned by Schering's U .S . subsidiary, Berlex Labratories .

(D) Pro Forma Adjusted amounts exclude ; (a) write-off of purchased . in-process technologies related to the Matrix acquisition an d (b) amortization expense on acquired identifiable intangible assets related to the PathoGenesis and Chiron Behring acquisitions .

Note: Due to rounding, quarterly earnings per share amounts may not sum fully to yearly earnings per share amounts.

CHIRON CORPORATION . CONDENSED CONSOLIDATED BALANCE SHEET S (Unaudited ) (in thousands) June 30, December 31 , 2003 200 2 Asset s Current assets : Cash and short-term investments $1,147,333 $879,08 0 Accounts receivable, net 289,380 278,62 5 Current portion of notes receivable 750 71.8 Inventories, net 196,005 146,00 5 Other current assets 108,413 86,29 4 Total current assets 1,741,881 1,385,72 2 Noncurrent investments in marketabl e debt securities 119,171 414 ;44 7 Property, plant, equipment an d leasehold improvements, net 403,904 373,55 8 Other noncurrent assets 812,095 786,61 7 Total assets $3,077,051 $2,960,34 4

Liabilities and stockholders' equit y Current liabilities $283,261 $298,63 6 Long-term debt 421,073 416,95 4 Noncurrent unearned revenue 54,711 62,58 0 Other noncurrent liabilities 88,724 81,80 9 Minority .interest 6,115 5,355 Put options -- 19,05 4 Stockholders' equity 2,223,167 2,075,95 6 Total liabilities and stockholders' equity $3,077,051 $2,960,34 4

SOURCE Chiron Corporation